Shulmaven

Federal Reserve Abandons Core Consumer Price Index - My blog in US News, January 26, 2012

2012-01-26T13:17:00.000-08:00

The link below is my blog on the change in Fed policy.

http://www.usnews.com/opinion/blogs/economic-intelligence/2012/01/26/federal-reserve-abandons-core-consumer-price-index

Obama's State of the Union Speech: The Good, the Bad and the Ugly - My Blog on US News 1-25-12

2012-01-25T09:54:00.000-08:00

http://www.usnews.com/opinion/blogs/economic-intelligence/2012/01/25/obamas-state-of-the-union-speech-the-good-the-bad-and-the-ugly

Letter to the Wall Street Journal, January 24, 2012

2012-01-24T05:10:00.000-08:00

You are dead right in calling President Obama, in his rejection of the Keystone XL pipeline "The Anti-Jobs President" (Review & Outlook, Jan. 19). However, you don't go far enough because he is also the antinational-security president. With Iran threatening to close the oil lanes in the Strait of Hormuz, the president is signaling that we are not really serious about energy security. President Obama would rather ship oil in by tanker from the Middle East than by pipeline from Canada. You can bet that the mullahs in Iran are smiling.

Full URL: http://professional.wsj.com/article/SB10001424052970204301404577172882585232096.html?mod=WSJ_Opinion_MIDDLEThirdBucket&mg=reno-secaucus-wsj

The Mullahs of Iran are Smiling

2012-01-18T12:12:00.000-08:00

This afternoon the Obama Administration denied Transcanada Pipeline's long stalled permit to construct the Keystone XL pipeline that would transport oil from Alberta, Canada to the Gulf Coast. We have written before on President's job killing action in delaying the permit for this $8 billion infrastructure project. The ostensible reason for denying the permit was the potential impact of a pipeline leak in Nebraska's Ogallala Aquifier. However a deal has already been made with the Nebraska Legislature to reroute the pipeline around the aquififier. Then why is Obama halting the project?

The answer is simple. He is sacrificing our national security on the alter of the environmental lobby that he deems necessary for his reelection. At a time when Iran is talking of closing off the Gulf of Hormuz to oil shipments and with our navy playing cat and mouse with the Iranian navy, President Obama stalls an energy project that would supply 800,000 barrels of oil per day to our Gulf Coast. Along the way the pipeline would pick up oil from the highly productive Baaken Shale in North Dakota. With completion of the project our nation would be less dependent on oil tankers coming in from Venezuela, the middle-east and Nigeria.

As a result the President just tied one hand behind his back in our upcoming dealings with Iran. To the Mullahs in Iran we are not serious and I am sure they are smiling tonight.

Will the Activist Consumer Come to Apartmentland?

2012-01-07T03:19:00.000-08:00

Paul Polman, the CEO of the consumer products behemoth Unilever, was recently quoted in The Wall Street Journal as saying, "Where we had activist investors in the 2000s, we will see activist consumers this decade." Over the past few months activist consumers armed with a social networking infrastructure have over-turned what appeared to be arbitrary and capricious debit card fees at the Bank of America and billing fees at Verizon Wireless. What the B of A and Verizon have in common is high switching costs. This same factor holds true, even more so, for apartment tenants.

To be sure the apartment business is far more decentralized than wireless services and banking, but make no mistake it is certainly susceptible to the same type of consumer activism. Afterall what can seem more arbitrary than tenants paying different prices for essentially the same apartment unit; a phenomenon created by the use of airline-type yield management software now utilized by large landlords. Furthermore with hotter markets on both coasts exhibiting rental increases well in excess of wage growth, it doesn't take a genius to figure out that tech savvy consumers will soon link up to share information and start to raise a ruckus.

Because of decade low vacancy rates and rising rents, apartments have been the darling of real estate and REIT investors over the past few years. Although rent growth has slowed somewhat in recent months, most investors continue to project out-sized increases over the next few years, especially in Manhattan, Washington, D.C. and the greater San Francisco Bay area. I would doubt that not one in a hundred real estate investors are factoring in the liklihood that their industry will soon be the target of the new activist consumer. The bottom line is that it is highly likely that the apartment sector will soon face headline and in some cases real economic risk to the rosy rent projections now being forecast.

The Long Slump, UCLA Anderson Forecast, December 2011

2011-12-09T03:43:00.000-08:00

“But for a lot of people, I know it doesn’t feel like the recession ever ended. The unemployment rate remains
painfully high, and more than two-fifths of the unemployed have been out of work for longer than six months,
by far the highest ratio since World War II.”1
Ben S. Bernanke

Let’s face it, despite a modestly growing GDP,
the labor market remains mired in a long slump. Next
year will mark the fourth year in a row with an unemployment
rate exceeding 9%, the worst performance
of the postwar era. (See Figure 1) Indeed, the broader
U-6 series, which takes into account part-time workers
seeking full time employment and discouraged
workers, has consistently been above 16%. Put simply,
there are currently 25 million Americans looking
for full-time work. Moreover the employmentpopulation
ratio remains below the level reached
at the official bottom of the recession in 2009. (See
Figure 2) Unfortunately, although we are forecasting
modest job growth on the order of 150,000 jobs
a month, total payroll employment will still be about
three million jobs below the late 2007 peak. (See
Figure 3) Given the decidedly weak labor market, it
is not a coincidence that real personal income is still
below the level reached in 2008. (See Figure 4)

Figure 1 Unemployment Rate, 2005Q1-2013Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Although recent data has improved and the notion
of a double-dip recession now appears to be off
the table, we continue to forecast real GDP growth at
a below trend rate over the next five quarters. Specifically
we are forecasting a 2% growth rate for the
current quarter and a sub-2% growth rate for most of
2012. (See Figure 5) However, for 2013 we envision
growth to exceed 3% as several of the contractionary
forces discussed below abate.

Policy in a Trap: The Ghost of David Ricardo

Pimco’s Bill Gross asked the following question
in his latest missive to investors, “Can you solve a
debt crisis with more debt?”2 The answer is usually
you can, except when sovereign debt in excess
of 80-90% of GDP becomes a barrier to growth.3 In
that case, the concept of Ricardian Equivalence may
come into play.4 David Ricardo, the great early 19th

Figure 2 Employment/Population Ratio, 1948 – October 2011, Monthly Data
Source: Federal Reserve Bank of St. Louis

Figure 3 Payroll Employment 2005Q1-2013Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4 Real Personal Income, 2000 – September 2011, In $Billions, Monthly Data
Sources: Federal Reserve Bank of St. Louis

Figure 5 Real GDP Growth, 2005Q1 – 2013Q4
Source: U.S. Department of Commerce and UCLA Anderson Forecast

century English political economist offered up the
theory that the issuance of government debt is essentially
equivalent to a promise to increase taxation in
the future. Realizing that, taxpayers save more today
to meet their projected tax obligations. When debt
is low, taxpayers do not worry about the prospect of
future taxation because they rightly believe that it will
remain outstanding forever and hence never be paid
off. As a historical matter, most folks have not had
kitchen table conversations about how high deficits
will increase their taxes in the future.

However, when debt is high, there is a very
real prospect that it will have to be paid off in the
future and the funds to make the required payments
will come from increased taxation and reduced
government spending. All of a sudden, the
deficit becomes real! (E.g. Greece) A similar process

Figure 7 Federal Funds vs. 10 Year U.S. Treasury
Yields, 2005Q1- 2013Q4F
Sources: Federal Reserve Board and UCLA Anderson Forecast

occurs in corporate finance where a modest increase
in leverage will actually lower the cost of capital.
However, once leverage is deemed to be excessive by
the financial markets, the cost of capital skyrockets.
Closer to home, the Obama Administration’s
proposals to stimulate the economy with social
security tax cuts and infrastructure spending today
to be financed by tax increases in the future is an
example of Ricardian Equivalence. In this case, the
government is explicitly promising taxpayers that
their taxes will go up in the future; no guesswork is
required. For the American consumer already reeling
from home and stock price declines, the prospect of
future tax increases would weigh on current spending.

Similarly, the Ricardian result holds true, to a lesser
extent, with financing the stimulus with future cuts in
long-term reductions in entitlement programs.
Thus, it is unlikely the economy would receive
the stimulative effects of the fiscal policy that normally
would be predicted by the standard econometric
models. In other words, fiscal policy as we have
known has come to a dead end. This eventuality is
a result of the high-deficit fiscal policy of the past
decade and the projection of mega-deficits as far as
the eye can see, Super Committee or not. (See Figure
6) In fact, the high deficits will occur against a backdrop
of declining real federal purchases, but rapidly
increasing transfer (entitlement) payments.

Similarly, the Fed has been following a full
throttle expansionary monetary policy since 2008.
The Federal Funds rate has been set at zero since
early 2009 and will remain there through 2013. (See
Figure 7) With the policy rate set at zero the Fed has
engaged in two massive quantitative easing programs
and recently put in place an “operation twist” to lower
long-term interest rates.

Another quantitative easing program looms on
the horizon. However, it remains to be seen whether
further policy measures will stimulate the economy.
To be sure the earlier policies likely put a floor under
the 2007-09 recession and planted the seeds for
recovery; it is not clear whether or not the policy has
been all that efficacious of late. Remember the implementation
of the second round of quantitative easing

Figure 6 Federal Surplus/Deficit,
FY 2000 – FY 2021F
Sources: Office of Management and Budget and UCLA Anderson Forecas

Figure 8 Global Stock Market Performance,
2011 through Nov. 25

Sources: The Wall Street journal

in September 2010 triggered inflationary fears with
a run-up in commodity prices that worked to depress
consumer spending. It appears that the Fed might be
pushing on a string, the bane of monetary policy.
Another factor inhibiting monetary policy is the
notion that very low interest rates can be contractionary.

I know this goes against the grain of Keynesian
theory, but there may be a new kind of paradox
of thrift at work. A year ago we wrote about the
phenomenon of how low interest rates actually can
encourage savings and reduce consumption.5 How
so? With very low interest rates, pension plans require
increased contributions to meet their actuarial obligations.
The same principle holds true for defined
contribution plans where a target level of savings has
to be reached in order to fund the desired amount of
retirement income.

Because the retirement planning
for most Americans never contemplated a 2% 10-Year
U.S. Treasury bond, the average American facing retirement
over the next 10-15 years is between a rock
and a hard place. Indeed, for those already retired,
low interest rates act as a depressant on consumption.
Thus, while low interest rates work to stimulate
purchases of homes, consumer durables and business
equipment, there is a very real drag coming
from reduced everyday consumption for current and
prospective retirees. Because we are in a whole new
world with respect to interest rates, it is still too early
to tell how powerful in suppressing demand the new
paradox of thrift is.

The Crisis in Europe

The economic situation in Europe continues
to deteriorate with the Eurozone placing its member
countries in straight jacket similar to the gold
standard rules of a century ago. Without the ability
to devalue their respective currencies, the troubled
countries of Portugal, Italy, Ireland, Greece, Spain
and perhaps France are forced to deflate their domestic
economies. Austerity is the rule of the day and it is
likely that the continent will be in recession next year.

With that, U.S exports to the Euro region will
slow and similarly for Asian and Latin American
exports thereby depressing activity world-wide. Thus,
the global economy will grow more slowly in 2012
than 2011. And this assumes that we avoid a full
blown banking crisis in Europe that could bring with
it a world-wide restriction in credit analogous to the
Lehman Brothers collapse of 2008.

Therefore, it is not an accident that most of the
world’s stock markets have suffered declines this
year. In fact, even with the August and November
swoons in U.S. share prices, the U.S. stock market
has held up far better than its counterparts around the
world. For example, as of late-November, the U.S.
market was down 8% year-to-date, while Germany
was down 21%, France down 25%, Japan down 20%,
China down 16%, and Brazil down 21%. (See Figure 8)

Figure 10 Real Consumer Spending,
2005Q1 – 2013Q4F

Sources: U.S. Cepartment of Commerce and UCLA Anderson Forecast

As a result, we forecast that after increasing
11.3% in 2010 and an estimated 6.6% this year, we
forecast that real exports will increase by only 3.4%
in 2012 and rebound to a healthy 7.7% in 2013.(See
Figure 9) The recently announced $40 billion airplane
orders announced by Boeing certainly augers well for
export growth later in the decade.

The Domestic Economy

Despite the scare coming from the recent decline
in stock prices, consumer spending, especially
on automobiles is continuing to grow. (See Figures
10 and 11) To be sure, the recent gains in consumer
spending might not be maintained, but, unlike the
sluggishness earlier in the year, it will remain a
source of modest strength. Moreover, automobile
sales are being buoyed by pure replacement demand
as the fleet is reaching the limits of aging. Furthermore,
housing starts have bottomed and while this
sector won’t be a major source of growth in 2012
we suspect that 2013 will bring with it a rebound in
construction as the backlog of excess supply is eaten
into. (See Figure 12)

Although investment in equipment and software
will continue to grow in 2013, it will come off of its
heady double-digit pace of the past two years. (See
Figure 13) We are forecasting growth of 6.7% and
7.1% in 2012 and 2013, respectively. Nevertheless,
this sector will be growing three times faster than the
overall economy.

Of course as we have noted for many years, the
state and local sector is undergoing a fundamental
restructuring as real spending continues to decline.
(See figure 14) Because of the prevalence of defined
benefit plans, this sector is being especially harmed
by the very low interest rates we are experiencing.
Last month, Rhode Island, under the weight of a huge
unfunded liability, radically reformed its pension
plans that included cuts for existing beneficiaries.
Put bluntly, the laws of arithmetic are overcoming

Figure 9 Real Exports, 2000 – 2013F,
Percent Change
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 11 Automobile Sales, 2005Q1 – 2013Q4
Sources: UCLA Anderson Forecast

Figure 12 Housing Starts, 2005Q1 – 2013Q4F,
in thousands, SAAR
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 13 Real Investment in Equipment and
Software, 2000 -2013F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 14 Real State and Local Government
Spending, 2005 – 2013F, Percent Change
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

the laws of politics, even in the very unionized and
very Democratic state of Rhode Island
Conclusion

The United States is facing an unemployment
crisis in a slow growth economy. A modestly growing
GDP on the order of 2% will not be sufficient
to lower the unemployment rate much below 9%
through 2013. Furthermore, government policy seems
to be incapable of noticeably improving the situation.
Indeed the Federal government will be reducing
purchases during the forecast period. The economy
will be sustained by modest increases in consumption
and business investment along with the beginnings of
a housing recovery in 2013.

Endnotes
1. Bernanke, Ben S., Remarks, At the Town Hall Meeting with Soldiers and Their Families, Fort Bliss, Texas, November 10, 2011, Board of
Governors of the Federal Reserve System.
2. Gross, William H., “Pennies from Heaven,” Pimco Investment Outlook, November 2011.
3. See Reinhart, Carmen M., and Kenneth S. Rogoff, “This Time is Different,” Princeton, Princeton University Press, 2009.
4. See Ricardo, David (1820), “Essay on the Funding System,” in “The Works of David Ricardo on the Life and Writings of the Author, J.R.
McColloch, London, John Murray, 1888. For the modern version of Ricardian Equivalence see, Barro, Robert J., “Are Government
Bonds Net Wealth,” Journal of Political Economy, 82:6, 1095-1117 and “On the Determination of the Public Debt,” Journal of Political
Economy, 87:5, 940-971.
5. See Shulman, David, “Risky Business,” UCLA Anderson Forecast, December 2010.

Letter to the Star Ledger, December 1

2011-12-01T04:46:00.000-08:00

The article “State’s corporate tax subsidies don’t pay off,” (Nov. 27) is absolutely correct in arguing that taxpayers pay a high price to generate a few jobs.

However, the author is wrong when she says the tax subsidies should be used instead to pay for more government.

If New Jersey is to make some headway in solving our unemployment crisis, it would be far better to lower all corporate taxes and lighten the regulatory burden on business.

It is no accident that New Jersey lagged behind in the past decade as years of Democratic administration policies exacted their toll.

David Shulman

The Dumb Party and the Evil Party

2011-11-19T04:36:00.001-08:00

We Americans are blessed with two major political parties; the dumb party and the evil party. Without question the Republican party is the dumb party. Never have I seen such a collection of wack-job candidates for the presidency and never have I seen such intolerant audiences at the debates. I am truly ashamed.

Look at the field, you have Newt Gingrich, a politician who has more baggage than Samsonite. Then you have a cranky old man in the person of Ron Paul. There is the lovely Michele Bachmann who makes a pretty good impersonation of the wicked witch in The Wizard of Oz. There is Rick Santorum who is so up tight that he looks like he is holding a pea in his butt. What I can I say about Herman Cain, a candidate who talks well but is just not ready for prime time. Forget about the sexual harassment allegations, he just doesn't know what's happening in the world. Then there is the distinguished governor of Texas, Rick Perry. He can't remember what agencies he wants to eliminate. Now Mitt Romney is a very bright guy, but he has taken two sides on all too many important issues so it is hard to tell what is core beliefs are. Jon Huntsman is the class act in field, but in the year of wack jobs, his nomination is not going to happen.

Most alarming is the field's elevating tax policy to a religion. Face it, tax increases will be necessary to solve our fiscal mess and any deal that offers up five or six dollar of spending cuts for every dollar of tax increases should be welcomed with open arms.

So much for the Republicans being dumb; the Democrats are evil. Why? They lie to the people. It is evil to make promises to people that can't be kept. They promise an entitlement state that they can't deliver on. It is cruel to offer a great pension to a 50 year old that won't be there when the employee retires. It is evil to say they support manufacturing and then come up with a host of rules making it impossible to manufacture. They support energy independence, except it can't be accomplished with domestic drilling and a pipeline infrastructure. They chase the chimera of "green tech" knowing it won't supply more than a few percent our energy needs in 2020.

Yes folks, we will have quite a choice to make in 2012.

Obama the Job Killer

2011-11-10T17:03:00.000-08:00

In delaying the Keystone XL pipeline to 2013, President Obama proved once and for all that he does not care about jobs, except perhaps his own. In kowtowing to the environmental lobby the $8 billion infrastucture project that would transport oil from the Canadian oilsands to the Gulf coast, President Obama is holding about 23,000direct jobs hostage to his political whim. Furthermore, upon completion we would have significantly improved our energy security. We would substitute Canadian oil for middle-eastern oil, a great trade-off, but not in the eyes of our President.

Let us hope that we will soon have a more enlightened leadership in the White House.

Shulmaven on CNBC

2011-10-12T11:43:00.000-07:00

I appeared on CNBC today discussing the Occupy Wall Street demonstrations and the unemployment crisis facing our nation. The interview was carried by a MSNBC blog.

The full URL: http://bottomline.msnbc.msn.com/_news/2011/10/12/8288425-cnbc-is-all-the-bashing-of-wall-street-warranted

Zakaria Supports Shulmaven on Infrastructure Projects

2011-09-29T03:51:00.000-07:00

Washington Post columnist Fareed Zakaria endorsed the Shulmaven proposal to fast-track environmental approvals and Davis-Bacon Act waivers for new infrastructure projects.He like Shulmaven understands we face a jobs emergency. This list grows.

full URL : http://www.washingtonpost.com/opinions/where-obamas-jobs-bill-falls-short/2011/09/28/gIQA5jne5K_story.html?hpid=z3

Stalled, UCLA Anderson Forecast, September 2011

2011-09-23T12:03:00.000-07:00

“Developments this summer have indicated we are on a dangerous new phase. The stakes are clear: we risk seeing the fragile recovery derailed.”1

Christine Lagarde, Managing Director, International Monetary Fund

The economy has stalled. To be sure, it has not
gone backward into recession, but there is certainly
no forward momentum and our outlook is far worse
than just three months ago. In fact, given the surprisingly
weak revised data for the first half of the year,
we expect that in the five quarter period ending in the
first quarter of 2012, economic growth will average
a decidedly weak 0.9%. (See Figure 1) If there ever
were an economy operating at “stall speed”, this one
is it.

We first introduced the concept of “stall speed”
in September 2007 and again discussed it in September
2008. In fact, we used the same “Stalled” title in
September 2008. What is it about September? The
concept of “stall speed” involves an economy growing
so slowly that any modest shock can trigger a
full-blown recession, just as when an airplane’s velocity
slows to such an extent where it can no longer
fly.2

Figure 1 Real GDP Growth, 2005Q1 – 2013Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

We are not, however, forecasting a new recession.
Why? Simply put, the three sectors that would
normally put the economy into recession are already
depressed; those being housing, consumer durables
and inventories. Even if housing starts drop to new
lows, this sector of the economy has shriveled so
much that it would only have a modest impact on
economic activity. For example, it is one thing for
housing starts to decline from an annual pace of two
million units to one million units and quite another
for starts to decline from 600,000 units to 300,000
units.

Thus, if we are to have a new recession it
would have to come from a collapse in exports, a generalized
decline in consumer spending with a resultant
decline in business investment. All plausible, but
we are not forecasting that eventuality.
Instead, we forecast economic growth to gradually
rebound in mid-2012 with the economy growing
at a modest 2.5% - 3% clip The factors driving the
return to growth include modest gains in exports,
consumption and equipment and software investment.
In that environment, employment growth will become
more meaningful with gains averaging about 150,000
jobs a month and the unemployment rate falling to a
still very high 8.6% by the end of 2013.

Nevertheless, recession or not, the employment
situation remains horrible. Job growth has stalled and
we forecast that the unemployment rate will soon
rise to 9.5%, above August’s elevated rate of 9.1%.
(See Figures 2 and 3) Thus, even by the end of 2013
we will not be back to the employment levels of late
2007. Indeed, the unemployment rate is being masked
by an unprecedented decline in the employment/
population ratio which is back to where it was in the
early 1980s. (See Figure 4) Simply put, while many
workers have left the labor force by going back to
school, retiring, or staying home to raise children --
all too many have left the labor force and have simply
given up.

Figure 2 Payroll Employment, 2005Q1 – 2013Q4

Source:Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3 Unemployment Rate, 2005Q1 -2013Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Therefore, in terms of the labor market,
we are not in an economic recovery, but rather
we remain mired in one long slump. This view is
consistent with the consumer confidence surveys and
the very low esteem the public has for the elected
branches of government.

Government Policy Response

From the beginning of the financial crisis in
August 2007, the Federal Reserve has thrown all but
the kitchen sink at the economy to forestall what they
thought to be the start of a new great depression. We
have witnessed a raft of special programs and two
major attempts at quantitative easing. Policy rates
have been set at zero since 2009 and the Fed has told
us that they will remain at zero through mid-2013,
truly an unprecedented step. (See Figure 5) With
the Fed anchoring the short end of the yield curve,
long-term interest rates have come in as well, with the

Figure 4 Employment/Population Ratio, 1948 –August 2013, Monthly Data

Sources: Federal Reserve Bank of St. Louis

Figure 5 Federal Funds vs. 10 Year U.S. Treasury
Yields, 2005Q1 – 2013Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

10-year U.S. Treasury bond actually breaching 2%.
Make no mistake, the last time we have seen government
yields this low was during the Great Depression.
To be sure, the Fed can do more, such as embarking
on another bond buying spree in the form of
a third quantitative easing program, but to us, it looks
like they are just about out of policy bullets. Furthermore,
it is not clear that the second round of quantitative
easing even worked.

To be sure, it elevated stock
prices for a while, but it also seems to have ignited
a commodity price surge that lowered real incomes
and sapped consumer confidence with gasoline prices
temporarily breaking through the psychologically
important $4 a gallon price barrier. Nevertheless,
because of the Fed’s dual mandate, they will have to
act. Our best guess is that the Fed will engage in an
“Operation Twist” where they will emphasize the purchase
of long maturities, to bring down already low,
longer-term interest rates.

Fiscal policy is caught in a trap. The July downgrade
of U.S. credit by Standard & Poor’s signaled
what we already knew. The plain fact is that the
federal government will be in an extended period of
fiscal consolidation, a fancy way of saying that longterm
budget deficits will be significantly reigned in.
(See Figure 6) Thus, it is highly unlikely that we will
see a fiscal stimulus program anywhere near the $800
billion appropriated in 2009. Nevertheless, assuming
a credible long-term fiscal consolidation program
can be put in place, admittedly a big assumption, the
federal government could step up near-term spending
on infrastructure and selectively cut payroll taxes.
However, given the lack of comity in Washington,
D.C., we are assuming only modest policy
adjustments. Specifically, for modeling purposes
we are assuming a continuation into 2012 of the 2%
payroll tax cut and the extension of emergency unemployment
benefits, reauthorization of the Surface
Transportation Act, and regulatory changes to make it
easier for homeowners with “under-water” mortgages
to refinance.

Why the Downward Revision to the Outlook?

Our case for recovery rested on the belief that
strong growth in exports coupled with continued
strength in business investment along with a modest
recovery in consumption and housing would generate
a subpar recovery on the order of 3% growth rate in
real GDP. It hasn’t quite turned out that way. To be
sure, exports are still growing, but not as fast as we
thought. (See Figure 7) Weakness in Europe, where
about one-third of our exports go, is casting a pall
over the sector. Furthermore, both Canada and Japan
suffered a decline in real GDP in the second quarter.
As a result, real exports are now expected to run $50-
$60 billion a year below what we previously thought
in 2012 and 2013. Business investment is remaining
strong, but the boost we expected from high-technology
capital goods is not as strong as we thought.

Figure 6 Federal Surplus/Deficit,
FY 2000 – FY2021F

Sources: Office of Management and Budget and UCLA Anderson Forecast

Figure 7 Real Exports, 2005Q1 -2013Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 8 S&P 500, Sep 2010- 2 Sep 2011, Daily Data

Sources: BigCharts.com

The situation in Europe is especially ominous.
The PIIGS (Portugal, Ireland, Italy, Greece and
Spain) are facing huge budgetary cutbacks to generate
the cash needed to service their debts. The European
banking system remains weighed down with not
only weak sovereign credits, but private credits that
have yet to be marked to market. As a result, a new
round of bank recapitalizations will be required. The
European bank stress tests were not quite as stressful
as they should have been. In the meantime, U.S.
money funds withdraw assets from European banks
conjuring up the nightmare of September 2008 when
Lehman Brothers failed. We are not there yet, but the
German stock market highlighted the nervousness by
dropping 20% in August. Thus, until Europe sorts itself
out, the global economy and U.S. exports remain
at risk.

We knew that consumer spending would remain
weak, but the recent 18% decline in stock prices from
the 2011 high to the August low has made us very
nervous about the high-end consumer. (See Figure
8) Remember that 5% of the households account for
40% of all household income and that has been the
force driving consumer spending on up-scale goods.
Before getting too carried away with the decline in
stock prices, we should recall Paul Samuelson’s famous
quip that “the stock market forecast nine out of
the past five recessions.”

Nevertheless, with the deleveraging process
far from complete, volatility in equity prices are
especially worrisome. Yes, consumer debt remains
$136 billion off its 2008 high, but that decline can be
accounted for by roughly the same amount of bank
loan charge-offs. (See Figure 9) That means that until
the debt is settled, the consumer still believes he/she
owes the full amount to the financial institution. The
loan is “dead” on the bank’s books, but could very
well be alive on consumer’s personal books. It’s no
fun being hounded by collection agencies.

We were right early on in the middle 2000s that
housing was in a bubble. However, for the past three
years we have been forecasting a recovery in housing
starts. It has yet to come. Thus, once again we are
ratcheting down our view. We now forecast housing
starts of 612,000, 709,000 and 967,000 units in 2011,
2012 and 2013, respectively. (See Figure 10) Last
quarter, for example, we were at 1,311,000 units for
2013. Quite a comedown. Furthermore, the reduction
in conforming loan limits from $729,750 to $625,500
on October 1st, though well justified on public policy
grounds, probably will exacerbate housing activity in
high cost areas over the near-term.

Figure 9 Total Consumer Credit Outstanding, 2000 – June 2011, In $ Billions, Monthly Data

Sources: Federal Reserve Bank of St. Louis

State and Local Governments in Fiscal
Consolidation Phase

Of necessity, rather than virtue, state and local
governments have been operating in a fiscal consolidation
phase since 2008. The tax receipts aren’t there
and unlike the federal government, the states find it
extremely difficult to run sustained deficits. To be
sure, there are exceptions, notably California, Illinois
and New Jersey, but even these three states have
taken the knife to their spending budgets. As a result,
by 2013, real state and local government spending
will have declined for six straight years. (Figure 11)
As we have noted before, the process of fiscal
consolidation is ongoing and it will be worsened
by changes in the healthcare law that will mandate
higher Medicaid spending. Because Medicaid gener-
ally accounts for between 15-30% of a state’s spending,
increases here are certainly non-trivial.

When combined with unfunded public employee pension
and post-retirement healthcare benefits, it is not hard
to see why state and local governments will find
themselves cash strapped for many years to come.
Indeed, the very low interest rates fostered by
the Fed will exacerbate the stress on pension plans.
Put bluntly, there isn’t a pension planner alive today
who thought the benchmark 10-year U.S. Treasury
bond would be yielding close to 2%. With actuarial
yield requirements at 7.5%-9%, the normal pension
arithmetic does not compute. Another way of looking
at the problem is that it represents the mirror image of
the Federal government’s obligations to fund Medicare
and social security.

Figure 10 Housing Starts, 2005 – 2013F

Sources: Bureau of the Census and UCLA Anderson Forecast

Figure 11 Real State & Local Government
Expenditures, 2000- 2013F

Sources: Department of Commerce and UCLA Anderson Forecast

Conclusion

As we noted at the outset, the economy is
stalled. Growth will be minimal over the next few
quarters and thereafter there will be enough strength
in exports and business investment along with modest
increases in consumption to propel the economy
forward at a 2.5%-3% pace. Fed policy will be as
accommodative as it can get, but fiscal policy is hampered
by the realities of the budget deficit and political
gridlock. In this environment, job growth will be
sluggish and unemployment will remain at recession
levels. The big risk is that fiscal and monetary problems
in Europe spill over into a generalized credit
crisis thereby triggering a global recession.

Endnotes
1. Lagarde, Christine, “Global Risks are Rising, But There is a Path to Recovery,” Remarks at Jackson Hole, August 27, 2011.
2. See Shulman, David, “A Near Recession Experience,” UCLA Anderson Forecast, September 2007 and “Stalled,” UCLA Anderson
Forecast, September 2008. For a technical discussion see, Nalewaik, Jeremy J., ,”Forecasting Recessions Using Stall Speeds,” Finance
and Economics Discussion Series 2011-24, Board of Governors of the Federal Reserve System.

Does Obama Really Care about Jobs?

2011-09-13T16:24:00.000-07:00

After President Obama's speech last week I was hopeful that we were close to some significant Federal action on the jobs front. (See my earlier post). But after seeing how the president wants to pay for his $447 billion program, I fear that all he really wants is a political issue. Put bluntly, jobs are secondary to him keeping his own job. He wants a fight, not a program.

The so-called "pay fors" are completely a non-starter with the House Republicans and some Senate Democrats. The president has trotted out his old income redistribution stand-byes of limiting tax deductions for high income earners, taxing a portion of hitherto tax exempt state and local interest, and increasing taxes on oil companies, hedge fund partners and corporate jet owners. It is obvious that income redistribution has a higher priority than employment for this administration. To be sure taxes are going to have to raised on high income earners, but that should be done in the context of deficit reduction. To use those revenues to fund a temporary jobs program, makes long term deficit reduction even more difficult.

If the President wanted to show his bona fides on the jobs issuue he should have offered up an array of liberal favorites in the health, education, environmental and entitlement areas. That would prove that among all other liberal goals, increasing employment is the first priority. As a result the unemployed will once again witness a food fight on Capitol Hill.

Obama Jobs Program: Good, but Less than Meets the Eye

2011-09-10T12:13:00.000-07:00

President Obama unveiled his $447 billion jobs program last Thursday. Most of the elements make sense and it will be far better than the $800 billion stimulus package put together by the then House Speaker, Nancy Pelosi in 2009. Several economists done cartwheels over the program, most notably Mark Zandi of Moody's, arguing that the program has the potential to increase economic growth by a full two percentage points next year. Trust me, Mark is either dreaming or totally in the tank for the Obama Administration.

In its essential elements the program envisions a 3.1% cut in payroll taxes for workers, up from the current 2%($175 bil.) a 3.1% cut in payroll taxes for businesses for incremental payrolls up to $50 million(($65 bil.)an extension of emergency unemployment benefits( $49 bil.) teacher and public employee retention($35 bil.), modernizing transportation infrastructure ($50 bil.) fixing schools($35 bil) and a few other things. First, most forecasters already modeled in the existing 2% payroll tax cut and the extention of emergency unemployment benefits. Second, not all of this will pass. Third, no forecaster has made any allowance for the contractionary effects of increasing taxes and/or cutting other spending to pay for the $447 billion program. Remember the President said the program will be paid for. If it is paid for concurrently, there is no Keynesian stimulus. Nevertheless, as I have been arguing for over a year, at least the Administration is trying to do something about the scourge of mass unemployment facing our country. Net net, it will help but not a whole lot.

Why? There was no mention energy development in the speech a private sector way of creating jobs. There was no mention of fast-tracking environmental approvals for the transportation project which means it will take forever for them to get started and of course all of this will be subject to costs and the rulemaking asociated with the prevailing wage requirements of the Davis-Bacon Act.

Buried in the speech there was a ray of hope on entitlement reform. The President admitted with respect to Medicare,"with an aging population and rising healthcare costs, we are spending too fast to sustain the program." He later added, "We have to reform Medicare to strengthen it." A very big admission and it opens the way for an entitlement deal later in the year.

Hiding from the Numbers

2011-09-03T04:49:00.000-07:00

Yesterday brought with it horrible data on employment. Job creation stalled with ZERO job growth reported for August. The unemployment rate remained at 9.1% and hourly wages and hours worked were actually down. Ugly numbers. But where was President Obama? He was nowhere to be seen. If the numbers were good he would have been in the Rose Garden promoting his economic policies. He shouldn't really do that either. Good data speak for themselves.

Our President unfortunately forgets that his task is to level with the American people. He failed yesterday. A great leader does not hide from bad news he discusses it in a straight forward manner. For example, in 1940 when the French Army collapsed in the face of the Nazi onslaught, Winston Churchill went on the air with "The news from France is bad."

The lesson here is simple, don't hide from the American people.

Bloomberg Endorses Shulmaven View for Infrastructure Projects

2011-08-23T14:21:00.001-07:00

Bloomberg News has joined Mort Zuckerman of US News and Noam Sheiber of The New Republic in endorsing the Shulmaven view of fast-tracking environmental approvals and waiving the prevailing wage requirements of the Davis-Bacon Act for new infrastructure projects. Their editorial calls for a $100 billion program. Hopefully President Obama will see the light.

Full url: http://www.bloomberg.com/news/2011-08-23/a-public-works-spending-deal-even-the-republican-party-can-embrace-view.html

An Open Letter to President Obama on Jobs

2011-08-21T04:07:00.000-07:00

Dear Mr. President:

I hope you are enjoying your working vacation in Martha's Vinyard. You sure could use a break from Washington and the emerging bear market on Wall Street. You told us that you will address the nation on the need to create jobs after Labor Day. I hope you come up with some good ideas in the clean ocean air. We surely can use them because we have a real employment emergency that is draining both the economy and the spirit of our nation.

Given the emergency, I assume that you are open to a few new and some old ideas about job creation. All the ideas you mentioned on your midwest tour such as ratifying the free trade agreements, passing the new patent law, extending the social security tax cut and extending unemployment benefits are mostly helpful, but they really won't do a whole lot in the short run.

So here are a few ideas that might move the dial.

1. We need an all out domestic energy program. That means more offshore drilling, establishing clear rules and best practices for hydraulic fracturing drilling technolgy that has the real potential to limit our dependence on foreign oil and approving the privately financed Keystone XL Pipeline that will bring Canadian oil to our gulf coast. Note that all of the above does not involve tax dollars. On the public side keep up and step up the research into energy alternatives, but have no illusions about all of the "green" jobs it will create.

2. Spend big on infrastucture. The $50 billion infrastructure bank is small potatoes and may take awhile to launch. Spend $200 billion, but fast track or eliminate the environmental approval process and waive the prevailing wage requirements of the Davis-Bacon Act. With very low interest rates and high unemployment, now is the time to borrow and spend for worthy projects.

3. Give employers a 5% tax credit for increasing their wage bill subject to FICA employment taxes. I think this would work far better than your current payroll tax cut.

4. Have Treasury sit down with the business lobbies and cut a deal on corporate tax reform to present to the Congress. I fear the normal process might take forever.

5. Fund the above with a combination of a one-time lower tax rate for repatriating foreign sourced corporate earnings that are idling overseas, a higher gasoline tax and a down payment on entitlement reform. By the way, if you can get it, going big on a grand bargain for reducing our structural deficit is good idea, but you have to convince yourself and your friends in Congress that the real heavy lifting has to be on the spending side.

None of this will be easy, but when you are President all the easy stuff gets decided before it gets to you. Enjoy your vacation and come back with a real program.

Sincerely,

David Shulman

The Debt Ceiling Deal: Looking for Cuts in All of the Wrong Places

2011-08-02T08:18:00.001-07:00

At last the debt ceiling deal is done. Our nation won't default and there will be about $2.2 trillion in cuts,although there maybe some tax increases included in that number. However $2.2 trillion represents a small downpayment on the $8 trillion that will ultimately be required. Yes, $8 trillion. The much discussed $4 trillion grand bargain was also only a downpayment on what is needed. Moreover with the economy softening much of the $2.2 trillion will be washed away with lower tax collections and higher automatic spending. Thus don't be surprised if we see both tax cuts and spending back on the agenda in the Fall.

The real problem with the deal is that the cuts are in the wrong places. Too be sure much Nancy Pelosi's stimulus package of two years ago had to be undone, but our nation still needs infrastructure, research and yes, defense spending. In my opinion we will come to regret the steep cuts in the defense budget.

What should have been cut are the three big drivers of the longer term deficit: medicare, medicaid and social security. The Republicans made a huge mistake in not offering up some tax increases to achieve cuts in these areas. Unfortunately we will have to wait until 2013 until painful cuts have to made in the major entitlement programs. What I am writing about is not politics, but rather arithmetic. Bluntly put, medicare, medicaid and social security are not sustainable. Indeed it is likely that in a few years we will say the same thing about Obamacare.

As an aside an elegant deficit reduction plan would have kept the taxes embedded in Obamacare and delayed implementation of the spending for three years. But the President and the Democrats really don't care about deficit reduction, just as the refusal of the Republicans to to accept modest tax increases demonstrate that, they too, do not care about deficit reduction either. The Simpson-Bowles Commission had it right and President Obama's biggest political mistake was his failure to endorse the their recomendations.

Letter to The Wall Street Journal, July 14, 2011

2011-07-14T05:44:00.000-07:00

Your front-page article "Canada Has Plenty of Oil, But Does the U.S. Want It?" (July 8) highlights the fact that the U.S. environmental lobby and its helpers in Congress are truly the "party of no."

It seems that the environmental lobby is against developing the Canadian oil sands, drilling offshore, drilling in the Alaskan wilderness, hydraulic fracturing, mountain-top coal mining, electric transmission lines connecting solar power to the grid in the California desert and nuclear power.

To be sure, there are and always have been environmental issues associated with energy development, but I wonder where the environmental lobby is going to get the power to air-condition its plush offices in Washington, D.C. We may just as well mail in the keys to our nation to Saudi Arabia if we are going to say "no" to all energy development.

Full url - http://online.wsj.com/public/page/letters.html?mod=WSJ_topnav_na_opinion

The End of a Dream

2011-07-09T13:39:00.000-07:00

As a child of the space age I am especially saddened that with the final voyage of the space shuttle Atlantis we are witnessing the end of the manned space program. I vividly remember watching the first moon landing on a grainy black and white TV in my Fort Bragg orderly room on a hot July night in 1969. If you asked me then what the future would bring, I would most certainly have said that by 2011 we would be launching star fleets to Mars and Venus. We dreamed big things back then. Now our dreams seem pitifully small and we can't even do little things like fixing roads and bridges.

I think the political process grossly underestimates the need a society has for heroes and big projects. I was at astronaut John Glenn's ticker tape parade in 1962 after he returned from space. Glen was a real hero. Although President Kennedy was not as popular when he was in office than he is today, the space program was among his most popular efforts.

It was the space program that inspired millions of students to become scientists and engineers and we have been living off of that legacy for decades. The astronauts were far better roll models for kids to look up to than the reality television of today.

I know that latter thought proves that I am a curmudgeon, but trust me, with this last flight, we are losing something real.

Hiding in Plain Sight: Mass Unemployment

2011-06-29T05:38:00.001-07:00

Last night I attended the annual Loeb Awards dinner sponsored by the UCLA Anderson School which honors the best that business journalism has to offer. You can call it the Pulitzer Prizes for business journalism. All of the main characters from The Wall Street Journal, The New York Times, The Washington Post, Bloomberg, CNBC, etc were there.

To be sure all of the awards were relevant and they honored stories, among others, on the BP blowout in the Gulf, the scandal at Remington Firearms, and a significant book on hedge funds, but just like last year there was nary a mention on the unemployment crisis facing America. We are now in the third year of the worst unemployment crisis since the 1930s and nobody seems to care.

It seems that politicians of both parties and the journalists who cover them are in a conspiracy of silence. Maybe no one has any real solutions or maybe too many of the unemployed are out of sight and out of the minds of the policy elites, but make no mistake our country is being destroyed worker by worker. Unless there will be a dramatic change, this is one story that will end very badly.

The Outlook for Commercial Estate: Asset Prices Ahead of Fundamentals, UCLA Anderson Forecast, June 2011

2011-06-16T11:14:00.000-07:00

The bull market psychology of the mid-2000s has returned to commercial real estate with prices for quality properties just 13% below their bubble peak in 2006. (See Figure 1) Near record low cap rates (the cash yield before capital expenses for real estate) of below 5% for quality office buildings in Manhattan and Washington, D.C. and for Class A apartments in broader geographies are becoming more the rule than the exception. In contrast assets in less than desirable markets are trading at 7-9% cap rates. Indeed the Manhattan office market has become so frothy that developers are now talking about starting 25 million square feet of space this decade, the highest level since the 1980s.

Similarly, though still well below their 2007 peak, the publicly traded real estate investment trusts (REITs) have tripled off their financial crisis lows of March 2009. (See Figure 2) Moreover, bankers who as recently as twelve months ago were shunning real estate loans have aggressively returned to the market. Simply put a near zero federal funds rate and 3% 10-Year U.S. Treasury yields have lit a fire underneath the high quality end of the real estate market.

Figure 1. Green Street Advisors Commercial Property Index, Dec 97 – April 11

Source: Green Street Advisors

Figure 2. Dow jones Real Estate index, I-Shares, June 2006 –27 May 2011, Weekly Data

Source: BigCharts.com

Indeed the long moribund commercial mortgage backed securities (CMBS) market is showing signs of recovery. Although issuance remains low, spreads for existing securities have dropped enough to enable new securities to be created. (See Figure 3) However, the Dodd-Frank financial reform legislation requirement for issuers to retain an interest in the securitization may limit a full revival of this sector of the market.

Figure 3. CMBS Issuance, 1999-2011E, In $billions

Source: FBR Capital Markets and UCLA Anderson Forecast

Despite the ebullience discussed above, all is not well in the commercial real estate capital market. When you go beyond “A-List” properties regional and community banks are probably sitting on about $200 billion in 20% or more “under-water” real estate loans. The nation remains littered with vacant office buildings, warehouses, hotels and strip centers in fringe locations. Indeed even higher quality assets in what are perceived to be second and third tier cities find it difficult to attract a bid from institutional investors. Of course the longer interest rates remain abnormally low the likelihood increases that the search for yield will ultimately find its way to assets that the institutional investor community are currently shunning.

Thus as long as the interest rate environment remains benign, commercial real estate capital markets will continue to do well. At least until the over-leveraging excesses of a few years ago return. However, the very low interest rate environment is not likely to remain with us for long. After all that environment is a result of the emergency conditions of the financial crisis. As we mention elsewhere in this forecast report, we expect both long and short term interest rates to raise, with 10-Year U.S. Treasury yields approaching 5% in 2013 and with that the very low cap rates of today will give way to a pricing correction.

Figure 4. Federal Funds vs. 10 Year U.S. Treasury Yields, 2000Q1 – 2013Q4F

Sources: Federal Reserve Board and UCLA Anderson Forecast

Lack of Supply Underpins Fundamentals

The financial crisis of 2007-2009, for all practical purposes, halted commercial construction. (See Figures 5 and 6) Since the 2007 peak total commercial construction declined by 64%, new starts by 80% and multi-family housing starts also suffered a peak to trough decline of 80%. To be sure, the collapse in demand coupled with the completion of starts occurring during the boom, sent vacancy rates soaring. (See Figure 6) But with no new supply, even modest increases in demand will work to gradually lower vacancy rates over time and with that rents will increase and in the case of apartments, because of some very special factors, rents are already rising noticeably.

Figure 5. Real Commercial Construction Spending, 2000Q1 – 2013Q13F
Source: IHS Global Insight and UCLA Anderson Forecast

Figure 6. Multifamily Housing Starts, 2000Q1 – 2013Q4F

Sources: U.S. Department of Commerce, and UCLA Anderson Forecast

But Weak Demand is the Problem

Although supply is not a problem; demand is. Simply put the economy is growing far too slowly to meaningfully reduce vacancy rates for all product types (especially office buildings), with the exception of apartments. (See figure 7) Even with employment increasing at a rate of 200,000-250,000 jobs a month; it will take a few years to return to the peak achieved in late 2006. (See Figure 8) And the all-important financial activities sector for the office sector, employment in 2013 will still be well off the prior peak. (See figure 9) This is hardly an environment for robust rent increases, especially for the suburban office market which is still suffering from the collapse of the single family home market. Remember all too many suburban office buildings are tenanted by financial service companies tied to housing (e.g. real estate brokers, title companies, mortgage brokers, lawyers, architects and banks).

Furthermore the on-going restructuring of the legal services business will weigh on demand for prestigious central business district office space. (See Figure 10) Simply put the business model of the legal profession is facing challenges from computerized document searches, outsourcing to India and a corporate rebellion against the “billable hour. Indeed several large law firms have created a non-partnership track for lawyers and have set up satellite locations in low cost locations such a Wheeling, West Virginia and Dayton, Ohio.

Figure 7. National office Vacancy Rate, 1991Q1 -2010Q1

Source: REIS
Figure 8. Nonagricultural Employment, 2000Q1 – 2013Q4F
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 9. Financial Activities Employment, 2000Q1 -2013Q4, SAAR

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 10. Legal Services Employment, 1990-Apr 2011, Monthly Data, In Thousands.

Source: Saint Louis Fed

The bright side of commercial real estate is the apartment market where the shock of dramatically lower prices has altered consumer psychology with respect to single family home purchases. (See Figure 11) A rush to buy has been replaced by a reluctance to buy and that reluctance is being reinforced by tighter credit standards. As a result the homeownership rate is falling to the benefit of rental apartments with the national apartment vacancy rate dropping from 8% to 6.2% over the past year. (See Figure 12) Moreover with much of the single family home vacancies sitting in the exurbs, the glut of vacant single family homes make them far less competitive with closer-in apartments.

According to a recent national survey net effective rents on move-ins and renewals are rising 4-4.5%, well above the 1% increase reported by the official consumer price index. It is because of the combination rising rents and low cap rates; we are forecasting a doubling multi-family starts from early 2011 to late 2013. As actual rental rates get reflected in the official consumer price index, the rate of increase in the so-called core CPI will vault above the Fed’s informal 2% target thereby inducing a tighter monetary policy. It is ironic that the seeds for higher cap rates will have its origins in rising residential rents.

Indeed with house prices at near record affordability levels and after a few years of rising real rents, consumers will once again learn the virtues of homeownership. In response ownership housing starts will return to more normalized levels and full apartment buildings will face a decline in occupancy rates.

Figure 11. S&P Case-Shiller 20 City Home Price Index, Jan. 2000 – March 2011, Jan. 2000=100

Source: Standard & Poor’s

Figure 12. Home Ownership Rate, 1997 -2010Q1, Percent

Source: U.S. Census Bureau and The New York Times

The demand for retail oriented real estate can be characterized as a tale of two consumers. The higher end consumer, benefiting from rising stock prices and employment stability is back while the lower end consumer is being ravaged by high unemployment, high gas prices and weak home prices. After all, 5% of the households account for 40% of aggregate household income. Simply put the Nordstrom shopper is spending while the Wal-Mart shopper isn’t.

Although retail sales have recovered, the growth rate in sales is well off the path of the mid-2000s. (See Figure 13) Consumers are still in a retrenching mode as the savings rate normalizes from the near zero level of five years ago. (See Figure 14) In addition e-commerce inexorably gains share over store-based retailing year after year. Witness the bankruptcies of Blockbuster and Borders as prime examples of the impact of e-commerce on store-based retailing. As a result, retail real estate which was the investment “darling” of the last decade faces a far more difficult future going forward.

Figure 13. Retail & Food Service Sales, Ex Autos, 1992-Apr 2011, Monthly Data, In $ billion.

Sources: Federal Reserve Bank of Saint Louis

Figure 14. Personal Savings Rate, 2000Q1 – 2013Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Reflecting a weaker than normal rebound in consumption, warehouse demand is slowly recovering from the massive inventory liquidation that took place during the recession.(See Figure 15) Inventories are now rising and will likely receive an impetus from the tragic tsunami/earthquake in Japan. Why? One of the many lessons coming out of Japan was the realization how fragile the global supply chain is. While “just-in-time” inventory control is still the order of the day, there will be a role for “just-in-case” supply management with a resultant increase in the level of inventories.

Figure 15. Real Business Inventories, 2000Q1 – 2013Q4
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Furthermore, because much of what is held in storage is imported, the rise in imports is an encouraging signs. (See Figure 16) Real imports have recovered all of the lost ground that occurred during the recession and are now making new highs. This factor certainly augers well for coastal-based warehouse-distribution facilities.

Figure 16. Real Imports, 2000Q1 – 2013Q4F, Quarterly Data

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Nevertheless the widening of the Panama Canal in 2014 has the potential to remake corporate logistical maps. No longer will Asian exporters be forced to use a ship-to-rail-link through west coast ports to reach the consumer markets of the Midwest and East. New competition for west coast ports will arise in Houston, Texas; Savannah, Georgia; and Charleston, South Carolina as shippers diversify their alternatives. Simply put, the west coast ports will lose their pricing flexibility.

Conclusion

It’s a happy time for quality commercial real estate in major markets and for apartments in general. As long as interest rates remain low investors will continue to pay historically high prices for those types of real estate. However, because demand growth remains tepid, market prices are increasingly vulnerable to even a modest rise in interest rates. In the meantime with the exception of rental housing new construction will remain muted over, at least, the next eighteen months. Thereafter a modest rebound in the other sectors of commercial real estate will likely occur.

The Real National Debt

2011-05-14T09:02:00.000-07:00

Congress is going through its near annual ritual of increasing the official debt ceiling on our national debt, which consists of treasury bonds and bills. The current ceiling is $14.3 trillion, far from trivial at roughly equal to our GDP, but well below the unfunded liabilties of social security and medicare. To be specific the trustees of both programs reported yesterday that social security has an unfunded liability of $17.9 trillion and medicare's unfunded liability is a frightening $38.3 trillion. Thus the two retirement programs have roughly 4X the liability of the official debt.

Thus any real budget solution has to involve radical changes in these two popular programs.(Note: I am a beneficiary of both programs.) Simply put benefits will have to be radically reduced over time and taxes to support both programs will have to be raised. I know that doing both is anathema to both political parties, but sooner or later we will need to have some real adults in the room. Too bad they can't be found.

The Great Deficit Debate: Opening Positions or Something More Serious

2011-04-14T07:58:00.000-07:00

At their best Congressman Paul Ryan's and President Obama's plans for deficit reduction represent opening positions in a very serious debate. At their worst, they are both political documents highlighting the governing philosophies of each political party. If something serious is to happen taxes are going to have to be increased and the three major entitlement programs of medicare, medicaid and social security have to be radically reformed. But remember in this debate Ryan is more right than Obama because there is no amount of increased taxation that is capable of defusing the debt time bomb our country faces. Simply put the Congress wrote checks that the economy can't cash. Thus if either party is serious there has to be a real conversation about means testing, end of life care( yes, the infamous "death panels") and market oriented reforms. We will soon see how serious serious they are. Remember the Bowles-Simpson Commission proposal has all of the elements needed to make a start at a serious discussion. Unfortunately both Ryan and the president aren't there yet.

Crisis of Faith

2011-03-15T11:07:00.000-07:00

Although we fancy ourselves to be of the modern world, we, like our ancient ancestors, are idol worshippers. To be sure we do not bow down to golden calves or Baal Peor, notwithstanding the Second Commandment, we have our own modern versions of idol worship. Many of us worship one or more of the false gods of environmentalism, market fundamentalism, secular liberalism, and technology, to name just a few.

With the nuclear meltdown in Japan coming within a year of the BP oil spill in the Gulf of Mexico our faith in large scale technology has been shattered. Moreover the failures of Tokyo Electric, BP and their respective regulators in government hardly gives one confidence in the large bureaucracies that increasingly run our lives. This lack of trust will make for more volatility in our economy and politics.

On the Mend, UCLA Anderson Forecast, March 2011

2011-03-11T07:23:00.000-08:00

The U.S. economy is getting better. Slowly, in fits and starts, real GDP is growing and employment is increasing. We are forecasting real GDP growth of 3.8% in the current quarter and through 2013 the economy will grow at a 3% clip. In this environment payroll employment will increase at a pace of 1.9 million in 2011, 2.6 million in 2012 and 3.0 million in 2013. Nevertheless, because employment fell so far dsuring the recession, that growth will be insufficient to saurpass the employment peak reach in the first quarter of 2008.

Although the reported unemployment rate dropped to a recent low of 9.0% in January 2011, we believe the data was partially the result of a statistical anomaly caused by an unusually large decline in the labor force. Hence the unemployment rate will rise initially rise modestly in the second quarter before beginning a welcome decline to below 8% by the end of 2013. Implicit in our forecast is that oil supplied won't be disrupted by the turmoil that recently appeared throughout the Middle East.

Growth Drivers - Equipment and Software, Exports and Autos

The economy is being propelled higher by strong increases in corporate spending on equipment and software. The fuel for this spending is coming from extraordinarily low interest rates, a rapidly recovering stock market and investment incentives coming out of Washington D.C.. Indeed independent of policy, investment is being spurred by technological innovation in wireless and cloud computing along with new natural gas drilling technologies that are reshaping the Nation's energy map. As a result the real business investment share of GDP will increase from 12.8% in 2010 to 15.4% in 2013.

The capital spending surge is being reinforced by a much imporved export picture. The newly emerging economies of Asia are not only exporting to the United States, but are also importing American made airliners, machinery, medical devices and farm products, for example. Adding impetus to the export boom has been the weaker dollar which makes American exports more competitive in international markets. As a result real exports are on track to grow at an 8.5-9% pace over the next three years.

After suffering its worst collapse since the Great Depression, the motor vehicle industry is on the mend. Recall that automobile sales declined by 38% from 16.9 million units in 2005 to 10.4 million units in 2009. Sales rebounded to 11.5 million units in 2010 and now appear to be on the road to near 16 million units by late 2013. For the Detroit portion of the industry that appeared to be near death, this is a remarkable recovery. A key factor driving the automobile recovery is the fact that cars wear out and have to be replaced and with normalized replacement demand to be reckoned to be on the order of 13 million units a year,meeting pent-up demand has become a decisive factor. Just as in the case of corporate investment, automobile demand is being spurred by low interest rates and imporved stock prices along with a much imporved product line.

The Laggards: Housing (for now) and State and Local Government

Unlike automobiles, it takes a long time for housing to wear out. Housing continues to wallow in its modern day depression as low interest rates are being more than canceled out by the glut of new product created during the bubble years of 2004-2007, the tidal wave of foreclosures and increased credit standards being imposed by lenders. Moreover hte reemergence of real cash down payments in the housing finance system has offset the 30% decline in prices. Indeed fears of a further ratcheting down in prices along with the shock of witnessing an unprecedented collapse in the price structure have kept buyers out of the market. Put simply the investment value of home ownership has declined. Furthermore the usual factors associated with housing weakness of tepid job growth and high unemployment are suppressing demand.

As a result we are forecasting only a modest recovery in housing starts this year to 658,000 units up from 586,000 units in 2010. Thereafter, as the employment situation improves, we forecast that housing starts will exceed one million units in 2012 and approach 1.5 million units in 2013 as pent-up demand offsets rising interest rates. Remember as strongas this recovery appears, a run-rate of 1.5 million units represents demographic demand and no more. As an aside, we anticipate that multi-family construction will recover more rapidly as the glut of housing in fringe areas supresses new single-family construction in the exurbs.

As w have noted many times in the past, state and local government is undergoing a fundamental restructuring analagous to what happened in the manufacturing sector over the past 40 years. Simply put, promises were made with respect to public employee pension and post-retirement health benefits that have become financially infeasible. With state and local budgets being drained by employee benefits and the ever-growing Medicaid program, there are insufficient funds available to fund the remainder of government such as education, environmental, public safety and recreation programs. Thus even as tax receipts improve, state and local budgets will continue to be squeezed triggering new rounds of employee cutbacks, furloughs and pay cuts. As we have seen in other sectors of the economy, this process will take a long time and it will be accompanied by highly publicized "flashpoints" such as last month's dispute in Wisconsin over pensions and union bargaining issues.

A Whiff of Inflation

Although inflation has been quiescent and as recenmtly as November the Fed seemed to be more worried about deflation, there is now a whiff of inflation in the air. Commodity prices have rocketed higher with corn and wheat up about 60% from a year ago levels and with even greater advances for for iron ore, up 78% and cotton up 130%. Oil prices- up until the Libyan crisis spike- were still up 20% from the year ago level and for no apparent reason the European Brent market has consistently traded at an unpcredented $15 premium over the U.S. West Texas benchmark. It appears that aside from fueling the stock market, the Fed's quantitative easing policy has lit a fire under commodity prices.

Perhaps more important, under the radar apartment rents are rising as would be homeowners remain renters. Several of the larger apartment owning real estate investment trusts(REITs) are reporting year-over-year rent increases on the order of 2-3%, compared to the 1% reported in the official consumer price index. Historically REITs lead the official data by about six months. To be sure, renters represent only 36% of thepopulation, cash rents statistically enter into the owners' equivilent rent calculation that reflects the cost of homeownership. As a result, despite continued high unemployment, the core consumer price index on a sequential basis will hit the Fed's informal 2% target by mid-2012 and exceed it in 2013.

Higher Interest Rates Ahead

Since 2009 the Federal Reserve has been running an "emergency" Zero Interest Rate Policy (ZIRP). We anticipate that policy will be with us thoughout 2011 as the Fed remains more concerned about its employment madnate that its inflation mandate. However as the employment situation begins to improve and the inflation rate approaches their informal 2% target, the ZIRP policy will come to an end in early 2012. Before that eventuality the Fed will start unwinding its $600 billion quantitative easing program that is scheduled to end in May.

However, longer term interest rates will begin to antipate the change in policy. Perhaps as early as next quarter the 10-Year U.S. Treasury Bond will reach 4% and be on the road to a 5% yield by the end of 2013. Of course interest rates move far more violently that what are anticipated in econometric models, wo we won't be surprised to see a more dramatic move sooner. We note that from early November to early December 2010 the yield on the 10-year Treasury spiked from 2.5% to 3.5%.

The interest rate outlook is being exacerbated by the mega-Federal deficits as far as the eye can see. The Bowles-Simpson Deficit Reduction Commission offered a rough outline to partially alleviate the problem last December, but neither the President's budget nor the recent proposed cuts in discretionary nondefense spending bythe House Republicans come close to getting to the core of the issue. The big "elepahnts" in the room are the entitlement programs of Medicare and Social Security and until those programs are dealt with, the long run deficit outlook will be problematic. Remeber entitlements are the Federal equivilent of the state and local pension issue. Just to note our forecast assumes modest cuts in domestic discretionary outlays and defense along with increased taxation on high income earners in 2013. We have not, however, modeled in any significant entitlement reform.

Conclusion

Assuming the rolling crisis in the Middle East does not disrupt oil supplies, the economy is on the mend. Real GDP will be growing at a 3% clip over the next three years along with accelerating gains in empoyment. By the end of the forecast period in 2013, the unemployment rate will be below 8% and payroll employment will approach the prior peak. Along the way inflationary pressure will increase with both headline and core consumer price indicies exceeding 2% by mid-2012. That eventuality will bring with it an end to the ZIRP policy and 10-Year U.S. Treasury Bond yields will be at more nromal 4+% range.

Gates Echoes Shulmaven

2011-03-03T07:30:00.000-08:00

Today's Wall Street Journal is running story saying that Bill Gates will charge public spending on healthcare and public employee pensions is crowding out needed spending on public education. This position is in keeping with the longstanding position of Shulmaven where we argue that curbing healthcare costs and public employee pension benefits is a "liberal issue." See the lede below.

"Billionaire philanthropist Bill Gates will step into the national debate over state budgets Thursday with a call for states to rethink their healthcare and pension sytems, which he says stifle funding for public schools."

The Battle of Madison

2011-02-19T10:26:00.000-08:00

Governor Scott Walker's epic showdown with Wisconsin's public employee unions is being played out on the Madison streets I know so well. Walker is rightfully seeking to reign in runaway public employee health and pension benefits to help bring the state's $3.6 billion projected deficit into balance. To be sure he may have over-reached in seeking to rollback a host of collective bargaining perquisites that the unions have long enjoyed, but as Barack Obama taught us so well, "elections have consequences."

Walker is fighting the good fight against one of the most reactionary elements of our society, the public employee union leadership. Pure and simple they represent "producer" over "consumer" interests. Where the 21st Century calls for flexibility the union leadership clings to obsolete work and retention rules making it all but impossible to fire incompetent workers and to organize work in a cost effective way.

Perhaps what is surprising is that the so called "liberals" are standing with these hidebound reactionaries. Simply put if public employee pension and health (current and post retirement) spending along with Medicaid remain on their current tracks, the will be no money left for "the liberal project." All of the wonderful education and environmental programs that the liberal community desires will fall by the wayside as employee benefits and Medicaid gobble up state budgets.

So I salute Governor Walker and wish him luck in rounding up the the recalcitrant Democrats who fled the state to avoid a vote on his proposals.

David Shulman's Crystal Ball

2011-01-30T05:29:00.000-08:00

Reprinted by permission from REIT Wrap dated January 19,2011.

Editor’s Note: REIT Wrap contributor David Shulman writes that he’s not
especially bullish on REITs this year. Neither, however, is he bearish.
REITs, Shulman says, are likely to be little changed from year-end 2010 in
2011. Why does Shulman see REITs treading water this year? He lays out his
case and the reasons for it, below. As always, your feedback is
encouraged. And best wishes for a profitable 2011!

After plunging 41.51% in 2008, the price-only version of the MSCI U.S.
REIT Index (RMZ) jumped 20.97% in 2009 and another 23.53% last year.

Yes, the closely followed benchmark remains well below – nearly 40% -- its
February 7, 2007 all-time high of 1,233.66. Before you get carried away
with how far away the index is from its 2007 peak; I should tell you that
I view the RMZ 2007 high as the equivalent of the Nasdaq peak of 5,132.52
in March 2000. Said differently, I don’t expect the RMZ to test its
all-time high anytime soon!

What lies ahead for REITs this year? My best guess is that the RMZ will
trade in a broad range -- between 680 to 820 – and end 2011 roughly where
it began the year, at 760-ish. Why am I not as bullish as others?

Simply put, in terms of equity valuation, REITs are way ahead of
themselves trading at 17X 2011 estimated FFO and trailing EBITDA. Frankly,
REITs are quite expensive. Remember the Standard & Poor’s 500-stock index
is currently trading at roughly 8X 2010 EBITDA and 13X 2011 estimated
earnings. And, to top it off, REITs are still trading at a roughly 15%
premium to net asset value. Of course this state of affairs has been with
us for quite a while. So, why should it be different this year?

The answer is not complicated. The great bond bull market of 2007 to 2010
appears to be over. Ten-year Treasury yields have surged from 2.5% in
early-November to approximately 3.3% as of this writing.

Whether the bond market sell-off resulted from concern over the Fed’s
quantitative easing policies, higher deficits coming from the recent tax
deal, or higher growth in 2011 coming from the same tax deal is really
irrelevant. The fact remains that yields have dramatically backed up
causing the recent huge underperformance by REITs versus the broad market.

Rising rates and still tepid earnings growth for REITs are not a formula
for strong gains in share prices. This will be especially true against a
back drop of double-digit earnings gains expected for the S&P 500 in both
2011 and 2012. Said differently, the headwinds coming from the bond market
will more than offset the modest earnings gains of about 6% that most
REITs will report in 2011 even if those earnings exceed current estimates,
which I think they will.

Wearing my UCLA hat, I recently forecast 2+% GDP growth in 2011 and
just above 3% growth in 2012. Though those numbers are low compared to the
4% GDP growth forecasts coming from several of the major investment banks
following the recent tax deal; the UCLA forecast was put to bed prior to
the deal. It also only included a one full year extension of the Bush-era
tax cuts and it did not include the very important payroll tax cuts that
were added to the compromise. If I had to do a new forecast today, I would
mark it up to 3+% in 2011 and 2012;, still below where the Wall Street bulls currently are.

The economic environment will be improving going forward. Even the more
modest UCLA forecast calls for 150,000 jobs a month in 2011 and just above
200,000 jobs a month in 2012. That kind of labor market improvement will
certainly help real estate absorption going forward. Contrast that data
with the very tepid 100,000 a month job gains reported for 2010.

More important, sometime this year, real estate and REIT investors will
conclude that the era of extraordinarily low interest rates has ended.
Interest rates will start to normalize and that means instead of sub-3%
10-Year U.S. Treasury yields, 4+% though still low, will become the norm.
As a result, the scramble for yield that we witnessed over the past few
years will abate making REIT yields relatively less attractive. Put
bluntly, REITs, in my opinion, are not priced for a more normalized yield
world and it will take a year or two of rising dividends to help them
catch up.

Over the longer-term REIT investors should keep a keen eye on several of
the tax proposals made by the Bowles-Simpson Deficit Reduction Commission.
Their proposals to lower income tax rates and tax dividends and capital
gains at the new lower ordinary rates (23% to 29%) would be a boon to REIT
investors as REIT dividend taxation declines and corporate dividend
taxation increases.

On the other hand, the commission’s proposal to lower the corporate income
tax rate to 23% to 29% makes the REIT corporate tax exemption far less
valuable. When coupled with longer depreciation schedules for REITs
compared to C-Corps more than a few real estate companies might decide
that the REIT structure might not be as suitable to their needs as they
once thought.

Although the commission’s proposals are now out of the “new”
news, the long-term fiscal deficit faced by the United States makes it
almost inevitable that its ideas will be soon be revisited.

In terms of sectors: an improvement in economic growth will likely benefit
the hitherto lagging regions of the economy as the expansion broadens. It
won’t only be New York and Washington D.C., so I suspect that the much
maligned suburban office sector might surprise to the upside in 2011.

Moreover, the really new thing in the tax compromise, the payroll tax cut,
will help the Wal-Mart customer far more than the Nordstrom customer in
2011. With improving employment and a much needed pay raise coming from
the payroll tax cut, strip and power centers might outperform malls
this year. That’s a tough call, because the high-end consumer will benefit
from a continuation of the Bush-era tax cuts.

In sum, it is hard for me to be bullish about REITs in 2011. (No surprise,
I’m sure, to those who know me.) On the other hand, it is also hard for me
to be really bearish, despite high valuations. The economic environment of
modest growth and still low, albeit rising interest rates, makes it hard
to be outright bearish. There is still way too much money out there that
is looking for a home in real estate!

-----------

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He
is now affiliated with Baruch College, the University of Wisconsin and the
UCLA Anderson Forecast. He can be contacted at
david.shulman@baruch.cuny.edu.

In Bloomberg Newswire, January 3, 2011

2011-01-03T13:28:00.000-08:00

“If you look at Jerry’s history, in 1975 the first thing he did was cut Ronald Reagan’s budget,” said David Shulman, a senior economist with the Anderson Forecast at the University of California, Los Angeles. “The Democratic legislature didn’t like it, but his poll numbers were high. It wouldn’t surprise me if he did that again.”

Full URL:
http://www.bloomberg.com/news/2011-01-03/brown-says-calif-budget-he-proposes-next-week-will-be-painful-.html

Letter to The New York Times, December 31

2010-12-31T05:30:00.000-08:00

To the Editor:

On the very week the census told us that over the past decade there was a mass migration of Americans out of high-tax states and into low-tax ones, you call for an increase in state taxation. The people you want to tax can and do vote with their feet, rendering higher taxation a far from optimal solution.

Nevertheless I will grant you that taxation should not be off the table when dealing with the fiscal crisis that is enveloping most of the states.

But unless the bottomless pit of public employee pension and post-retirement health benefits is dealt with, no amount of higher taxation will be able to solve the problem.

David Shulman

Full URL:

http://www.nytimes.com/2010/12/31/opinion/l31states.html?_r=1&ref=opinion

A Reality Check on Congress' Lame Duck Session

2010-12-23T05:51:00.000-08:00

The results speak for themselves. Simply put it was not a victory for President Obama or the congressional Republicans, but rather it it was a victory for the popular will. On every major issue the popular will was carried out. Public opinion favored a tax compromise, repeal of 'don't ask don't tell," passage of the Start Treaty, aid for the 9/11 responders and a rethinking of the FY 2011 spending plan. Public opinion was divided on the 'Dream Act" and that failed to pass.

Thus before rushing to conclusions that a new era of commity has descended over Washington, D.C., it more likely that on the controvesial issues that lie ahead there will be all-out street fights. The popular stuff will pass, but the really difficult fights over spending, taxation, environmental regulation and healthcare will be the norm.

Risky Business, UCLA Anderson Forecast, December 2010

2010-12-09T07:25:00.000-08:00

"In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable."
- Ben S. Bernanke, "Rebalancing the Global Recovery," November 19, 2010

With short-term interest rates already at zero, the measured inflation rate approaching zero and the unemployment rate stubbornly remaining near 10%, a deflation-haunted Fed decided to experiment with a policy characterized as quantitative easing. (See Figure 1) On November 3rd, the Fed announced that it would expand its balance sheet by $600 billion dollars over the next eight months by buying intermediate-term Treasury bonds. Its purpose was not so much as to increase bank reserves, which it will do, but rather to lower long-term interest rates and as a consequence raise asset prices, thereby stimulating consumption and investment.

The unstated goals of this exercise in money printing are to lower the exchange value of the dollar and to lower real wages by causing inflation to

Figure 1 Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1- 2012Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

increase relative to money wages. The former set off a firestorm of criticism at the G-20 meeting in Seoul, Korea increasing the risk of growth-dampening trade policies and as for the latter, although a theoretically appealing way of lowering the unemployment rate, it’s hard to see how a lower real wage in the construction industry, for example, will stimulate housing construction. Nevertheless, from an aggregate perspective a path to a more fully-employed economy could very well be through the wage adjustment process. That process is well underway in many sectors of the economy with the growing use of two-tier wage contracts and mandatory furloughs.1

The risks associated with the policy are that by monetizing the Federal deficit, it could lead to far more inflation than the Fed forecasts; it could engender a dollar crisis that would make it far more difficult to fund our fiscal deficit and it could negatively impact the dollar as the world’s reserve currency. Obviously, the additions to the Fed balance sheet will make it more difficult to unwind the extraordinarily easy monetary policy of the past few years.

Nevertheless, we must be mindful of the fact that the Fed has a dual mandate from Congress, which in the words of Chairman Bernanke "are to promote a high level of employment and low, stable inflation."2 Simply put, the Fed, as a creature of the Congress, has to try to fulfill its mandate or face the political consequences. To be sure, there are many critics who believe that rather than increase employment, the Fed will increase inflation, but with fiscal policy constrained by high deficits and stalemated politics; the Fed is the only game in town.

To us, a real risk is that the policy doesn’t work in reducing unemployment thereby lowering the Fed’s credibility. Indeed, clear signs of the Fed losing some of its credibility where a sell-off in the bond market more than undid the interest rate declines that took place in September and October and a surge in the prices of globally traded commodities that took place in anticipation of the quantitative easing policy. In essence, market fears of future inflation and/or dollar weakness have offset much of the positive effects that were to come from rising bond prices
Although it wasn’t called quantitative easing at the time, the Fed followed a balance sheet expansion policy in the context of near zero short-term interest rates during the 1930s. Then Fed chairman, Mariner Eccles characterized the effectiveness of monetary policy as "pushing on a string."3 All it did was increase bank reserves without transmitting any stimulus to the real economy, much like today.

After all, from late 2007 to the present, bank reserves increased nearly 30-fold with minimal upside effects on the economy. (See Figure 2) That is why Chairman Bernanke is stressing the asset market channel rather than the banking channel to transmit monetary policy. Of course it certainly can be argued that reserve expansion put a floor underneath the economy preventing something far worse. But, we must keep in mind a Fed without credibility is a clear negative for the economy, think the 1970s. While a Fed with credibility certainly aided the 25 year 1982- 2007 boom.

Figure 2 Total Bank Reserves, 2007Q4 – 2012Q4F

Source: Federal Reserve Board UCLA Anderson Forecast

Our Forecast

Our view is that the new Fed policy will be modestly helpful and the most recent economic data have been encouraging. As a result, we have revised up both our real GDP and inflation forecasts from last quarter, but unfortunately even with jobs gains averaging 150,000 a month in 2011 and 200,000 a month in 2012, unemployment will remain above 9% through the third quarter of 2012. (See Figure 3) We expect that real GDP will grow at a 2% plus annual rate through the third quarter of 2011 and then ramp up to a 3% or so growth rate. (See Figure 4) With respect to inflation, we are less fearful of deflation than Chairman Bernanke and we expect consumer price inflation to be at or above the Fed’s informal 2% target by late next year. (See Figure 5) The higher apartment rents now being reported by the publicly traded apartment REITs will soon find their way into the consumer price index.

Figure 4 Real GDP Growth, 2005Q1 -2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 3 Unemployment Rate, 2005Q1-2012Q4

Figure 5 Headline vs. Core Inflation,
2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Why with such high unemployment is economic growth so sluggish? Historically, steep downturns are followed by steep upturns, but not this time. As we argued last quarter and previously, the economy is suffering from a debt hangover that will require many years of deleveraging to recover from.4 Consumption growth, instead of running at an historical 3% rate is now slogging along at a 2% clip as consumers increase their savings rate to repair their tattered balance sheets. (See Figures 6 and 7) Furthermore, with real wages stagnant, debt constrained consumers do not have the wherewithal to go on a consumption binge. (See Figure 8)

In fact, the economy just might be suffering from a new version of Keynes’ paradox of thrift. In the 1930s, Keynes argued that whereas savings for an individual was a virtue, for an economy in recession it is a vice because if every household cuts back on consumption the entire economy remains mired in a slump. Today, however, with very low interest rates, consumers and pension funds have to save more and/ or increase their contributions to achieve their target stock of savings. Moreover, it goes without saying that those consumers who are already retired are being forced to cut back on consumption because of reduced interest income. Thus, one of the challenges facing the Fed’s quantitative easing policy is that lower interest rates could have the perverse effect of lowering consumption rather than increasing it.

Figure 7 Personal Saving Rate,
2000Q1 – 2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 8 Employment Cost Index, Real Private Sector Wages and Salaries,
2000Q1 -2012Q4F

Figure 6 Real Consumption Growth,
2000 – 2012F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Furthermore, much of the increase in consumption is going to imports. Where a year ago net exports were contributing to growth, it is now inhibiting growth. (See Figure 9) That is why a weaker dollar is necessary part of the adjustment process in that it would work to reduce imports and increase exports. (See Figure 10) Of course, the adjustment process would be made easier if China moved with greater alacrity with respect to the upward revaluation of its currency. Nevertheless, in order for net exports to structurally improve, the savings rate has to rise. Why? The U.S. now consumes more than it produces and borrows the difference from abroad. If consumption were reduced to equal production the savings rate would rise and the trade deficit would disappear.

Housing continues to be in the doldrums. We had hoped to see a meaningful recovery in 2011, but that has been pushed back into 2012. The near complete breakdown in the foreclosure paperwork process has dramatically slowed the price discovery process and introduced a new element of uncertainty. We are now forecasting housing starts to be 757,000 and 1,196,000 units in 2011 and 2012, respectively, compared to an estimate of 604,000 units for 2010. (See Figure 11)

The Restructuring of State and Local Government

Although most business cycles have similar characteristics, each cycle is different in its own way. In the current one instead of the state and local sector

Figure 9 Net Exports, 2005Q1 – 2012Q4

Figure 11. Housing Starts, 2005 – 2012F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10 U.S. $ Trade-Weighted Exchange Rate

Sources: Bureau of the Census and UCLA Anderson Forecast
Source: IHS Global Insight and UCLA Anderson Forecast

gradually increasing throughout the business cycle, this time it is in decline. Simply put, the state and local government is now undergoing the same type of restructuring that the private sector has endured over the past two decades. As a result, we do not expect any meaningful growth in state and local spending over the next several years. (See Figure 12) That is to say, the tax base cannot keep up with the growth in public employee pension and Medicaid outlays and as a consequence other sectors of state and local budgets will be squeezed. This phenomenon will be reinforced by the election of a flock of new budget cutting governors last November. Over the long-run, the growth path of Medicaid and pension expenditures, of necessity, will be lowered.

Fiscal Imbalances Remain

As we noted earlier, high deficits are constraining the Federal government to engage in further fiscal stimulus. Indeed, the newly elected Congress might just be in the mood for fiscal consolidation on the spending side of the budget. As for the tax side, we are assuming for modeling purposes a tax compromise where all of the Bush tax cuts get extended for one more year and in 2012 high income taxpayers will see their tax rates rise. However, we caution a highly partisan Congress might fail to compromise on the tax issue leaving the economy vulnerable to a massive tax hit in January.

Figure 12 Real State and Local Government Expenditures, 2000 – 2012F

Figure 13. Federal Surplus/Deficit, FY 2000-FY2020F

Source: U.S. Department of Commerce and UCLA Anderson Forecast
Source: Office of Management and Budget and UCLA Anderson ForecastUCLA Anderson Forecast

Until Congress grapples with the long-term nature of our fiscal problems, we will be living a period of ongoing uncertainty with respect to taxation. The chairman’s mark of the Bowles-Simpson Deficit Reduction Commission offers a good start, but the politics don’t seem to be there for a meaningful solution. Congress does not seem to be in the mood to cut entitlements will raise taxes even if taxes are meaningfully reformed with lower rates and fewer deductions.

In the meantime, we forecast mega-fiscal deficits for as far as the eye can see. (See Figure 13) Thus, in our opinion, gridlock is bad. Without the two parties coming together there cannot be any meaningful solution to the long term fiscal imbalances we now face.

Conclusion

Despite all of the issues outlined above, the economy will continue to muddle through with modest growth and distressingly high unemployment. The economy is healing, albeit at too slow of a pace, but we forecast there will be an acceleration of growth in late 2011 that will gradually work to lower the unemployment rate. Inflation will pick up quicker than the Fed now expects and as a consequence the extraordinary policy measures taken will gradually be reversed and a gradual tightening cycle might begin in early 2012.

Endnotes

1. See, Uchitelle, Louis, "Unions Yield on Pay Scales To Keep Jobs," The New York Times, November 20, 2010, p.1
2. Bernanke, Ben S., "What the Fed did and why: supporting the recovery and sustaining price stability," The Washington Post, November 4, 2010.
3. Meltzer, Allan H., "A History of the Federal Reserve Volume 1, 1913-1951," (Chicago: University of Chicago Press, 2003), p. 62.
4. See Shulman, David, "The Uncertain Economy," UCLA Anderson Forecast, September 2010.

Did Vornado go After the Wrong Retailer?

2010-11-24T14:03:00.000-08:00

Reprinted by permission from REIT Wrap dated November 15, 2010.

By David Shulman

In early October, Pershing Square Capital Management and Vornado Realty Trust (VNO) announced they acquired beneficial ownership of 16.8% and 9.9%, respectively of JC Penney Co. (JCP) common shares. Both are widely regarded as savvy real estate investors; so, JCP shares spiked 45% on the news and are now trading at around $31 a share.

JCP is loaded with real estate, but much of it is leased and only 49% of their stores are located in malls, -- mostly Class B malls.

JCP operates just over 1100 stores encompassing 112 million square feet. JCP owns 416 of their stores, but 119 are on ground leases yielding a free and clear total of 297 stores. In addition it owns approximately 4.7 million square feet of warehouse/distribution space.

Goldman Sachs has valued JCP’s real estate at between $1 and $1.5 billion based on low in-place lease rates. Based on a per box valuation Newport Beach, California headquartered Green Street Advisors pegs JCP’s real estate value between $3-$4 billion on an equity market cap of just north of $7 billion. The Green Street Estimate, in my opinion, is the more accurate one.

There is no question that as a stock trade, Pershing Square and Vornado have made a lot of money for their investors/shareholders. (Something both have done before previously, albeit separately, when they both bought Sears (SHLD) shares.) That said, at its current valuation, it is hard to make a compelling case for JCP based on its real estate valuation.

First, I am not a believer in the “REITCO/OPCO” strategy of spinning off the real estate assets of a department store into a REIT and keeping the retail in an operating company. Something Pershing Square’s Ackman proposed when he went after Target (TGT). Simply put, all the leasing real estate at market rates would do is weaken JCP’s already below investment grade rating.

Second, though JCP’s most recent earnings provided some hope, JCP has of late been a very weak retailer. Sales have gone nowhere since 2003 and profits have collapsed. In contrast JCP’s major competitor, Kohl’s (KSS) has seen its sales nearly double over the same time period.

Third, unlike interior mall stores, the department store business model is based on paying minimal rents and Goldman Sachs estimated that JCP pays an average rent of $3.55 a square foot. Perhaps a new tenant would be able to pay far more creating the opportunity to create “sandwich” leases.

In addition JCP’s stores sales generate an unimpressive $150 a square foot in sales. Kohl’s, on the other hand, generates just under $200 a square foot in sales. Further, like most department store chains, its store base is relatively old with just over 60% built before 1990. Against that statistic, 20% of their stores are located in the Sunbelt states of California, Texas and Florida.

Neither Pershing Square nor Vornado has tipped its hand on what it views as the “end game” for their JCP investments. One possibility would be to close many department stores (a lot of them) and harvest their value for alternative uses, such as in-line mall stores or possibly residential, in the case of stand-alone stores. Such a strategy, however, would take considerable time and in the case of mall-stores it would involve amending reciprocal easement and operating agreements.

If JCP isn’t a real estate story, what might VNO and Pershing Square have in mind? My guess is that JCP is a retailing turnaround story where capital could be allocated far better than it has been. For instance, pre- recession, JCP earned $4.86 a share and $4.75 a share in 2006 and 2007, respectively. On those earnings JCP sold above $80 a share.

In contrast consensus estimates call for earnings of $1.43 a share in 2010 and the consensus for 2011 is $1.79 per share. Prior to the recent Pershing Square/Vornado announcements , JCP was changing hand in the low 20s.To be sure, JCP earnings are somewhat understated because of noncash GAAP charges ($237 million in 2009) for their now fully funded pension plan. Those charges will go away by 2014.

In order the bring earnings back to anywhere near their prior peaks management would have to, in the words of Goldman Sachs analysts Adrianne Shapira and Jonathan Habermann, improve capital allocation by lowering cap-ex and buying back shares with the $3 billion in cash on their books, rationalize and monetize real estate assets and reinvigorate their basic retailing business.

No question that VNO and Pershing Square can bring skill sets to the table that would enable JCP management to accomplish at least two of those goals. However, given the “poison pill” that JCP just put into place, a meeting of the minds (at least near term) seems unlikely.

Further, at least near-term, Vornado may be handicapped as a result of the recently announced departure of its retail head, Sandeep Mathrani who takes over early next year as CEO General Growth Properties’ (GGP).

Yes, JCP’s earnings appear to be at or nearing a cyclical trough. However, the retailing environment is far from benign. Deleveraging middle-market consumers wracked by substantial losses on their homes, makes for a powerful headwind facing JCP. Which means it will be awhile, at least, before JCP can execute a turnaround.

JCP stock was cheap when Pershing Square bought their shares at 23 and when VNO bought its shares at 26. There is certainly less of a margin of safety today. Nevertheless, with JCP trading at under 7X EBITDA it seems a better investment than VNO stock trading at 18X EBITDA. The larger question, however, is whether investing in JCP was the best use of capital for a REIT acting like a hedge fund.

Given Vornado’s retailing roots I wasn’t surprised to see Steve Roth and Mike Fascitelli go after a retailer. JCP would not have been my first choice, however. From a strategic standpoint, Macys (M) is a far better fit for VNO. M has much better mall-based assets than JCP and its flagship store is adjacent to VNO’s vast holdings in Manhattan’s Penn Station submarket. If the VNO’s Hotel Pennsylvania site is worth X, then under certain circumstances the Macys full block position on 34th Street is worth 2X. Of course, at its current price of roughly $25 a share, M can hardly be called “cheap.”

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

Election Rap Up

2010-11-03T11:24:00.000-07:00

The Republican Party did somewhat worse than the surge I expected two weeks ago. In the House I was pretty close to the mark with the Republicans picking up about 65 seats compared to the 70 seats I envisioned. The Democrats did better in the Senate than I expected by losing 6 seats for sure and possibly a seventh compared to the nine I expected them to lose. Nevertheless it was a good night for Shulmaven. The voters rightly held the Democrats responsible for the high unemployment we are now suffering from.

The big losers last night were obviously President Obama and the Democrats, but largely unnoticed in the press commentary was a string of defeats for Sarah Palin, who in her own way may have cost the Republicans Senate control. Palin favorites Christine O'Donnell in Delaware, Sharon Engle in Nevada and especially Joe Miller in Alaska all went down to defeat. Her stock has peaked and with that she will be less of player in 2012 than most people now imagine. Further, those defeats will make it easier for Republican regulars to bring the Tea Party into the fold and will, in liklihood, make the Tea Party more realistic with respect to future candidates. They will learn that winning is important.

Also beneath the radar was the silent war going on between Senators Chuck Schumer and Dick Durbin to replace Harry Reid as majority leader. With Reid's win a temporary truce has settled on the battlefield. Too bad, it would have been fun to watch, but for Shumer and Durban it has feel like coitus interruptus.

In the Washington Post, "Federal Reserve's, Bernanke's credibility on line with new move to boost economy"

2010-11-01T06:28:00.000-07:00

November 1, 2010, P. 1

"The greatest risk for the Fed in taking this action is that it could extend the economy's funk by giving a sense that either no one is in charge or that the people who are in charge can't get it right," said David Shulman, senior economist at the UCLA Anderson Forecast. "The whole psychology of that could leak back into the economy."

Full URL - http://www.washingtonpost.com/wp-dyn/content/article/2010/10/31/AR2010103103818_pf.html

The New Republic Picks up Infrastructure Idea (from July 4 Post)

2010-10-30T04:15:00.000-07:00

See "Desperate Measures" by Noam Sheiber, October 29, 2010

Shoot the hostage (i.e., kneecap your allies to finagle more government spending). It’s no secret that Democrats are keen to pass a major infrastructure package, which would have the dual benefit of supporting the economy in the short-term while making us more productive over the long-term. Pretty much everyone who studies these things agrees that our infrastructure is either badly outdated, in a state of disrepair, or both. (The American Society of Civil Engineers estimates that the country could use about $2.2 trillion worth of upgrades and repairs over the next five years.) But, of course, Democrats had zero luck passing a major infrastructure package after the initial stimulus in early 2009. It’s hard to believe they’re going to fare much better with a House Republican majority that’s constantly looking over its shoulder at pitchfork-wielding Tea Party activists. Particularly since several of these activists are on the verge of coming to Congress themselves.

Still, a deal on infrastructure spending may not be entirely out of reach, at least if the White House is ruthless enough. One idea along these lines comes care of David Shulman, a senior economist at UCLA’s Anderson Forecast center. Shulman proposes a several-hundred-billion dollar infrastructure package in which the administration agrees to suspend Davis-Bacon, the law requiring contractors for government-funded construction projects to pay locally prevailing wages, as deemed by the Labor Department. Conservatives complain that the law artificially inflates costs and is a sop to labor. (I have somewhat mixed feelings toward the law but am more sympathetic.)

Shulman would also have the administration fast-track environmental approval of construction projects—under current law, it can take months to assemble the various environmental-impact statements and reports, and there can be costly litigation along the way. Shulman recommends that the White House oversee an accelerated environmental review process and set up some provision for expediting judicial review. (The American Prospect’s Harold Meyerson hinted at some similar ideas back in May.)

Unions and environmentalists would howl, of course—in many cases for good reason. But that’s partly the point. (In fact, the louder the better.) If a spending package has the right opponents, then the conservative media-industrial complex may come around, bringing the GOP leadership along with it.

Full URL - http://www.tnr.com/article/economy/78762/desperate-obama-economy-republican-congress

My History with Santa Monica Place

2010-10-27T10:35:00.000-07:00

Reprinted by permission from REIT WRAP Special Report dated October 20, 2010. Editor's Note: David explains that with respect to the design and retailing elements, Macerich (MAC) did a spectacular job rennovating Santa Monica Place. For investors, however, he concludes, the all-in results will likely be less than spectacular.

by David Shulman

Santa Monica Place is a 524,000 square foot regional mall anchored by Nordstrom and Bloomingdale’s. it is located four blocks from the beach in the heart of downtown Santa Monica.

What is striking about the renovation completed in August of this year is that it represents the conversion of a 1970s fortress mall into an open mall fully integrated into the thriving street scene of the very popular 3rd Street Promenade thereby creating a four block long urban retail environment.

Aside from being open, Santa Monica Place differs from suburban malls in that it sits on a very compact 9.9 acre site and instead of having six parking spaces per one thousand square feet it only has four spaces per one thousand square feet.

The 2000 space parking structures are owned by the city and are included in the 9.9 acre site. Given the tight urban environment, it makes for difficult traffic and parking during peak times. This situation is partially mitigated by nearby city parking for the 3rd Street Promenade.

Because the site is so close to the ocean, about half of the trade area is in the water. The other half of the trade area consists of some of the priciest real estate in America.

My own history with the project goes back to the public hearing held by the Santa Monica Redevelopment Agency in 1974. Two competing designs were presented at the hearing: one by The Rouse Company and the other by The Hahn Company. Both firms CEO’s, Jim Rouse and Ernie Hahn, appeared at the hearing.

The project was initially envisioned to be much larger, five more acres, and it included another whole block to the west where hotel, office and residential uses were contemplated.

The Rouse Company, breaking Hahn’s near monopoly on California mall redevelopment projects, won the competition with a Frank Gehry design for the full mixed-use project. Nevertheless, after the project was scaled down to its current size, Rouse brought in Hahn for their construction expertise and made them a 50% joint venture partner.

That was before Frank Gehry became the world famous architect that he now is today. Gehry was not happy how the project turned out. For example in Barbara Isenberg’s, “Conversations with Frank Gehry,” (2009) Gehry said “… we designed it as a mixed-use project, not just a dumb shopping center. Then for reasons beyond my control, the city wouldn’t support it, and so it ended up being just a shopping center.” In Joshua Olsen’s “Better Places Better Lives: A Biography of James Rouse,” (2003) Gehry was more succinct, “It’s not something I go show people.”

What was my role in this saga? In 1974, I was a graduate student at UCLA. I was also a community activist in Santa Monica. The city attorney called us a bunch of long-haired – I wish I still had the hair and my politics have moved to the right -- hippies who dressed up in suits to impress various regulatory bodies.

I was a leader in the opposition to the mall, first before the City, then before the California Coastal Commission and we were allied with a parallel law suit brought on behalf of clients of the Legal Aid Society of Los Angeles. We were opposed to the project on the following grounds:

1. We fundamentally disagreed with the notion that government could take property from a private owner and then turn it over to another private owner. A precursor to the famous Supreme Court case, Kelo v. New London.

2. We argued that the property in question was not blighted. (The city’s newspaper was located in the redevelopment area) and therefore the redevelopment was not lawful.

3. We believed that the $15 million of tax increment bonds issued by the redevelopment agency was a flat out subsidy to the development that expropriated tax dollars that rightfully belonged to the school district and the county. If Santa Monica wanted a shopping center, the private sector should build it. I was quoted in the local newspaper saying, “I don’t believe in subsidizing department stores.”

4. We believed that the mall project was part in parcel with the city’s other redevelopment project in Ocean Park which was designed to remove lower income people from the city. In a word, “gentrification.”

5. Finally, if a mall were to be built, it should be open. Why have an enclosed mall in the most temperate climate in the U.S.? Our design ideas included a “parasol” roof which Gehry was sympathetic to.

We lost and the original mall opened in 1980 at a cost of about $60 million for Rouse/Hahn and $15 million for the taxpayer. The Coastal Commission did require a small open air viewing deck as a condition for a permit and the law suit required the city to come up with about one million dollars for a grab bag of public benefits to fund housing and park projects. That piece was funded by Rouse/Hahn.

Ultimately Rouse bought out Hahn’s 50% interest and then sold the entire project to Macerich in 1999 for $132 million. Analysts at the time estimated the deal was done at a 9% cap rate and to keep the arithmetic simple I am assuming the initial NOI to be $12 million. Just as an aside, in 2000 as Lehman Brothers REIT analyst I conducted a Los Angeles property in 2000 and we toured both Santa Monica Place and the adjoining Promenade. The highlight of that property tour was a cameo appearance of super-model Cindy Crawford.

Macerich knew that Santa Monica Place has issues when it bought it. It was an obsolete fortress mall with middle market stores in a high income area. Meanwhile right next to it was the edgy and newly revitalized 3rd Street Promenade attracting hoards of locals and tourists.

Though the mall was generating about $400 a square foot in sales for its occupied space, its days were numbered. It is likely that the mall’s peak NOI occurred in the first year Macerich bought it.

Now let’s look at the development economics. Macerich stated that it expects Santa Monica Place to generate initial sales of about $800/square foot soon rising to $1,000/square foot - making it a Super-A mall. Net rents are in the $70-$100/square foot range and common area maintenance charges are anticipated to be $27/square foot. MAC is telling investors that it expects to generate a stabilized return of 9- plus percent on its incremental investment of $265 million, or about $25 million a year. Within a few years MAC expects to be generating $27 million a year. A more than successful outcome for a mall headed for the graveyard.

In order to achieve those targets, MAC assumes that it will achieve its leasing targets for the 50,000 square feet on the mall’s third level encompassing the former third floor of the Bloomingdale’s space. Trust me; this represents a leasing challenge because the mall’s third level is devoted to high-end restaurants, a farmer’s market-type retail operation called “The Market” and public open space. If this space were easy to lease, it would have been leased already.

Further, if we start with the original purchase price of $132 million and an initial NOI of $12 million, the returns don’t look so great. All-in MAC now has about $400 million in the project, including some capital expenditures made for the old mall. An initial return of $25 million on that equates to 6.25% and the incremental return on the renovation costs amounts to a low 4.9%. ($25million-$12 million)/$265 million)

If significant value, from the stand point of the 1999 acquisition, is to be created Santa Monica Place would have to be valued a cap rate well south of 6%. This comment should be viewed as a criticism, but it just goes to show how capital intensive the mall business is.

I would be remiss not to point out that MAC will receive a very important intangible benefit from the renovation; it will have a show case asset just a few blocks south of its corporate headquarters.

As for me personally, I feel vindicated that my efforts of over thirty years ago have finally born fruit. A very successful open mall was built and the renovation was accomplished without the contribution of public money.

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

Despite Closing Polls, Republican Wave Election Likely

2010-10-20T10:24:00.000-07:00

The latest polling data now indicate that this year's competitive Senate races are closing with the leaders of both parties losing ground(e.g. Boxer in California and Toomey in Pennsylvania). Nevertheless because I think this will still be a big Republican year, my best guess is that the GOP will pick up 9 Senate seats, one short of a majority. If I am right, expect to see Senators Lieberman and Nelson holding an auction to determine whether on not they will continue to vote with the Democratic leadership. Net net, Republican Mitch McConnell will be the next majority leader.

As fas as the House goes my best guess is that the Republicans will pick up about 70 seats, far from the 130 seat blow-out of 1894, but way better than the 52 they picked up in 1994. Figure a 250-185 GOP majority. The big questions are what they do with it and can it carry over to 2012. In 1996 the GOP barely hung on and in 1948, the Republican victory of 1946 turned into a debacle. Remember neither party has a magic wand to solve our Nation's deep seated problems and the electorate is, to say the least, very volatile. Thus it would be premature to write-off Democratic prospects for 2012.

This year's election is about two numbers, 9.6% and 17.1%. The former is the official unemployment rate and the latter is the "all-in" unemployment rate that counts involuntary part-time workers and discouraged workers. For whatever reason the Obama Administration and the Democratic majorities in Congress failed to make employment Job One. They will now suffer the consequences.

The Uncertain Economy, UCLA Anderson Forecast, September 2010

2010-09-15T21:15:00.000-07:00

““Look at the uncertainty,” said one senior Fed official. “Are we facing
deflation or inflation? Are we up or down? Growing or not?””[i]

Against a backdrop of growing policy uncertainty, the economy stalled in the second quarter with real GDP growing at a revised 1.6% annual rate. Indeed we forecast that the economy will continue to crawl at a 1.4% rate in the current quarter and then grow at a very tepid 2% growth rate for the following four quarters. (See Figure 1) Indeed we don’t visualize a return to trend growth to approach 3% or so until late 2011. In this environment the unemployment rate will remain extraordinarily high ending this year at 9.7% and 2011 at 9.5%. (See Figure 2)

Given the huge decline in output that took place in 2008-09, the economy should be growing at 5-6% annual rate, not the 2% rate that we now envision. What normally happens in a recovery is that the proverbial baton is passed from government spending and inventory restocking to housing, consumer spending and investment. In this recovery somewhere along the way the baton was dropped as housing double-dipped and consumer spending stalled. (See Figures 3 and 5) Although it is hard to visualize the double dip in the quarterly housing start data, it is very evident in the collapse of monthly existing home sales after the expiration of the homebuyer’s tax credit. (See Figure 4) To be sure, equipment and software spending has remained strong, but leading indicators of activity and corporate announcements suggest that it too, will fall from its recent heady pace. (See Figure 6)

Figure 1. Real GDP Growth, 2005Q1 -21012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 2. Unemployment Rate, 2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3. Housing Starts, 2005Q1 – 2012Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 4. Existing Home Sales, 2005 – July 2010
Source: National Association of Realtors

Figure 5. Real Consumption Expenditures, 2005Q1 -2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Spending on Equipment and Software, 2005Q1 – 2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

What Ails the Economy?

We have two broad explanations as to what is ailing the economy. The first is the balance sheet recession hypothesis we outlined nearly two years ago which is broadly analogous, with the important exception of the U.S. not experiencing a foreign exchange crisis, to the analysis put forward by Carmen Reinhart and Kenneth Rogoff.[ii] In their historical work, “This Time is Different,” they outline the history of eight centuries of financial collapses and come to the conclusion that recoveries from the bursting of debt fueled financial bubbles are invariably slow and are associated with unusually high unemployment rates and an explosion in government debt. Sounds familiar, doesn’t it? Simply put because the imbalances engendered by the prior boom, it takes a long time for an economy to heal from a financial collapse. It certainly doesn’t have to be as bad as the 1930s or Japan’s lost two decades, but in their view a quick recovery to the semblance of the pre-boom normal is not likely.

The recovery from the balance sheet recession is being exacerbated by an extraordinary increase in policy uncertainty which is amplifying the usual economic uncertainties associated with recessions. . As early as December 2008 and almost continually thereafter in the UCLA Anderson Forecast we noted that fiscal, monetary and regulatory policy uncertainties coming out of Washington, D.C. would limit consumption, investment and hiring.[iii] In a way, policy making has become “iatrogenic” in that instead of curing the economic disease it is making it worse.

Policy makers in Washington D.C. don’t seem to understand that the decision of a firm to hire an employee is an investment decision and therefore subject to all of the budgetary criteria that goes into the buying of equipment. And remember there are no health insurance premiums associated with buying a computer. The investment/hiring decision is subject to forecasts on the future of tax, environmental, energy, financial, labor and healthcare policies.

At the present time, business firms can only make the wildest guesses as to what corporate and individual tax rates will be next year and for that matter three years from now, what the cost of healthcare will be, whether or not there will be a revived cap and trade policy with respect to carbon emissions or whether the Environmental Protection Agency will step in with regulations of their own absent a statute and whether it will be easier or more difficult to hedge risks with financial derivatives. Furthermore, it certainly does not help to have the perception, true or not, that the Administration is at best ignorant of business or at worst, hostile to business.

A Late New Deal Analogue

There is a loose historical analogy to the current environment. In the middle of the 1937-38 recession the term “capital strike” entered the political vernacular as several prominent New Dealers, in particular Secretary of the Interior Harold Ickes and Assistant Attorney General Robert Jackson, attacked the business community for “sabotaging” the New Deal.[iv] Of course left out of their theory was the impact of the full implementation of the Wagner National Labor Relations Act and the adoption of a tax on undistributed corporate profits along with a monetary tightening and the tax increases associated with the beginning of the Social Security payroll tax. In light of this history, it would be fair to say, that today's business community doesn't have a clue as to how hostile government policy can be.

Nevertheless, after two national radio speeches on the subject calling for direct controls on the economy by the previously mentioned New Dealers, the subject was dropped like a hot potato as Roosevelt adopted an all-out Keynesian deficit spending policy. With the likelihood of a European war increasing, President Roosevelt became more conciliatory towards business, the tax on undistributed corporate profits was effectively repealed and the full implications of the Social Security program became more widely understood. As a result the economy began to recover well before the advent of rearmament.

A Tax Compromise

Thus it would certainly help if there were at least a perceived truce between the business community and the Obama Administration. Because the drafting and adopting regulations associated with the healthcare and financial reforms will go on well into 2013, a good start would be to compromise on the contentious tax issue. that can actually be accomplished this month! One example of a bipartisan compromise would include permanently setting the tax on dividends and capital gains at 15% compared to the 20% rate for both proposed by the Administration and 39.6% for dividends should the current law lapse, increasing the top rate on ordinary income to 39.6% as contemplated by the Administration and the lapsing of current law, but have the Bush tax cuts remain in force for incomes up to $400,000 for a joint return instead of $250,000 as proposed by the Administration. Add to that setting the inheritance tax exclusion for a family at $7.5 million as proposed by the Administration or $10 million as proposed by some congressional Republicans. And maybe they could throw in the taxing of carried interest capital gains for private equity and hedge funds at ordinary income tax rates.

There you have it, a reasonable compromise where both parties can declare a victory, but can they actually come together and do it? The Obama Administration would get its higher top rate and a step, albeit smaller, toward deficit reduction and the congressional Republicans would get their low taxes on capital. Above all the economy would achieve at least a vestige of certainty with respect to tax policy. One of the worst things that could happen would be a one year extension of the Bush tax cuts. The uncertainty would remain, incentives would be untouched and the economy would have the increased burden of debt. Remember policy makers are playing with fire with respect to the tax issue. A recent article co-authored by former Council of Economic Advisors Chair Christina Romer noted that exogenous increases in taxation have caused severe shocks to economic activity.[v]

Problems Confounding Policy

The Fed has tried practically everything in its policy toolkit to halt the recession and engender recovery. Short-term interest rates have been cut to zero, its balance sheet has exploded, the open market committee has purchased mortgages and long-term treasury bonds with abandon (quantitative easing) and they announced that short-term interest rates will remain low for “an extended period.” Yet unemployment remains high and the recovery is faltering. At the recent Jackson Hole conference, Chairman Bernanke promised he would do whatever it takes to keep the recovery going.[vi] Whether further quantitative easing will work remains to be seen but to the public it is beginning to look like pushing on the proverbial string. After all, record low mortgage rates are not triggering a housing boom, far from it.

Our view is that monetary policy will work with an unusually long lag. We forecast that the Fed’s zero rate policy will remain in place for at least another year and after that the Fed Funds rate will slowly increase. (See Figure 7) Concomitantly long-term interest rates will likely remain unusually low and we anticipate that the yield on 10-Year U.S. Treasury notes won’t exceed 3% until the third quarter of 2011.

Figure 7. Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1 – 2012Q4F,
Source: Federal Reserve Board and UCLA Anderson Forecast

Despite the ongoing policy ease, we expect inflation to remain quiescent during the forecast period. (See Figure 8) Both headline and core inflation will be under control staying below 2% for all of 2011 and the risk of deflation, though nontrivial, remains small. Despite the low rate of inflation, low nominal rates will keep real returns to savers extraordinarily low.

Figure 8. Headline vs. Core Inflation, 2005Q1 – 2012Q4
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

With respect to fiscal policy the Obama Administration is on track to pile up a record decade of deficits. (See Figure 9) Somewhere along the way taxes will have to increase substantially, an inevitable policy uncertainty, and entitlement spending will have to cut radically. In the meantime fiscal policy is not working the way it is supposed to be. Instead of spending with alacrity, consumers are saving and where consumption and investment are rising, a significant portion of it is coming in the form of increased imports. (See Figures 10 and 11) Stimulus in America is turning out to be great news for the exporters of China and Germany.

Figure 9. Federal Surplus/Deficit FY 2000 – FY2010F

Source: Office of Management and Budget and UCLA Anderson Forecast

Figure 10. Personal Saving Rate, 1990Q1 – 2012Q4
Source: Department of Commerce and UCLA Anderson Forecast

Figure 11. Real Imports, 2005Q1 – 2012Q4F, Quarterly Data

Source: Department of Commerce and UCLA Anderson Forecast

Conclusion

In an economy wracked by a post financial bubble environment and living in a theme park of policy uncertainty, we forecast very sluggish growth accompanied by high unemployment. As time passes the economy will naturally heal and the policy uncertainties will resolve themselves to the extent that growth will return to a 3% path and unemployment will begin on its long trajectory downward. We forecast that these more ebullient trends will become noticeable by 2012.

Higher savings and increased imports seem to be one of the key reasons why macroeconomic policy is not working the way the traditional models would have it. Thus if policy is to work it will have to restore the confidence of businesses and consumers to spend and invest in America. A real reduction in policy uncertainty would go a long way toward that end.

[i] Financial Times, August 19, 2010, p.1.
[ii] Reinhart, Carmen M. and Kenneth S. Rogoff, “This Time is Different,” Princeton; Princeton University Press, 2009.
[iii] See Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008
[iv] See Brinkley, Alan, “The End of Reform,” New York: Knopf, 1995, pp. 56,57
[v] See Romer, Christina D. and David H. Romer, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, 100, June 2010, pp.763-801.
[vi] See Bernanke, Ben S., “The Economic Outlook and Monetary Policy,” August 27, 2010.

The Shaky Foundation Supporting Long-Term REIT Performance

2010-08-25T06:42:00.000-07:00

Reprinted by permission from REIT WRAP Special Report dated August 16, 2010.

By David Shulman

Though the first decade of the 21st century has been characterized as “lost” for most equity investors, REITs stood out by generating a 9.75% compound annual return as measured by the total return version of the MSCI U.S. REIT Index (RMS) for the 10- year period ending in July 2010.

This performance is truly remarkable when viewed against the backdrop of a small negative total return for the S&P 500. Moreover after undergoing a near death experience in 2008/2009, REIT investors are once again looking forward to high single-digit returns for the new decade.

However, REIT performance over the last decade did not come from rising earnings and dividends; rather, it came from the tailwind of multiple expansion that is hardly sustainable. Add to that the “meltdown’s” impact (e.g. dilution resulting from massive stock issuance and significant dividend cuts, which helped right-size balance sheets) and the future appears guarded.

Where in 2000 REITs typically traded at FFO multiples in the 6-9 X range, today they trade in the 15-20+ X range. Moreover in 2000, according to data provided by Green Street Advisors, REIT forward AFFO yields were about 700 basis points above the forward earnings yield for the S&P 500; today, REIT forward AFFO yields are nearly 400 basis points below the S&P 500.

In other words, from a valuation perspective REITs are trading at the mirror image of their levels in early 2000 and it is more than likely going forward REIT performance will suffer from the headwind of multiple contraction.

TROUBLING RECORD

Beneath this stellar REIT performance is a very troubling record with respect to earnings and dividend growth. I dare say that few analysts in 2000 would have forecast the flat to down earnings that most REITs experienced over the past decade. To be sure 2000 represented a cyclical peak in REIT earnings and 2010 represents results around a cyclical trough, but the fact remains that 10 years is a long time.

Let’s get into the data. I examined the earnings and dividend performance for almost all (20) of the equity REITs that are covered by the Value Line Investment Survey. The data excluded those REITs who were bought out during the decade. Nevertheless, I believe it to be a good, though far from perfect sample, in that it leaves out a few of the major mall companies that did well.

I used Value Line because the data is readily available and it presents long term results on a consistent basis. However to be more current, I am using current IBES estimates for 2010 and Zachs Investment Research for future growth rates. The 10 year record for FFO and dividends are presented in a table at the end of this column.

Several of the “blue chip” REITs did well over the decade. The best FFO growth was reported by Public Storage (PSA) where FFO almost doubled and dividends more than doubled. Simon Property Group (SPG), Vornado (VNO), Federal Real Estate Investment Trust (FRT) and HCP (HCP) all reported credible increases in FFO and dividends. Boston Properties (BXP) reported higher FFO but a slightly lower dividend and AvalonBay (AVB) and Washington REIT (WRI) reported modest increases in FFO, but significantly higher dividends. (NOTE: In 2000 FRT, PSA, HCP and for that matter SPG weren’t as highly regarded as they are today. Moreover with respect to BXP and VNO the data ignore the impact of very substantial capital gain distributions made by those two REITs.

On the hand there were many REITs in 2000 that were perceived to be of high quality that faltered during the past decade. Apartment Investment and Management (AIV), Duke Realty’s (DRE), Prologis (PLD) and Developers Diversified (DDR) had their FFO and dividends decline by more than 50%. Such highly regarded REITs as Kimco Realty (KIM) and Equity Residential (EQR) will earn less and pay smaller dividends in 2010 than they did in 2000. The same is true for Weingarten Realty Trust (WRI), UDR (UDR), and BRE Properties (BRE). The mid-Atlantic office companies, Mack-Cali (CLI) and Liberty Property Trust (LRY) are also earning less and paying out less to their shareholders. The same holds true for Healthcare Realty Trust (HR).

In contrast to their short-run low-balling of earnings estimates, sell-side analysts are ever optimistic with respect to long term growth. Going forward analysts believe that REIT FFO growth rates will be in the range of 4-7% for most REITs, save for a few outliers. It may turn out that way, but history is on the side of the skeptics.

To be sure real estate fundamentals might drive REIT earnings higher, but where most analysts miss the mark it is with respect to capital expenditures and adverse changes in capital structure which are inherently difficult to forecast. Remember that the fastest growing REIT in the sample was PSA with a historic growth rate of 6.1%. Among the better performing REITs the growth rates ranged from 5.1% at SPG to 0.7% for AVB. Against the backdrop of the past decade, a seemingly modest 4% growth rate is stellar.

Similarly dividend growth left much to write home about. AVB, FRT, PSA, VNO and WRE reported solid dividend growth -- in the range of 32%-106%. On the other hand dividend payouts were crushed at AIV, DDR, HR, and PLD. This is hardly a record that inspires confidence for the coming decade.

Said differently, for REITs to work in the coming decade, multiples have to remain high and historically optimistic analyst forecasts have to be realized. We do not have the luxury of low multiples to protect us from untoward events.

Figure 1. REIT FFO and Dividend Growth Per Share, 2000 – 2010E

REIT '00 '10 CAGR Est.CAGR '00 '10 %Ch
FFO Dividend

AIV $4.81 $1.28 -12.4% 6.3% $2.80 $ .40 -86%
AVB 3.70 3.97 0.7 6.6 2.24 3.57 59
BRE 2.38 1.87 -2.4 6.1 1.70 1.50 -12
BXP 3.46 4.23 2.0 5.2 2.04 2.00 - 2
DDR 2.19 .86 -8.6 N/A 1.44 .08 -94
DRE 2.46 1.08 -7.9 26 1.64 .68 -59
EQR 2.50 2.16 -1.5 4.9 1.58 1.35 -15
FRT 2.56 3.88 4.2 7.1 1.82 2.64 45
HCP 1.66 2.15 2.6 6.4 1.47 1.86 27
HR 2.62 1.32 -6.6 5.3 2.23 1.20 -46
KIM 1.35 1.11 -1.9 3.0 .91 .64 -30
LRY 3.17 2.65 -1.8 8.7 2.13 1.90 -11
CLI 3.79* 2.79 -3.0* 5.0 2.38 1.80 -24
PLD 2.21 .59 -12.4 34 1.35 .60 -56
PSA 2.59 4.70 6.1 19 1.48 3.05 106
SPG 3.28 5.40 5.1 7.9 2.02 2.40 19
UDR 1.47 1.11 -2.8 4.4 1.07 .73 -32
VNO 3.86 5.17 3.0 10.3 1.97 2.60 32
WRE 1.79 1.97 1.0 1.0 1.23 1.73 41
WRI 1.93 1.66 -1.5 4.6 1.33 1.04 -22

*-Corrected

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

Dividend Yields, Bond Yields and Macroeconomic Policy

2010-08-14T09:18:00.000-07:00

Last week Aaa rated Johnson & Johnson (JNJ) sold 10 year bonds at a 3.15% yield, well below the 3.71% dividend yield on its common stock. Old codgers like myself remember that stocks in general, with the exception of 1929, invariably yielded more than bonds until mid-1958. After that bonds always yielded more than stocks. As I wrote in my "Paradigm Shift" paper for Salomon Brothers in 1995 the reason for the revaluation of share prices then, in the view of Benjamin Graham, was that macroeconomic policy had the ability to prevent depressions. That view was logically based on policy successes that worked to end the recessions of 1948-9, 1953-4 and 1957-8 with the last one being particularly deep.

What the capital markets are now signalling is that stocks are especially cheap in the light of the past 50 or so years of history or perhaps, more ominously, the markets no longer believe that macroeconomic policy can work in preventing either a depression or a long period of Japanese-like stagnation. In a nutshell, at least for now, it is a vote of no confidence in the Obama Administration and the Fed.

In my own view its a little of both. Stocks are cheap, but the macro environment is extremely troubling. By way of disclosure, my family owns shares in JNJ.

In the Washington Post, "GDP report: Economic growth slows with 2.4 percent rate in second quarter", p. a1

2010-07-31T04:31:00.000-07:00

"The problem is it looks like the consumer was really weakening in June, so you're starting the third quarter in a position of weakness," said David Shulman, senior economist at the UCLA Anderson Forecast. "The components of this report are ugly."

Full URL: http://www.washingtonpost.com/wp-dyn/content/article/2010/07/30/AR2010073000806_pf.html

Is the U.S. Headed for a Double-Dip Recession?

2010-07-28T17:48:00.000-07:00

Reprinted by permission from Reitwrap special report dated July 19, 2010.

By David Shulman

Double-dip recessions are rare. The last one occurred from 1979-82 when a renewed round of Fed tightening triggered back-to-back declines in output. That hasn’t (isn’t) impacted discussions of whether the U.S. is headed (imminently, some argue) for a double-dip recession, however.

And last Friday’s nearly 3% drop in the broad market won’t do anything to diminish fears of a dreaded double-dip is looming. Reinforcing that concern was a decline in 10-year U.S Treasury bonds to nearly 2.9%.

Remember, of late, the bond market has been a much better forecaster of future economic activity than the stock market. Nevertheless, my own view is that the economy will not experience a double-dip recession. Instead I believe we are in for a sustained period of very slow growth. Over the next four quarters I would not be surprised to at least one quarter with real GDP growth less than 2% and no quarter with growth above 3%.

What accounts for my skepticism that the U.S. will experience a double-dip recession? Because, in the words of my UCLA colleague Ed Leamer, it usually takes a coordinating mechanism, to trigger a recession and absent an even worse crisis emanating from a collapse in the Euro, I don’t see it. Absent that trigger, there seems to be just enough impetus in capital spending, exports, inventory accumulation and modest increases in consumer spending to offset the weakness coming from deleveraging, policy uncertainty, state and local government spending and higher income taxes next year.

REITs were only beginning to reflect the coming sluggish growth reality with the late June to early July decline in share prices. How so? If my view about the future course of the economy is close to the mark, investors were beginning to realize that FFO estimates for later this year and all of 2011 are way too high. My guess is that the already optimistic analysts got sucked into much of the happy talk that was present at NAREIT’s recent REIT/WORLD confab in Chicago. If I am correct on that score -- they will likely be disappointed.

To be sure much of the optimism was grounded in a very real improvement in the real estate operating environment that took place over much of the first half. And second quarter results should be fine. However, my interpretation of what happened earlier this year is consistent with the inventory cycle the broader economy experienced. From the point of view of the tenant, leased real estate is much akin to business inventory that expands and contracts over the business cycle.

What happened earlier in the year is that enough tenants realized that they had excessively cut back on their space needs and either ceased cutting back or made modest additions to space. That showed up as improved, or, at least, less negative, absorption. Let’s make this concept a bit more specific by using apartment demand, which analysts and companies alike are most bullish about, as an example.

Just like most businesses apartment renters were shocked by the speed of the economic decline in late 2008 and early 2009. It seemed that we were headed for The Great Depression 2.0. Renters responded by staying put or moving in with friends and/or parents. As a consequence vacancy rates rose and apartment rents dropped. No surprise here. Then in late 2009 and in early 2010 without any meaningful employment growth, apartment demand picked up as tenants realized that the world wasn’t as bad as previously thought. With demand rising without employment growth, company managements and analysts began to mark-up their future outlooks, figuring logically that if things are getting better without employment growth, demand would really explode once jobs were being created in any meaningful amount.

It can certainly turn out that way, but if the increase in apartment demand was just a temporary inventory adjustment by tenants who recognized that a depression was off the table, then the future outlook for apartment rents and occupancies would be far more tepid. Obviously if the economy double-dips we would be in a whole new ball game, but the sluggish outlook I envision would mean that there would very little follow through to the demand increases experienced earlier in the year.

Similarly the demand for retail space will continue to remain depressed. Witness the very sluggish growth in June same-store sales reported last week. For whatever reason it seems that the economy really down-shifted in June. Furthermore the consumer continues to retrench from the leverage bubble of a few years ago. For example total consumer credit outstanding has been declining almost continuously since July 2008. As of May 2010 it was down $167 billion, or 6.5%. This decline is unprecedented since the start of the series in the early 1940s. More forward looking, the recent strength in high-end retailing waned in June, perhaps in response to a transitory fall stock prices. Note: There will be substantial and permanent tax increases for high-end consumers taking place next January with further rounds to come in 2012 and 2013. Analysts who expect high-end retailing to save them are whistling passed the graveyard.

In the case of the office sector, the weakest of the major real estate food groups -- with the notable exceptions of Manhattan and Washington D.C., the recovery in demand will have wait until the second half of 2012. Although private sector employment has been growing modestly, the all important financial sector continues to exhibit monthly declines. The recent blip up in Manhattan investment banking employment is the exception, not the rule.

Warehouse demand has reflected the swing in inventories from huge declines to modest accumulation. This recovery process still some legs in it, but it will likely wane by the end of the year as the inventory adjustment is completed.

All told my main point is that although I don’t think the economy will experience a double-dip, a sustained period of tepid growth will not bring with it any meaningful recovery in REIT earnings. Tepid growth when starting from a fully or near fully employed (occupied) economy can and does generate significant earnings growth, but that is not the case when vacancy rates are high.

Simply put, there is too much downward pressure on rents. This is especially true in a very low inflation environment. Going back to the sub- 3% yield on the 10-year Treasury bond, a yield that low implies there will be an insufficient dollar flow in the economy to ratify rent increases.

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

"Spending controls are key," Letter to the Star Ledger, July 6

2010-07-06T13:02:00.000-07:00

I wish Paul Mulshine would get off his Proposition 13 fixation. (“California dreaming on property taxes,” July 4). To be sure, New Jersey’s property taxes are way too high, but a Proposition 13-like solution is not the answer. I lived in California in 1978, the year Proposition 13 passed, and authored two academic articles (National Tax Journal and Southern California Law Review) on the subject.

Mulshine neglects two fatal flaws in Proposition 13. First, two identical houses standing side-by-side can and are taxed at substantially different levels. For example, it is not unusual to have one house taxed at $3,000 and another at $10,000 depending on the initial purchase price. Second, with property taxes cut back, California over-relies on volatile income taxes to fund public services. That is why the state is subject to periodic budget crises as flush times bring with them runaway spending that has to be cut back when an economic downturn causes a collapse in income tax receipts. Sounds familiar, doesn’t it?

The real solution is spending control at all levels of government. The compromise agreement announced over the weekend is a good start, but no real reform is possible without significant reductions in pension and health care benefits for public employees.

Full URL:http://blog.nj.com/ledgerletters/2010/07/new_jersey_property_tax_cap_wo.html

Democrats Adjourn, while Unemployed Suffer

2010-07-04T11:53:00.000-07:00

The Democrats control the White House and both Houses of Congress. They certainly have the power and, yet they don’t really seem to care about our nation’s most pressing problem, mass unemployment. On this July 4th nearly 15 million Americans are counted as unemployed and another 9 million are too discouraged to look for work or are under-employed. Indeed nearly one million workers dropped out of the workforce over the past two months. Given this crisis, what does the Congress do? It adjourns for the holiday. Meantime an extension of unemployment benefits and Pentagon funding await action.

Where is the concern for job creation as the officially unemployed and new entrants to the labor force wait and wait and wait? Although I have few ideas on the subject (see below), it is not all that clear what Congress can really do. Nevertheless it is hardly helpful to pass and propose new legislation that increases business uncertainty and feeds into the reluctance to hire. It seems that the Obama Administration has a giant checklist, stimulus-passed, healthcare-passed, financial reform-almost passed, cap and trade –in deep trouble, immigration reform-going nowhere. The checklist is the priority meanwhile the plight of the American worker falls by the wayside. If the Administration were serious about the economy creating jobs it would put a time-out on new regulations and cut business and payroll taxes. The deficit hawks would respond, how do you pay for it? Answer: redirect unspent stimulus money and cut out year spending on entitlements. And if Congress really had the nerve it would borrow $500 billion at 4%(current 30 year rate) to fund infrastucture projects with limited, meaning fast track, environmental review and without the prevailing wage provisions of the Davis-Bacon Act.

The Administration would not as it did a week ago hold up a loan guarantee from the Export-Import Bank for coal mining machinery to an Indian utility on global warming grounds. Only because of an outcry from the Wisconsin delegation where the machinery is made and the potential for embarrassment at an Obama event there did the Administration relent. It is chicken-shit stuff like this that drives businesses crazy.

Of course the Republicans are offering no solutions either, but they do not have the burden of being in control. The Democrats have the burden and they are royally blowing it. So much so that they may soon give the Republicans the opportunity to show that they are serious.

Are REITs Pricey? You Betcha!

2010-07-03T10:18:00.000-07:00

Reprinted by permission from REIT Wrap Special Report, June 24, 2010

By David Shulman

This month’s column won’t win me the “Mr. Congeniality” award. As those who have followed my work over the years will attest—this is nothing new.

What I will outline below is my view that relative to stocks, REITs and for that matter real estate, look very over-priced. This cannot persist long-term!

History suggests that in recoveries from structural bear markets, the previous bull market leaders tend to significantly lag after an initial rally. For instance, the tepid performance of technology stocks, the bull market leadership of the 1990s, over the past decade. As a result, today, tech stocks look cheap compared to real estate.

At this month’s NAREIT meeting in Chicago Sam Zell told the audience that “a REIT is a stock, first last and always.” Like stocks in general REITs respond to broad macroeconomic and industry specific fundamentals and are valued by stock market metrics.

Try as NAREIT would like to compare REITs with real estate, every trading day the shares are evaluated by stock investors in general not just investors seeking a real estate proxy. As a matter of fact this behavior is exactly what many of the pioneers of the modern REIT era had hoped for.

Because, REITs do not trade in their own real estate-centric cul-de-sac, they are continuously compared to other sectors of the stock market and by the normal metrics of stock market valuation REITs appear to be especially over-priced.

According to data compiled by Michael Bilerman’s team at Citigroup REITs are trading at a weighted average FFO multiple of 15.3X on 2010 estimates. As we all know, FFO is not a normal stock market metric, in fact it an alien measure so here we will use some common equity valuation measures that are also suitable for REITs.

Two appropriate measures would be free cash flow yields to equity (net income per share plus depreciation minus capital expenditures and incremental working capital requirements/equity market capitalization which is analogous to Reitland’s AFFO yield) and EBITDA multiples (Enterprise Value/EBITDA). By these metrics REITs are currently trading at an estimated 5.1% free cash flow yield based on 2010 estimates and 16.6X latest quarter EBITDA run rate.

By comparison the broader market, according to Goldman Sachs, is trading at a 7.0% free cash flow yield 7.9X EBITDA based on consensus estimates for 2010. On average, then, corporate equity returns about 40% more free cash per dollar invested than REITs and trades at half the EBITDA multiple.Further free cash flow in the corporate sector is after research and growth capital expenditures, while the estimate of AFFO only subtracts maintenance capital expenditures.

In order to better make my point let’s compare the valuation metrics for several of the leading REITs and compare them with well known industrial companies. Put bluntly the valuation differences are stark. By way of reference I have included an estimate for unleveraged physical real estate assuming a 7% cap rate, 50 basis points of management fees and 100 basis points for capital expenditures.

Below are the estimated 2010 free cash flow yields and EBITDA multiples for the selected REITs followed by an estimate for physical real estate and then the data for the selected industrial companies. Notice that my list of industrials includes such premier growth companies as Apple Computer (AAPL) and Google (GOOG). The data for the REITs are from Citi. The data for the industrial companies come from multiple sources, largely Factset and my own calculations.

REITs
AvalonBay (AVB) 3.2%, 24.8X
Equity Residential (EQR) 4.0%, 19.9X

Simon Property Group (SPG) 4.9%, 16.4X
Regency Centers (REG) 4.7%, 15.4X

Boston Properties (BXP) 3.5%, 16.7X
Vornado (VNO) 4.2%, 17.0X

AMB Property (AMB) 3.7%, 18.6X
Public Storage (PSA) 5.1%, 16.2X
Ventas (VTR) 5.4%, 16.5X

Physical Real Estate @7% cap rate 5.5%, 15.4X

Industrials

Apple Computer (AAPL) 4.7%, 14.3X
Google (GOOG) 5.6%, 12.8X
Microsoft (MSFT) 8.2%, 7.9X

Abbott Laboratories (ABT) 9.0%, 9.4X
Johnson & Johnson (JNJ) 8.2%, 8.0X

Emerson Electric (EMR) 5.1%, 10.4X
Illinois Tool Works ( 8.2%, 11.3X
3M (MMM) 7.0%, 8.8X

Coca Cola (KO) 6.0%, 12.3X
Procter & Gamble (PG) 6.1%, 10.2X

Exxon Mobil (XOM) 5.5%, 7.2X
Chevron (CVX) 6.2%, 4.9X

The data clearly suggest that investors value one dollar of real estate cash flow far more than one dollar of corporate cash flow. In fact AvalonBay is way more expensive than Apple Computer and Google looks real cheap relative to all of the REITs!!! Furthermore Abbott Laboratories, Johnson & Johnson and Microsoft have free cash flow yields in excess of 8%, 60% higher than the average REIT. From a valuation perspective either both real estate and REITs are extraordinarily expensive or that stocks, in general, are a super bargain.

This discrepancy in valuation may not mean all that much to a dedicated REIT manager who is required to invest in the real estate space, but to a diversified manager of equities and to an asset allocator the valuation differences have to be troubling.

To be fair the markets could be signaling that in the years to come real estate cash flows will be far more durable than corporate cash flows. That certainly is possible, but as we have seen over the past few years the real estate economy seems to be inexorably linked to the overall economy. It is, therefore, hard to imagine a weak corporate profit environment being a good thing for real estate demand. Moreover should the current monetary and fiscal policies lead to a significant inflation later in the decade, the extraordinarily low interest rates we are now experiencing will become a thing of the past. In that environment the low 5%-7% cap rates of recent years could very well revert to the more normal 8% to 10% range.

Yes, real estate cash flows could very well outperform corporate cash flows in a more inflationary environment as depreciation allowances prove to be inadequate to replace equipment. During the inflationary 1970s corporate cash flow lagged well behind net income as the cost of replacing inventory and equipment at higher and higher levels became a very real drain on cash flow. It was in that environment where real estate cash flows proved themselves to the broad investing community. Are we going back to that world? Not likely in my opinion.

Alternatively most investors believe that the real growth in the global economy over the next decade will take place outside of the United States. It is, therefore, improbable that domestic real estate cash flows will outperform the cash flows being derived from the global corporations listed above which leaves me hard pressed to explain the valuation differences.

Simply put at current prices, non-REITs appear much more attractive than domestic real estate and REITs and because REITs are generally trading at premiums to their underlying real estate value, look even more expensive.

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and theUCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

The Outlook for Commercial Real Estate: The Rocky Road Ahead, UCLA Anderson Forecast, June 2010

2010-06-17T04:17:00.000-07:00

When I started writing this section in early May my tentative title was “Party Like its 2006.” Despite all of the well publicized problems facing the commercial real estate industry, asset prices for both buildings (up 20%) and publicly traded real estate investment trusts (nearly triple) were recovering rapidly, bidding wars for individual properties were breaking out and credit spreads for commercial mortgages were in steep decline. (See Figures 1, 2, and 3) Indeed the improved environment was reflected in the rising optimism of Southern California office developers. (See Figure 4) Simply put the Fed’s zero rate policy was working its wonders and investors were willing to look past the current problems of high and rising vacancy and mortgage default rates. Remember with very low interest rates the banking strategies with respect to commercial mortgages of “delay and pray” and “extend and pretend” can and actually are working.

Figure 1. Green Street Advisors Commercial Property Index, Dec 97 –April 10

Source: Green Street Advisors
Figure 2. Dow Jones Real Estate Index, I-Shares, June 2006 – May 2010, Weekly Data

Source: BigCharts.com

Figure 3.Super-Senior AAA CMBS Spreads to Swaps, Jan 07 –May 10, Monthly Data

Source: Bloomberg

Figure 4. UCLA-Allan Matkins Office Developer Sentiment Survey

Source: UCLA Anderson Forecast and Allan Matkins

For a short time it seemed that the combination of very low interest rates and slow, but sure economic growth were more than enabling the industry to work its way out of rising defaults in its $3 trillion dollar debt load. However the “Euro Crisis” brought with it rising credit spreads and fears that an aftershock from the 2007-09 credit crisis would make it far more difficult to restructure the industry’s debt burden. Our view is that the improvement in real estate capital market sentiment was way over done. To be sure there will be a recovery, but that recovery will likely occur in fits and starts. In a word it will be rocky. There is just too much debt that has to be worked through and it will take time to re-characterize a significant fraction of it as equity. After all Fitch Ratings has forecast that loans 60 days or more past due in the $536 billion CMBS market will rise from the current 7% to 11% by yearend.

The Collapse in Supply

From a fundamental point view vacancy rates are peaking. (See Figure 5 for office vacancy rates) New starts came to a screeching halt at the end of 2007 and with modest growth vacancy rates will gradually decline. Real commercial construction spending will suffer a peak-to-trough decline by early 2011 of 51% since the 2007 high. (See Figure 6) Similarly multi-family starts declined by 80% from 378,000 in the first quarter of 2006 to 77,000 units in the fourth quarter of 2009 and only a gradual rebound is forecast. (See Figure 7) Thus new supply will not be problem for the next several years.

Figure 5. National Office Vacancy Rate, 1991Q1-2010Q1

Source: REIS

Figure 6. Real Commercial Construction Spending

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 7. Multifamily Housing Starts, 2000Q1 -2012Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Structural Weakness in Demand

The real problem, however, is on the demand side. Put bluntly, the modest economic growth we a forecasting means that it will take several years to bring the supply and demand for commercial real estate into some semblance of balance. Why? The economy is in such a deep hole that total employment in early 2010 was back to where it was in late 1999. (See Figure 8) After peaking in December 2007, total payroll employment dropped by 8.4 million jobs making the recession, in term of employment, 3-4 times worse than prior postwar recessions If employment growth is a rough proxy for commercial real estate demand, than every project built in the first decade of the 21st century can be viewed as superfluous. To be sure there is a more than a little hyperbole involved with the prior sentence, but you get the picture. That is why even in a limited construction environment, excess capacity will weigh on commercial real estate for many years to come.

Figure 8. Nonagricultural Employment, 2000Q1 – 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

A skeptic might argue that total employment, which includes manufacturing and construction jobs, might have little to do with office, high end retailing and apartment demand. A fair point so let’s look at financial activities employment. As of the first quarter financial activities employment was off by 730,000 jobs since its fourth quarter of 2006 peak, a decline of 8.7%. (See Figure 9) An industry that was once viewed in secular growth category has proved itself to be highly cyclical, not a good omen for the stability of future office demand. More importantly financial activities employment is now back to where it was in mid- 1999! Indeed employment in this sector is forecast to be well below its peak level at the end of 2012.

Figure 9. Financial Activities Employment, 2000Q1 -2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

In a related vein even the law business, a core tenant for pricey CBD office space, is now under extreme stress. Employment in legal firms over the past year declined by 28,000 jobs, or 2.5%. Now here is a business, which was once thought to be recession-resistant, now suffering through the pains of a fundamental restructuring of its business model, the billable hour.

In terms of the office demand I am hard pressed to come up with a scenario where demand recovers quickly and because the employment declines have been so severe it is reasonable to assume that many office using firms a carrying excess space relative to their needs. Thus as leases roll over tenants will just as likely reduce their space demands as increase them.

In the case of retail demand, the consumer has been chastened by the bear market in homes and stocks and a significant fall in the rate of pay increases. Where earlier in the decade and in the late 1990s private sector compensation was growing in the 3-4% range, of late it has been increasing at a 1-1.5% rate. From 1991-2007 consumers financed part of their consumption out gains accruing from rising stock and home prices. As a consequence the savings rate collapsed from an historic 7-10% down to a low 1-2%. It has subsequently popped to 4-5% and in all likelihood it is on the road back to 7% after an intermediate decline from 2011-2013, caused by increased taxation on high income taxpayers, to the 2-3% range. (See Figure 10) Along the way consumers have started to pay down debt in an unprecedented manner. After rising inexorably for decades total consumer credit outstanding dropped by an unprecedented $130 billion or 5% from September 2008 to March 2010.

Figure 10. Personal Savings Rate, 2000Q1- 2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Thus it does not take rocket science to explain that the combined effects of falling asset values, slowed compensation growth, high unemployment and debt pay downs have made for a very disappointing retail environment. To be sure retail sales have bounced off the bottom, but remember total retail sales in April were still 3.7% below their November 2007 peak. (See Figure 11) This data certainly smells like there is quite a bit of excess capacity in retailing.

Figure 11. Retail Sales, 2005 –April 2010, Monthly Data

Source; U.S. Department of Commerce

Because so much of what is sold by retailers is imported, the demand for coastal warehouse space will be less than ebullient. After collapsing during the recession imports are now growing, but at a rate far slower than during the import boom of 2003-2007. (See Figure 12) Furthermore west coast ports will face increased competition from the Panama Canal where a major widening project is scheduled to be completed in 2014. Simply put the ship-to-rail link to the Midwest and east coast will be facing new competition through an all ship link to the Atlantic and Gulf coasts via the Panama Canal. To be sure the Panama Canal alternative is not without issues, but it does offer shippers the opportunity to limit their dependence on west coast ports.

Figure 12. Real Imports, 2000Q1 -2012Q4F, Quarterly data, In $2005.

Source: Department of Commerce and UCLA Anderson Forecast

Trust me, this not a forecast I want to be right about, but it is hard to visualize anything but a long hard slog ahead for the real estate economy that will be eased by limited new supply. Indeed much of the recent strength in the overall economy has come from massive doses of fiscal and monetary stimulus. In a nutshell, the economy is highly medicated. Thus we won’t really understand the underlying strength of the economy until the Fed ends its zero interest rate policy and the federal deficit drops from 11% of GDP to an optimistic 3% of GDP. Nevertheless it is a far cry from all of the gloom and doom we heard about commercial real estate in 2009.

I would like to think we have learned a lot over the past few years. One of the lessons that I have taken away from the experience is that the Great Moderation of 1982-2007 is over and we are about to enter a new world that is beyond the working experience of most real estate professionals now in the field. My guess is that going forward commercial real estate demand will be growing more slowly and that it will be more cyclical. As a result investors could very well find it difficult to exceed the long run 7-9% total returns for unleveraged real estate reported by the National Conference of Real Estate Investment Fiduciaries.

Obama's Return to Earth

2010-06-05T11:17:00.000-07:00

One of the political by-products of the horrible oil spill in the Gulf of Mexico is that it has ended, once for all, the image of President Obama as "messiah" or as "The One." During the campaign all too many of my liberal friends were in a state of rapture over Obama's then candidacy. In their view he would truly be the miracle worker who would right all of the wrongs of the Bush Administration.

Unfortunately he is a mere mortal. No parting of the Gulf waters here so the crews could cap the leaking well a mile below the surface of the sea. Had this incident happened under George Bush the long knives of impeachment would have been unsheathed, but the well would still be leaking just as it is now.

What this return earth means is that come 2012, the near idolotrous zeal the white liberal community exhibited for Obama will be a shadow of its former self.

What's Wrong With ATM Deals? Plenty!

2010-05-29T11:16:00.000-07:00

Reprinted by permission from REIT Wrap Special Report, May 20, 2010

by David Shulman

When the history of the next REIT bear market is written, one of its causes almost certainly will be the widespread uses of at-the-market, or ATM, offerings.

Simply put an ATM is a “slow motion” stock offering that enables an issuer to dribble out shares over an extended period of time based on a defined percentage of trading volume. The total amount of stock involved can be substantial; typically, it runs around 10%, but sometimes as high as 25%, of the shares outstanding at the time of registration with the Securities and Exchange Commission. A REIT with an ATM can issue shares at will; except during “black-out” periods (e.g., surrounding earnings releases).

Roughly a third of the equity REIT universe has an ATM on file with the SEC currently. The list includes some blue-chip REITs [e.g., Avalon Bay (AVB), Boston Properties (BXP), Equity Residential (EQR), and Essex Property Trust (ESS)]. That so many REITs have jumped on the ATM bandwagon is hardly an argument for ATM deals. The case against ATMs was recently (April 20) put forth (convincingly, I’d add) in a piece posted to NAREIT’s website (http://www.nareit.com) by Joe Harvey, president and Chief Investment Officer for Cohen & Steers (CNS), one of the largest buy-side REIT shops. Over roughly two decades, Cohen & Steers and I have occasionally differed on issues; on this one, however, we’re on the same page!

Yes, companies announce when they have signed agreements to offer shares via an ATM. But it is difficult, especially for “retail investors,” to know who is doing the selling. Is it the company (a dilutive sale) or another shareholder? In that way investors large and small alike have an equal opportunity to be “arbed” by the issuer. It is a conundrum that is at odds with the transparency that REITs talk about so frequently. That’s not the only issue, however.

Something more insidious is going on. ATMs create the illusion that equity is cheap and can be sold at will. It is just too easy! Plus, because the costs associated with issuing shares via an ATM offering are well below those associated with a conventional follow-on deal, the sales pitch to REITs by investment bankers is straightforward. Unfortunately, issuing equity is far more serious than a stop at the local ATM to pick up some cash. Specifically, REIT managements that use ATMs don’t have to answer investor questions about the use of proceeds, or the outlook for their businesses. And, investors don’t learn how many shares have been sold via the ATM offering until the REIT issues an announcement; typically, when it announces earnings. Is this the sort of full disclosure and good corporate governance that investors expect from REITs?

It is not surprising that Cohen & Steers along with other dedicated buy-side REIT shops might take issue with the widespread use of ATMs. After all, it is the institutions that get first crack at conventional follow-ons. An advantage they don’t have in the case of ATMs. However, because they are acting in their own self-interest doesn’t put them at odds with the interests of individual investors. Nor does it diminish the validity of the points made by Cohen & Steers’ Harvey.

Personally, I believe the fairest and most transparent way to issue stock is through a rights offering, which gives shareholders in the REIT a pro rata right to maintain their proportionate interest in the company. Though widely used in Europe, Japan and Australia, rights offerings haven’t been used (generally) in the U.S. for decades. Why? It is a long story (grist, perhaps, for a future column).

Thus far, the REIT bull market has papered over the potential negative side-effects of these “stealth equity offerings.” Oftentimes, what feels good at the moment may leave investors with a serious hangover down the road. Consider the rush to embrace forward equity deals, roughly a decade ago. Admittedly, forward equity deals were far more toxic than ATMs. Nevertheless, the law of unintended consequences is ignored at our peril. And there’s no way around the fact that whatever their perceived benefits, ATMs debase the value of the shares outstanding prior to issuing shares via an ATM offering.

-----------

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He
is now affiliated with Baruch College, the University of Wisconsin and the
UCLA Anderson Forecast. He can be contacted at:
david.shulman@baruch.cuny.edu.

Where Was Corzine's Ax a Few Years Ago? Letter to The Wall Street Journal, May 28

2010-05-28T04:53:00.000-07:00

I read with great interest that Jon Corzine is taking the ax to 10% to 15% of MF Global Holdings Ltd.'s workforce ("Corzine Takes Ax to MF Global," Deals & Deal Makers, May 21).
New Jersey would have avoided the fiscal crisis it is now facing if only former Gov. Corzine had acted with such alacrity and applied the same results-oriented standards to the state's business.
David Shulman

REIT Merger Wave: Don't Hold Your Breath

2010-04-24T07:34:00.000-07:00

Reprinted by permsion from REIT Wrap Special Report, April 14, 2010.

By
David Shulman*

The heated battle for General Growth Properties and the general increase in merger activity across corporate America has increased speculation that a new wave of REIT mergers will soon be upon us. Although certainly possible, don’t hold your breath. Simply put, with REITs trading at 130% of net asset value, according to Green Street Advisors, a Newport Beach, California-based buy-side boutique, it makes little sense for a REIT to pay 130 cents plus an acquisition premium and merger costs for 100 cents of assets. The more obvious play is to acquire assets in the private market for 100 cents which is now happening, albeit slowly.

Of course all of my investment banker friends, yes I do have friends in the banking community, would argue that an acquiring REIT can easily get around this issue by using their high-priced stock as an acquisition currency. In that case the acquirer would be paying with their own newly minted 130 cent dollars. It is not as simple, however. In order for a merger to be successful there has to be value creation for the acquiring company and merely purchasing assets does not create value unless the shares of the acquirer are truly over-valued (issuing what Warren Buffet has called “counterfeit currency”). In either case in order to create value the acquiring shareholders have to end up with more value at the end of the deal than at the start.

For instance if REIT A issues 25% of its stock to acquire REIT B, then upon completion of the transaction REIT A’s shareholders would own 80% of the newly combined company. Thus for the merger to work for REIT A’s shareholders 80% of A+B has to be worth more than 100% of A. This metric is a very high hurdle because, aside from the mall sector, there are no real economies of scale in REITland. Said differently it is very difficult for a REIT to create value though public-to-public mergers in the current environment. Yes there are savings to be had by “vaporizing” the G&A costs of the acquired company, but over time as firms grow larger the initial G&A savings wither away in the form of higher executive compensation and a larger bureaucracy. Indeed, the absence of economies of scale and the tendency for G&A to drift higher with firm size make it so difficult to point to successful public-to-public REIT mergers.

Nevertheless, the lure of using high priced stock for acquisitions is too hard for many REIT executives to resist. An easy way of disabusing them of this notion is to restructure the merger as a cash transaction. Would the buyer pay cash for an acquisition and fund it by a public offering of stock? From the point of view of the buyer this is no different than issuing stock directly to the seller. However, the fig leaf of directly using high-priced stock to pay for the acquisition would disappear and shareholders would be forced to look at the transaction’s true cost.

The discussion thus far has been generic so let’s focus in on the more micro issues as to who would be the buyers and sellers if there were to be a merger wave. It has been long known that there are too many small REITs trading in the marketplace that have no real reason to be public. Many of these companies would probably like to be acquired, but for too many obvious reasons there are no real bidders, especially at a significant premium to net asset value. If these companies weren’t taken over during the great privatization wave of 2004-07, when will they be taken over?

Moreover if you look at the larger companies in each sector it unlikely that a Vornado (VNO), Boston Properties (BXP) or a Brookfield (BPO) would buy a suburban office company. Any one of them might want to do a “strategic” deal in buying Los Angeles oriented Douglas Emmett (DEI), for example, but I doubt it would be for sale and if it were, it certainly wouldn’t come cheap. Remember in M&A parlance the word “strategic” is a synonym for overpay. It is also unlikely that an Equity Residential (EQR) or an Avalon Bay (AVB) would buy any of the smaller apartment REITs operating in the southeast or southwest.

In the case of the mall sector, there’s lots of speculation that once the General Growth saga is settled that “the loser” might be on the prowl for Macerich (MAC) or Taubman (TCO). We remember Simon (SPG)/Westfield’s (WDC) failed attempt to buy Taubman. But can you visualize Simon or Brookfield going after CBL & Associates (CBL) or Penn REIT (PEI) for example? Very unlikely.

That leaves the possibility of small- or medium- sized REITs buying each other. It is possible to visualize, for example, Camden (CPT) acquiring Post Properties (PPS) or Duke Realty (DRE) merging with Highwoods Properties (HIW) as well as M&A activity in the healthcare sector. Again all of these hypotheticals still have to overcome the merger issues I raised earlier.
For those reasons, it is my sense is that the “real M&A activity” will take place with public companies buying private assets. Although it is unlikely there will be the feeding frenzy that many though would emerge a year ago, many private assets will have to trade because they cannot support the capital structures they are burdened with. Some of these transactions will come in the form of purchasing whole companies that were privatized only a few years ago, but most will be in the form of one- off transactions such as the recent purchases of busted condominium projects by Equity Residential and Essex Property Trust (ESS). The economics of these one-off transactions are far preferable to buying an existing REIT at a 130%+ premium to net asset value.

Yes, the money spigots have opened to real estate investing and there are few bargains available in the private market for core real estate. Nevertheless, core assets might still be available at a “fair price” and non-core assets or core assets with leasing risk might offer significant opportunities for REITs with the appropriate skill sets. If I am close to the mark, then it looks like AMB Property Corp. (AMB) did exactly the right thing when it recently sold roughly $425 million in stock to make “…equity investments in co-investment funds, acquisitions of properties, portfolios of properties or interests in property-owning or real estate-related entities.”

*-David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and theUCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

A Shot Across the Bow

2010-03-28T14:34:00.000-07:00

Last week's rapid rise in interest rates sent a shot across the bow of the recovering U.S. economy. It was no accident the the rise in 10-year U.S. Treasury yields to 3.85% from 3.69% the week before occurred immediately after Congressional passage of the massive healthcare reform bill. Although the Congressional Budget Office scored it modestly deficit favorable, the real truth is that all of the medicare cuts and tax increases could have been used to reduce the deficit. Instead of cutting the deficit by $1 trillion over ten years, the resources will be used to finance a new entitlement program.

Remember the tax increases on high income earners and the medicare cuts were "low hanging fruit." The hard work lies ahead of us and the bond market now recognizes how difficult the task of deficit reduction will be. Thus interest rates will continue to rise and the nascent recovery will be put at risk.

"The Bipolar Economy," UCLA Anderson Forecast, March 2010

2010-03-26T06:27:00.000-07:00

The economy seems to be suffering from a bipolar disorder. For example since 1985 there have been 15 quarters where real GDP expanded by 5% or more including the 5.9% gain in fourth quarter. In every one of them, except for the fourth quarter of 2009, payroll employment typically expanded on the order of a 2-3% annual rate. In contrast employment contracted at an annual rate of 1.3% in the fourth quarter. Unfortunately the closest comparable was during the “jobless” recovery of 2003 where in the third quarter of that year real GDP grew by 6.9% and payroll employment increased at 0.1% crawl. In economics terms “Okun’s Law,” which defines a relationship between GDP growth and unemployment, appears to have broken down as gains in productivity swamped the employment effects of a growing GDP.[i]

Ironically the sluggish growth in payrolls could be an unintended side effect of all of the economic medication coming from fiscal and monetary policy. The stimulus seems to working its effect on GDP and temporary hiring, but make no mistake the follow through to a sustained expansion in employment has been disappointing. After all long term hiring decisions are not generally based on temporary tax and spending programs coupled with a non-sustainable zero interest rate policy. In addition all of the policy uncertainty coming out Washington has made more difficult for businesses to ascertain their long term cost structures. Nevertheless the economy is now on growth path and employment will soon be increasing, albeit modestly.

After a stunning inventory-led 5.9% increase in real GDP in the fourth quarter, we expect the economy to grow at a 3.2% rate in the current quarter and continue to grow at a 2%+ rate for the remainder of the year. (See Figures 1 and 2) Moreover real GDP is forecast to grow at a 2.3% and 3.2% pace in 2011 and 2012, respectively. However, in keeping with our bipolar disorder thesis unemployment will remain high throughout the forecast period. We forecast that the unemployment rate will be 9.6% at the end of 2010, just a tad lower than where it is today and 9.1% at the end of 2011. (See Figure 3) Why? Simply put employment growth will struggle to stay barely ahead of labor force growth. Furthermore, with the modest employment growth we are forecasting, payroll employment will still be two million jobs below its peak in 2007 by the end of 2012! (See Figure 4) Even after creating about 200,000 jobs a month in 2011, the economy will find it very difficult to climb out of the 8.4 million lost job hole it dug for itself.

Figure 1. Real Inventory Change, 2005Q1 – 2012Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 2. Real GDP Growth, 2005Q1 – 2012Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2005Q1- 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4. Payroll Employment, 2005Q1 – 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

The Basis for Recovery

The recovery we envision is based on strength in business equipment and software, exports, and a revival in home construction from its postwar nadir to a more normal level of housing starts. (See Figures 5, 6 and 7) With the exception of housing all of these forces are now in train.

Figure 5. Real Equipment and Software Spending, 2005Q1-2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Exports, 2005Q1 – 2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Figure 7. Housing Starts, 2005Q1 – 2012Q4

Source: Bureau of the Census and UCLA Anderson Forecast

Growth will be held back by declines in nonresidential construction and the hitherto resistant state and local government sector. (See Figures 8 and 9) Nonresidential construction is suffering from weak demand and the after effects of the credit crisis. As is typical for most cycles nonresidential construction lags the overall economy. Thus we expect to witness a recovery here starting in the second half of 2011.

In contrast the ongoing restructuring of state and local government represents a fundamental structural adjustment. Something more than the recession is at work. The era of public employment and compensation well exceeding private sector averages is coming to an end. Further exacerbating the situation is the trillion dollar underfunding of state and local pension plans.[ii] A gap that will be closed by a combination of reduced employment, lower pay, lower benefits, higher employee contributions and higher taxes.

Figure 8. Nonresidential Construction, 2005Q1 – 2102Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 9. Real State and Local Government Spending, 2005Q1 -2102Q4

Source: Department of Commerce and UCLA Anderson Forecast

Although the recent data on retail sales have been somewhat better than expected, we continue to believe that balance sheet impaired consumers will reign in their spending. To be sure consumer spending will be growing, but the 2% or so growth that we are forecasting will be far less ebullient than the 2005-7 housing bubble era. (See Figure 10)

Figure 10. Real Consumer Spending, 2005Q1- 2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Interest Rates and Inflation: The Big Question Marks

Despite the high unemployment rates we forecast, with the economy on the mend, we anticipate that the Federal Reserve will start moving away from its zero interest rate policy this fall. Simply put, the financial emergency of 2007-2009 is over and we believe that the Fed will soon recognize this reality. To be sure interest rates will remain historically low throughout 2011, but the way will be open to more normal interest rates. Concomitantly the yield on 10 year U.S. Treasury notes will gradually rise above 4% later in the year and rise modestly thereafter. (See Figure 11) Indeed the deficits arising from the financial crisis and its hangover will exert upward pressure on interest rates for a long time to come. (See Figure 12)

Figure 11. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2005Q1 – 2012Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

Figure 12. Federal Deficit, 2005 – 2012F

Source: Office of Management and Budget and UCLA Anderson Forecast

Despite the sluggish growth we are forecasting, we believe that the real risk the economy faces is that of inflation. By way of analogy the Fed’s monetary policy has strewn kindling wood throughout the economy that could ignite into inflation at any time. Presently the kindling is wet and is in no danger of ignition, but in a few years that might not be the case. We believe that the Fed understands this risk and that is why we believe policy will be tightened this year.

Our forecast assumes that inflation will remain under control. Nevertheless core CPI is forecast to be modestly in excess of the Fed’s historic target of 2% in 2012. (See Figure 13) Yes, 2012 is a long way off, but markets have a way of telescoping future events into current market prices with astounding rapidity.

Figure 13. Core CPI, 2005Q1 - 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Conclusion

Modest GDP growth will soon translate into job growth, but the unemployment rate will stay above 9% through 2011. After a huge inventory rebound, economic recovery will be led by equipment and software, exports and housing. Offsetting these strong sectors will be weakness in state and local government, nonresidential structures and tepid consumption growth. Although the threat is real, inflation will remain modest throughout the forecast period as the Fed ends its zero interest rate policy and gradually returns interest rates to more normal levels.

[i] See, Daly Mary and Bart Hobijn, “Okun’s Law and the Unemployment Surprise of 2009,” FRBSF Economic Letter, March 8, 2010.
[ii] “The Trillion Dollar Gap,” The Pew Center on the States, February 2010.

Letter to NY Times(Online Edition), Mar 12

2010-03-13T06:20:00.000-08:00

To the Editor:
Re Bob Herbert’s column and “The Emotion of Reform,” by David Brooks (column, March 9):
It was great to see Mr. Herbert and Mr. Brooks agreeing with each other. President Obama’s maniacal obsession with health care shows complete disregard for the jobs crisis facing our country. Moreover, as Mr. Brooks points out, the focus on health care has created so much uncertainty in the small-business community that new hiring has all but ceased. Wake up and connect the dots.
David Shulman

http://www.nytimes.com/2010/03/13/opinion/lweb13herbert.html?scp=1&sq=%22David%20Shulman%22&st=cse

An Uneasy Look at Leverage

2010-03-10T17:27:00.000-08:00

Reprinted by permsion from REIT Wrap Special Report, March 2, 2010

By David Shulman*

Every REIT CEO and CFO should tattoo on their foreheads the following inscription, “Mike Kirby is right.” Mike Kirby is, of course, Director of Research at Green Street Advisors. He has been a voice in the wilderness calling for REITs to deleverage their balance sheets on the easy to understand grounds that higher leverage is statistically associated with lower long term shareholder returns and that unleveraged commercial real estate, which declined by 30% (likely an under-estimate of the true decline) in the early 1990s and 40% from 2007-2009, simply cannot afford to have leverage ratio in excess of 50% of gross value. Two crashes in 20 years are a bit much for an “asset class” heralded by the pension consultants as “safe.” By the way my UCLA dissertation written in 1975 found no gains to leverage for the few REITS that were in existence from 1963-74.

Moreover there really isn’t any support in financial theory for REITs to be leveraged. Kirby rightly notes the famous leverage indifference theorem of Miller and Modigliani which states that in a world of no personal and corporate taxation there are no gains to be had by leveraging up the balance sheet and in fact there is the risk of the enterprise bearing the costs of bankruptcy. As General Growth is showing us, those costs can be quite substantial.

The real “advantage” from leverage comes from the tax deductibility of interest at the entity level which REITs don’t have. To be sure interest payments at the REIT level can shield income from taxation at the personal level when it is paid out as a dividend, but to the extent that REITs are owned by tax exempt institutions that advantage goes away. Put simply REITs at best receive minimal benefits from leverage, but all of its costs.

If all of what I am saying is true, why do REITs leverage up? My own answer is that leverage has been in the DNA of every real estate professional ever since the first developers in the ancient city of Ur came on the scene. Besides, leverage is made for long-lived assets with relatively stable income streams. That is why institutions usually like to finance income producing real estate, but just because there is a willing lender doesn’t necessarily mean there should is a willing borrower. Nevertheless there are willing borrowers because the empire builder that resides in every real estate professional cannot just say “No” to the crack dealers of Wall Street.

So if theory says “No”, and the evidence says “No”, but existing practice obviously says “Yes” to leverage, where do we end up? What the market might be saying, to state the obvious, is that low leverage is benign and high leverage is malignant. Thus the degree of leverage a REIT takes on should not jeopardize the firm under stress conditions. The questions are where do you draw the line and what is the right measure for leverage.

First we have to dismiss the most widely used measure of leverage, debt/gross asset value. Why? Debt/gross asset value is a poor measure because it is very cap rate dependent. For example, at the height of the recent boom many REITs thought themselves to be conservatively financed with a 60% debt ratio. However when cap rates moved from say 6% to 9% the debt ratio exploded to 90%. In order to avoid the spot cap rate problem a more appropriate ratio to use would be debt/EBITDA which takes into account the ability to service the debt including amortization independent of fluctuating cap rates. Furthermore this metric has the advantage of being widely used in the corporate bond market.

I would argue that 5X EBITDA is the appropriate leverage metric for most REITs. Indeed a ratio of 5X EBITDA gives a great deal of credit for the stability of real estate cash flows. Remember the typical investment grade industrial corporation normally does not exceed 3X EBITDA.

Let’s assume that a REIT owns 10 buildings of equal value and it historically trades at around 12X EBITDA. In the old days a prudent owner would have mortgaged seven of the buildings at 60% and kept three unencumbered for both safety and opportunistic purposes. In this example the leverage ratio for all 10 buildings would be 42% (70% X 60%) or 5X EBITDA (42% X 12).

I would, therefore, argue that 5X EBITDA is a normalized maximum level for leverage for most REITs. If you want to quibble, as long as apartments have access to lower rate Freddie and Fannie financing at 70% of value, you could certainly make a case for 6X EBITDA for apartment REITs. Conversely for the operationally cyclical hotel REITs, debt should not exceed 3X EBITDA. Needless to say that with most REITs trading in excess of 7X EBITDA, the deleveraging process that began last April still has a long way to go.

Where do pension funds come in? It is no secret that many large pension funds and endowments with leveraged real estate investments got clobbered in the recent downturn. In my view it was an inevitability brought on by a complete misperception of risk. Put bluntly leveraged real estate is different from unleveraged real estate. It is much riskier. The higher risk can be categorized in two ways.

First whenever a pension fund engages in a leveraged transaction, it is, in effect, shorting it own bond portfolio. How so? All a pension fund has to do to understand this concept is to “gross-up” its leveraged asset and fully consolidate it on its books. For example take a hypothetical pension fund with the following asset allocation: $600 million equities, $300 million bonds and $100 million leveraged real estate/private equity.

In this example a $100 million real estate/private equity investment with $300 million of debt on it would be booked as a $400 million asset with a concomitant $300 million liability. In reality by booking only the equity, the pension fund is under-stating its investment in real estate and over-stating its investment in fixed income securities as the real estate debt cancels out the bond assets. Distilled down the pension fund portfolio is holding $600 million in equities and $400 million in real estate/private equity -- not exactly what you would call a “conservative” asset allocation. When looked at this way is not a surprise that a seemingly small allocation to real estate had such a drastic effect on pension fund performance.

If you prefer a different approach, the second way to look at leveraged real estate in a portfolio is to view it as a warrant. People tend to forget that in the original options pricing paper by Black and Scholes common equity was viewed as an option to buy back the firm from its bondholders. When leverage is low this notion is of minimal significance, but when leverage is high it becomes very obvious and it is this insight that theoretically underpins much of what goes on in capital structure arbitrage.

If a pension plan fully understood that its leveraged real estate investments were really long term options (warrants) and classified them as such they would have had a far better understanding of the risks embedded in their portfolios. It, therefore follows that, leveraged real estate certainly does not belong in the plain vanilla real estate bucket.

There is, of course, an agency argument for high leverage in REITs and private equity. Briefly stated leverage is required to increase the return on equity that is so necessary to compensate the best talent. That certainly was the argument from 2004-2007. However, many of the most talented real estate professionals crashed and burned with everyone else in 2008. It seems to me that the agency argument is better suited for bull markets than bear markets. All told, then, the evidence suggests that less leverage is preferable to more.

*David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at david.shulman@baruch.cuny.edu.

Time to Pull the Plug on Obamacare

2010-03-01T11:11:00.000-08:00

Being a glutton for punishment, I watched nearly all of last Thursday's Blair House forum on Obamacare. I expected very little to come out of the meeting and I was not disappointed. Simply put, the Democrats want to expand coverage, but don't really want to pay for it, and the Republicans don't want anything to pass. Unfortunately doing nothing keeps us on the road to perdition and passing Obamacare only makes things worse.

What both parties understand, but are unwilling to admit, is that the current system is bankrupting the Nation. Medicare has a $38 trillion unfunded liability and yet the Democrats want to exacerbate the situation by expanding coverage and the Republicans are now positioning themselves as the saviors of Medicare. Give me a break.

Obama and his cohorts, sucking up to their paymasters in organized labor, punted on the one big measure that would have a chance in bending the cost curve, the excise tax on "Cadillac" plans. If the Republicans really cared about costs, they would have pushed Obama on this issue. But no, in fear of anti-tax Grover Norquist, they can't come out in public in favor of any tax.

At the end of the day, if we are to break not bend the healthcare cost curve, sterner measures will be needed. A few suggestions, a stiffer tax on "Cadillac" plans, real cuts in medicare, ending the middle-class entitlement of nursing home care under Medicaid, ending fee for service medicine, triage with "end of life" panels, and a payroll tax to fund expansion of care to let all of the particpants know that healthcare is not a free good. Remember both Social Security and Medicare are funded with payroll taxes. If the Democrats want healthcare so bad, they should be willing to tax their own constituencies. After all this is how it works in social democratic Europe. Thus we should put the horse before the cart and cut costs first and generate real savings and then we should rightfully expand coverage.

The New Macro Environment for Commercial Real Estate

2010-02-20T06:13:00.000-08:00

Reprinted by permission from Reit Wrap Special Report Dated February 10, 2010

by David Shulman*

Thankfully the economy now appears to be on the mend and employment will soon be rising, but I fear that few real estate professionals fully realize how deep of a hole the demand for commercial real estate is in. For the most part real estate investors believe that after leveling off in 2010, rents and occupancies will begin to increase in 2011 and with severely limited new construction, “normal” market conditions will return by 2012 or 2013. It is on these assumptions that today’s pro formas and REIT FFO estimates are being built.

If the economy were recovering from a cyclical recession I would fully endorse the market consensus. Unfortunately the Great Recession of 2008-09 was not a cyclical recession; it was a balance sheet recession whose effects will linger for many years to come. Let me explain. A normal cyclical recession is usually induced by Fed tightening seeking to tame inflation. Once the tightening takes hold, the Fed eases and after awhile the economy begins to grow again.
Indeed the natural state of the economy is to grow and within a year or so economic activity surpasses the prior cyclical peak.

A balance sheet recession is different. In this instance consumers and businesses find themselves over-leveraged with assets trading at values well below the debts on them. Thus balance sheets have to be repaired and this process takes time. For example the U.S. economy, even after the huge stock market rally, still finds itself $10-11 trillion poorer in terms of stock market and home values. As a result, consumers who once thought themselves as rich now think themselves as poor. They react to this reality by paying off debts and increasing savings. Simply put the credit constrained consumer can’t spend and the more affluent balance sheet impaired consumer won’t spend. When all consumers respond in this manner, aggregate demand stays depressed for years.

Sluggish economic growth going forward would not matter all that much if the economy were operating close to its natural capacity. However this is not the case. After peaking in December 2007, total payroll employment is off by 8.4 million jobs making the recession 3-4 times worse than prior postwar recessions. In fact total employment in January has now returned to where it was in September 1999! If employment growth is a rough proxy for commercial real estate demand, than every project built in the first decade of the 21st century can be viewed as superfluous. To be sure there is a more than a little hyperbole involved with the prior sentence, but you get the picture. That is why even in a limited construction environment, excess capacity will weigh on commercial real estate for many years to come.

A skeptic might argue that total employment, which includes manufacturing and construction jobs, might have little to do with office, and high end retailing and apartment demand. A fair point so let’s look at financial activities employment. As of January financial activities employment was off by 709,000 jobs since its December 2006 peak, a decline of 8.5%. An industry that was once viewed in secular growth category has proved itself to be highly cyclical, not a good omen for the stability of future office demand. More importantly financial activities employment is now back to where it was in May 1999!

In a related vein even the law business is now under extreme stress. Employment in legal firms over the past year declined by 44,000 jobs, or 3.8%. Now here is a business, a core tenant for Class A office space, which was once thought to be recession-resistant, now suffering through the pains of a fundamental restructuring of its business model, the billable hour.

In terms of the office demand I am hard pressed to come up with a scenario where demand recovers quickly and because the employment declines have been so severe it is reasonable to assume that many office using firms a carrying excess space relative to their needs. Thus as leases roll over tenants will just as likely reduce their space demands as increase them.

In the case of retail demand, the consumer has been chastened by the bear market in homes and stocks and a significant fall in the rate of pay increases. Where earlier in the decade private sector compensation was growing in the 3-4% range, of late it has been increasing at a 1.3% rate. Earlier in the decade and in 1990s consumers finance part of their consumption out gains accruing from rising stock and home prices. As a consequence the savings rate collapsed from an historic 7-10% down to around 1-2%. It has subsequently popped to 4-5% and in all likelihood it is on the road back to 7%. Along the way consumers have started to pay down debt in an unprecedented manner. After rising inexorably for decades total revolving consumer credit outstanding dropped by an unprecedented $109 billion or 11% from September 2008 to December 2009.

Thus it does not take rocket science to explain that the combined effects of falling asset values, slowed compensation growth, high unemployment and debt pay downs have made for a very disappointing retail environment. To be sure retail sales have bounced off the bottom, but remember total retail sales in December were still 7% below their November 2007 peak. This data certainly smells like there is quite a bit of excess capacity in retailing.

Of course many of you reading this article will probably shrug it off as one of Shulman’s perpetually bearish rants. Trust me, me I do not want to be right about this, but it is hard for me to see anything but a long hard slog ahead of us. Indeed much of the recent strength in the economy has come from massive doses of fiscal and monetary stimulus. In a nutshell, the economy is highly medicated. Thus we won’t really understand the underlying strength of the economy until the Fed ends its zero interest rate policy and the federal deficit drops from 11% of GDP to an optimistic 3% of GDP.

I would like to think we have learned a lot over the past few years. One of the lessons that I have taken away from the experience is that the Great Moderation of 1982-2007 is over and we are about to enter a new world that is beyond the working experience of most professionals now in the field. My guess is that going forward commercial real estate will be growing more slowly and that it will be more cyclical.

*David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. An earlier version of this article was presented at the University of Wisconsin Real Estate Club.

The Idiots in the Senate

2010-01-23T14:52:00.000-08:00

The United States Senate is full of complete idiots. With hooker-loving David Vitter(R-LA), primary-scared John McCain(R-AZ), and two sure losers this November on the Democratic side,
Barbara Boxer(D-CA) and Russell Feingold(D-WI) all coming out against the renomination of Fed Chairman Bernanke, something is really wrong. To be sure Chairman Bernanke is not without sin, too much monetary ease in 2003-4 and regulatory failures with respect to sub-prime mortgages, but he and a few others really did save our country from The Great Depression 2.0.

What are these Senators thinking? Voting against Bernanke won't save their hides, but should the nomination go down, watch out below for stocks, bonds and the U.S. Dollar. Even if these idiots don't care about the markets, at the end of the day, they are voting against job creation and for higher unemployment rates.

In the Dow Jones Newswire, "Ex-Tarp Chief: Proposals Should Consider Broad Risk

2010-01-22T17:23:00.000-08:00

JANUARY 22, 2010, 4:35 P.M. ET
UPDATE: Ex-TARP Chief: Proposals Should Consider Broad Risk

(Adds post-speech comments from Lambright in fourth paragraph.)
By Marshall Eckblad
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--The former chief investment officer of the U.S. government's Troubled Asset Relief Program said Friday proposals for overhauling the U.S. financial system should focus on limiting broad risks at institutions large and small.
Risk "could arise from lots of small institutions," said Jim Lambright, who left the TARP program last summer, at a financial services conference hosted by the Australian Consulate in New York.
President Barack Obama said in a speech Thursday he is committed to limiting the investment activities and risk levels of the nation's banks, and he also signaled the biggest banks could be forced to shrink.
Lambright didn't address any specific proposals in his speech. He said after the speech that he was challenging the audience to ask "where risks might migrate to other parts of the system."
Lambright was an appointee in the Bush administration under then-Treasury Secretary Henry Paulson, but stayed on to work for the Obama administration.
David Shulman, a former executive at Lehman Brothers and now an economist at the UCLA Anderson Forecast, told Dow Jones Newswires on Thursday that any regulatory overhaul should include capital requirements for bigger hedge funds to prevent banks from being exposed to risk at less regulated firms.
-By Marshall Eckblad, Dow Jones Newswires; 212-416-2156; marshall.eckblad@dowjones.com

Source:http://online.wsj.com/article/BT-CO-20100122-712290.html?mod=WSJ_latestheadlines

An Upset in Massachusetts?

2010-01-17T08:55:00.000-08:00

I now think that GOP insurgent Scott Brown will upset Democrat Martha Coakley in this Tuesday's primary. What was unthinkable a month ago, a Republican winning the late Senator Kennedy's seat, has now become a real posibility. Why? Aside from Coakley running a very poor campaign as evidenced by her calling Red Sox pitching star Curt Schilling a Yankee fan, it has become apparent that President Obama's health-care plan has lost its popularity in bluest Massachusetts. After all Massachusetts voters have been living with an earlier version of Obamacare for the past few years and are not all that happy with it. Further exacerbating the situation was the backroom deal with organized labor exempting labor union members and government employees ( a redundancy) from the tax on Cadillac health plans through 2018. For all of the talk of CSPAN visibility during the 2008 campaign, Obama has lost his good government gloss by getting to caught up in the dealmaking ways of the Capitol.

However there is a more subtle reason why Scott Brown will likely win. Just as in New York City, where the electorate showed their resentment to Mayor Bloomberg changing the rules to allow him to run for a third term by reelecting him by the slimmest majority, Massachusetts voters will rebel against the party sachems for changing the rules to allow Paul Kirk to temporarily take Senator Kennedy's seat by appointment rather than election. The Senate Democrats needed a 60th vote quickly. They got it, but they will now pay for it by losing it in an election.

To be sure Brown is running in the bluest of blue states, but I remind you that in another blue state, goodie two-shoes Minnesota, wrestler Jesse Ventura surprised all of the pundits and was elected governor. That's why it is not a stretch to visualize the former Cosmo nude model to be sitting in the U.S. Senate.

On the talk shows today all of the pundits were focusing on the implication for Obamacare in the Senate should Brown win. They are all myopic as usual. Should Brown win, Obamacare will lose its majority in the House! A Senate loss in Massachussetts means that House Democrats have very few safe seats in 2010.

In the Xinhua News

2009-12-10T17:04:00.000-08:00

U.S. economy to see modest growth but high unemployment
www.chinaview.cn 2009-12-10 17:24:00

Print
LOS ANGELES, Dec. 9 (Xinhua) -- The U.S. economy is on a "modest growth path that will be accompanied by extraordinarily high rates of unemployment," according to the University of California, Los Angeles (UCLA) Anderson Forecast released Wednesday.
The UCLA Anderson Forecast is one of the most widely watched and often-cited economic outlooks for California and the United States.
The Forecast says this slow growth reflects the lagged effects of the implosion of consumer balance sheets and is a result of the transition from an import-oriented, low-savings economy to a more export-oriented, higher-savings one.
Fueling the transition is the Obama administration's "weak dollar policy," which encourages exports and discourages the consumption of imports, the Forecast says.
The combined effect will cause real consumer spending to grow at a modest 2 percent rate, far below the historical 3-3.5 percent rate, the Forecast predicts.
UCLA Anderson Forecast senior economist David Shulman noted in a report titled "Lost and Found" that the recession established postwar records for declines in stock prices, home prices and employment and that, over the past decade, the unemployment rate had more than doubled while real wages rose by a modest 6.5 percent.
There were now a half-million fewer people on the non-farm payroll than there were 10 years ago, said Shulman.
With most of the recession's damage done, Shulman predicts slow growth for the U.S. economy.
He forecasts that, after growing at a rate of 2.8 percent in the most recent quarter, real gross domestic product in the United States will settle into a 2 percent growth rate for 2010 before rising to about 3 percent in 2011.
The unemployment rate will likely peak at 10.5 percent in the first quarter of 2010, then settle at or above 10 percent for the rest of the year, according to Shulman.
"We hypothesize that one reason for the high rate of unemployment is that business firms who hitherto viewed office overhead costs as fixed now view them as variable," said Shulman.
"Where in prior recessions much of the marketing, finance, research and administrative employees were generally immune from layoffs, the new management regimes have made those functions vulnerable to severe cutbacks," he added.
Shulman also noted in his report that government policymakers were "highly medicating" the economy with record federal deficits and a zero interest-rate policy from the Federal Reserve. While necessary to avoid an economic free-fall, Shulman asserts that these policies are not sustainable in the long run.
UCLA Anderson Forecast director Edward Leamer examined past economic recoveries and attempted to forecast how the current recovery would play out.
Leamer said that, unlike in the past, consumers, who had "already spent income we are never going to earn" and who were now more focused on savings, could not be counted on to spend the economy into recovery.
In his opinion, U.S. exports are the potential driver of a successful economic recovery. He even metaphorically suggests that "we will need to turn our shopping malls into factories."
For California, UCLA Anderson Forecast senior economist Jerry Nickelsburg said the outlook for the rest of the year involved little or no growth.
He said the golden state's economy would begin to pick up slightly in the beginning of 2011 and, by the middle of 2011, begin to grow at more normal levels.
Nickelsburg said the keys to California's recovery were exports of manufactured and agricultural goods, increased public works construction, and increased investment in business equipment and software.
The Forecast predicts total employment in the state will contract by 4.3 percent in 2009 and that no new jobs will be generated in 2010.
Unemployment will get worse, rising to 12.7 percent in the fourth quarter of 2009, according to the Forecast.
But once growth returns in 2011, employment will begin to grow faster than the labor force, at a 1.7-percent rate, and the unemployment rate will begin to fall, but the economy will not be generating enough jobs to drive the unemployment rate below double digits until 2012, according to the Forecast.
Real personal income growth will be a negative 2.7 percent in 2009 before returning to positive growth of 0.4 percent in 2010 and 2.8 percent in 2011, according to Shulman.

Full URL, http://news.xinhuanet.com/english/2009-12/10/content_12625137.htm

"Lost and Found," UCLA Anderson Forecast, December 2009

2009-12-09T10:02:00.000-08:00

“Many shall be restored that now are fallen, and many shall fall that now are in honor.” Horace – Ars Poetica[i]

The first decade of the 21st Century is over. Good riddance! It has truly been a lost decade for labor and capital. In stunning contrast with the ebullience of late 1999 there are now a half million fewer people on nonfarm payrolls than at the start of the decade. To be sure late 1999 represented a business cycle peak while late 2009 represented a trough, but make no mistake the recent recession established postwar records for declines in employment, home and stock prices. Over the decade the unemployment rate has more than doubled and real wages rose by a very modest 6.5%. Concomitantly the federal budget swung from a $91 billion surplus in FY 1999 to a record $1.4 trillion deficit in FY 2009. All of the gory details are presented in Figure 1.

Despite the 64% stock market rally off the March lows, both nominal and real stock prices are far off their yearend 1999 levels by 26% and 42%, respectively. Needless to say this poor performance is a far cry from the wild-eyed bullishness of the dot com era and it perhaps fitting that the early 2000 signature AOL-Time Warner merger became undone this month with Time Warner spinning off the remnants of AOL.

In sharp distinction oil, gold and of all things, very staid U.S. Treasury bonds enjoyed spectacular bull markets during the decade. Gold and oil prices nearly tripled and quadrupled, respectively and long term U.S Treasury bonds that offered current yields just above 6.5% advanced by 34% during the decade. Along the way the trade-weighted foreign exchange value of the U.S. dollar declined by 24%. Median existing home prices, after soaring earlier in the decade, went into free fall after 2006 and ended up a modest 22% in nominal terms and actually declined by 5% in real terms.

Thus the overall performance of the labor, capital, housing and commodity markets during the decade, hardly of which were any of it forecast, gives rise to great deal of humility when forecasting the economic outlook for the next few years. Nevertheless, in the spirit of “often wrong, never in doubt,” we trudge on and we trust by the time 2020 rolls around much of the current pessimism will give way to a more hopeful environment. Simply put the economy is in a painful period of transition. Thus, we would like to think that the next decade is the mirror image of the last where we start from a cyclical trough and end at a peak.

Figure 1. Selected Economic Indicators Late 2009 vs. Late 1999

The Near-Term Outlook

Similar to last quarter we continue to believe that the economy is on a modest growth path that will be accompanied by extraordinarily high rates of unemployment.[ii] Specifically we forecast that after growing at 2.8% in the most recent and current quarters, real GDP growth will settle into a 2% growth path for much of 2010 and be closer to 3% in 2011. (See Figure 2) With such sluggish growth the unemployment rate will likely peak at 10.5% in the first quarter and remain at or above 10% for almost all of next year. (See Figure 3)

We hypothesize that one reason for the high rate of unemployment is that business firms who hitherto viewed office overhead costs as fixed now view them as variable. Thus where in prior recessions much of the marketing, finance, research and administrative employees were generally immune from lay-offs, the new management regime has made those functions vulnerable to severe cutbacks. Indeed such previously recession resistant industries such as finance, advertising and media have witnessed an unprecedented amount of job cuts. Further exacerbating the employment situation is uncertainty about tax, healthcare and energy policies coming out of Washington.

Figure 2. Real GDP Growth 2000:Q1 – 2011:Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2000:Q1 – 2011Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

The slow growth outlook reflects the lagged effects of the implosion of consumer balance sheets and is a result of the economy in transition from being an import oriented low savings rate one to a more export and higher savings oriented one. (See Figures 4 and 5) That transition is being pushed along by the administration’s weak dollar policy which encourages exports and discourages the consumption of imports. The combined effect will cause real consumer spending to grow at a modest 2% rate, well below the more historical 3-3.5% rate. (See Figure 6) Nevertheless the savings rate won’t rise in a straight line. For example the scheduled increase in income taxation for high income earners in 2011 will depress savings for that year.

Figure 4. Growth in Real Imports and Exports, 2000:Q1 – 2011:Q4F
Source: Department of Commerce, UCLA Anderson Forecast

Figure 5. Savings Rate, 2000:Q1 – 2011Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Consumption Growth, 2000-2011F

Source: Department of Commerce and UCLA Anderson Forecast

We would be remiss if do not discuss the current controversy with respect to housing activity. In terms of prices and home sales it appears that housing is finally on the road to recovery. To be sure with 23% of the nation’s houses with mortgages underwater, foreclosures continue to rise; but we believe that is already factored into the decision making process of both buyers and sellers. Thus given mortgage rates below 5%, affordable prices and demographically driven pent-up demand we, like most macroeconomic forecasters, believe that housing starts will rise to around 850,000 units in 2010, up from an estimated 574,000 in 2009. (See Figure 7) We also allow for the gradual winding down of the Fed’s mortgage backed securities purchase program. However, analysts who are much closer to the ground, like our friend Ivy Zelman of Zelman & Associates, believe that housing starts next year will be in 600,000 – 700,000 range because of the lack of construction and development financing. Should that be the case, our 2010 view for the economy as a whole would necessarily be marked down.

Figure 7. Housing Starts, 2000 -2011F

Sources; Department of the Census and UCLA Anderson Forecast

The Highly Medicated Economy

Let’s be clear, policy makers are highly medicating the economy with record federal deficits and a zero interest rate policy coming from the Federal Reserve. (See Figures 8 and 9) While necessary to abate the free fall in the economy that took place in late 2008 and early 2009, both fiscal and the monetary policies are not sustainable in the long run. Deficits will have to be reduced and interest rates will return to more normal levels. In fact the deficit projections below do not include another stimulus package and the inevitable cost-overruns associated with the healthcare package now moving through the Congress. The “never-never land” world of financing the deficit at a near zero interest rates will soon be looked upon as the very low teaser rates offered to homeowners a few years ago as the cost of financing the national debt explodes.

Thus we do not really know whether or not the signs of economic revival are the temporary result of the medicine being applied or the result of a healing process that will put the economy on the road to a self sustaining recovery. We suspect that it is a little of both and that is why we do not anticipate that the Fed will tighten policy until late in 2010 nor will tax hikes be enacted, except for healthcare, beyond what are already scheduled to take place in 2013.

Figure 8. Federal Deficit, Unified Budget, FY 2000 – FY2019F
Sources: Bureau of the Budget and UCLA Anderson Forecast

Figure 9. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2000Q1 – 2011:Q4F
Sources: Federal Reserve Board, UCLA Anderson Forecast

Nonetheless there are many permanent aspects to the current policy regime. Homeowners and businesses are using the current low rate environment to refinance high cost debt. Indeed the high yield corporate bond market has just experienced its greatest rally in history. (See Figure 10) Furthermore, although far from ideal, consumer balance sheets are being improved by the wave of foreclosures and mortgage modifications. How so? Simply put, debt is being extinguished at the expense of losses in the financial system. We know it is not pretty, but that is how the process works with respect to business bankruptcies.

Figure 10. High Yield Corporate Bonds vs. Treasuries, July 06 –October 09.

With all of the stimulative “medication” in the system it would be logical to assume that the most likely side effect would be a ramp up in inflation. Indeed we believed that is the message coming out of the foreign exchange and gold markets. Nevertheless with so much excess capacity in labor and product markets, we believe that inflation will not manifest itself within the 2011 forecast horizon. Indeed we are forecasting consumer price inflation to average a modest 2% over the next two years.

The Fiscal Crisis of the States

From New York and New Jersey in the east, to Michigan and Illinois in the mid-west, to Florida in the south and to California and Oregon in the west, state and local governments are enduring their worst fiscal crisis since the Great Depression. While the private sector has dramatically cutback employment by 4.6% in the twelve months ending October, state and local employment declined a modest 0.8% while state tax receipts plummeted 10.7%. (See Figure 11) Public employment is being sustained by massive infusions of Federal cash, but that cash will run out at the end of 2010. Perhaps there will be another stimulus package, but the inevitable restructuring of state and local government lies ahead of us. Remember the decline in share prices this decade noted at the start of this essay has decimated public pension plans. Put bluntly, state and local pension plans have made promises that the taxpayers can’t keep. As a result state and local purchases will be flat at best for several years to come. (See Figure 12)

Figure 11. State and Local Tax Collections, 2006Q3-2009:Q3

Source: Nelson A. Rockefeller Institute of Government

Figure 12. Real State and Local Spending, 2000 – 2011F
Sources: Department of Commerce and UCLA Anderson Forecast

Conclusion

When economic historians look back on the recent recession and the sluggish recovery we are forecasting, we believe they will note that the 2007 -201? Era signaled that the U.S. economy entered a period of transition. The characteristic of the period involves the inability of export growth to completely offset growth declines in consumer spending and state and local spending. Over time the savings rate will increase and once it stabilizes in the 5-7% range, consumption will once again grow with the economy. Meantime, after a modicum of restructuring takes place in the state and local government, that sector once again will be a source of modest growth. By mid-decade 3-4% economic growth accompanied by mid-single digit unemployment rates will once again become the norm. Thus instead of being a lost decade, we will once again find our way back to the economy’s historical growth path. Therefore we are not in the “new normal” camp for the entire decade.

[i] Opening quotation in Graham, Benjamin and David L. Dodd, “Security Analysis,” 6th Ed., (New York: McGraw Hill, 2008, originally published in 1934).
[ii] See Shulman, David, “The Long Goodbye,” UCLA Anderson Forecast, September 2009.

Letter to The Wall Street Journal, Nov. 6

2009-11-06T05:18:00.000-08:00

Don't Follow Failed Japanese Example

The new regulations allowing banks to classify underwater commercial real-estate loans as "performing" will create "zombie" banks that will plague our economy well into the next decade ("Banks Get New Rules on Property," Money & Investing, Oct. 31). These regulations mimic the failed Japanese approach of the 1990s and will, unfortunately, have the same effect. Simply put, weighed down with bad loans "zombie" banks don't lend.
Instead of restructuring real-estate loans, the underlying banks should be restructured through equity infusions from the public or with TARP funds, with the underlying real estate sold into the marketplace. Broadly speaking, that was the Resolution Trust Corp. solution of the early 1990s.
David Shulman
Berkeley Heights, N.J.
Mr. Shulman was head of real-estate research at Salomon Brothers from 1986 to 1991 and was senior REIT analyst at Lehman Brothers from 2000 to 2005.

In the Dow Jones Newswire, "Wells Fargo Defers Reckoning On Troubled Mortgage Balances," Nov.3

2009-11-03T17:42:00.000-08:00

Because of troubled borrowers like Annan, Wells Fargo risks tethering itself to what former Wall Street executive David Shulman terms "wasting assets," since borrowers facing years of negative home equity have little incentive to maintain or improve their homes. "You've got to give the homeowner incentive," says Shulman, now a senior economist at UCLA Anderson Forecast. "Otherwise, they're sitting there as a tenant."
http://online.wsj.com/article/BT-CO-20091103-709084.html?mod=wsjcrmain

Letter to the Star-Ledger, Nov. 1

2009-10-31T08:00:00.000-07:00

Can’t spend anymore
Is Tom Moran out of his mind ("More state debt or more open space, what’s a voter to do?" Oct. 28)? A "No" vote on open-space bonds is a no-brainer. New Jersey, by any common sense definition, is bankrupt. We are California without the climate. Thanks to the combined efforts of past and present governors, the state is no position to borrow another nickel, much less $400 million.
Sorry folks, Trenton’s big spending party is over.

Stock Analysts Blow it Again

2009-10-29T07:59:00.000-07:00

As a former analyst it never ceases to amaze me to see all of the hype associated with companies beating their typically low-balled earnings estimates. For example, according to one of my buddies at Goldman Sachs, 80% of the first 260 S&P 500 companies reporting earning this quarter exceeded consensus estimates, well above the more typical 65%. Indeed only 13% of the companies missed their consensus estimate, compared to a more normal 20-25%.

What gives? They blow it every quarter! The current quarter more so. It reminds me of what the late Howard Cosell would say when the Dallas Cowboys were having a particularly bad night, "never have I seen such continuing ineptitude." It seems to me that there is absolutely no adaptive learning in the Wall Street analytical community. The reason for this piss-poor behaviour is that most analysts suck up to company management and strive to keep their estimates in line with what they know is low-balled company guidance. In order to be in the flow of information and have access to company management they have to play ball.

The managements of Wall Street firms understand this and they do NOT compensate analysts on the basis of the accuracy of their earnings estimates. If they did, analyst salaries would be alot closer to the minimum wage than seven figures a year. Everybody in the institutional community knows the game. Unfortunately the public doesn't and it is a disgrace of the business press and especially CNBC for not informing the public the fraud that is being perpetrated on them.

As a final point a 12 year old could beat Wall Street analysts every time by taking the midpoint of a given company's earnings guidance and add 5% to it!

In the Washington Post, "Economy is kick-started, but can it motor ahead?," October 28, 2009

2009-10-28T06:55:00.000-07:00

"The patient is out of intensive care, but is still highly medicated," said David Shulman, senior economist at the UCLA Anderson Forecast. "So you don't know how much of this growth is driven by short-term stimulus and how much of it is self-sustaining. My guess is this is going to be the best quarter of growth for a long time."

For full article see, http://www.washingtonpost.com/wp-dyn/content/article/2009/10/27/AR2009102704120.html

Tom Friedman's Best Column, Ever

2009-10-12T10:33:00.000-07:00

Tom Friedman rightly responded to the Nobel committee's bizarre awarding the Peace Prize to Barack Obama by, in effect, nominating the American soldier as the most important peacekeeper of the last century. I can't do justice to his column, "The Peace (Keepers) Prize," so here is the direct weblink. http://www.nytimes.com/2009/10/11/opinion/11friedman.html?_r=1&scp=2&sq=thomas%20l.%20friedman&st=cse

The Long Good-Bye, UCLA Anderson Forecast, September 2009

2009-09-17T17:24:00.000-07:00

“But the world is not in a run-of-the mill recession. The turnaround will not be simple. The crisis has left deep scars, which will affect both supply and demand for many years to come.”[i]

Olivier Blanchard, Director, International Monetary Fund Research Department

Although the worst recession in seven decades likely ended in the current quarter, its negative effects will linger well into the next decade. As we noted previously the recession had its origins not so much in imbalances in the real economy, but rather in the over-indebtedness of consumers and businesses that will take time to cure. Simply put it was a balance sheet recession.[ii]

As a result both consumption and investment will be weighed down by the process of deleveraging the balance sheets of consumers, businesses and financial institutions. Not only will financial institutions be less willing to lend, but consumers and businesses will be less willing to borrow. This process differs from normal recoveries where there is a natural inclination to borrow and spend after a period of Fed tightening that induced recession in the first place. Remember the Fed was easing well before the start of the current recession. That is why that even after an extended period of zero official interest rates the economy is only now showing hopeful signs of recovery.

That said, after four quarters of decline, economic growth is resuming. We forecast that real GDP will increase at an annual rate of 2.1% in the current quarter and 2.3% in the fourth quarter. For all of 2010 we forecast quarterly growth to average 2% with noticeable improvement at the end of the year. (See Figure 1) A lion’s share of near-term growth will come from a dramatic reversal in inventories. After plunging at a revised annual rate of $159 billion in the second quarter, real inventories are forecast to increase by $12 billion in the fourth quarter accounting for almost 1 1/2% of real GDP. (See Figure 2) However, once the big swing in inventories is spent, growth will remain very modest for most of 2010. Two other important swing factors are the recovery in exports and the long awaited rebound in residential construction. Exports are being helped along by the rebound in production that is taking place in Germany, France, Japan, China and Southeast Asia. Nonetheless, if our view of sluggish overall growth is close to the mark, the unemployment rate will be above 10% well into next year. (See Figure 3)

Figure 1. Real GDP Growth, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 2. Change in Real Inventories, 2000:Q1 – 2011:Q4, SAAR
Source: Global Insight and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2000:Q1 – 2011Q4F
Source: Global Insight and UCLA Anderson Forecast

Our cautious view of growth rests on the belief that after a two decade consumer spending binge based initially on rising stock prices and then on rising home prices fueled by extraordinarily easy credit has ended. (See Figure 4) Instead of increasing their nest eggs by deferring consumption, households took advantage of the ebullient asset markets to buttress their balance sheets and to over-consume housing and automobiles. Now consumers seeking to accumulate assets will have to do it the old fashioned way, by directly increasing savings through a reduction in consumption. (See Figure 5) Simply put, credit impaired lower income consumers can’t spend the way they used to and wealth impaired affluent consumers won’t. To be sure the stock market has rallied 50% off its March lows and housing prices apparently have made a bottom, but both of these asset classes are trading well below their highs of only two years ago.

Figure 4. Real Consumption Growth, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast.

Figure 5. Saving Rate, 2000 – 2011F, Quarterly Data
Source: Global Insight and UCLA Anderson Forecast.

Fiscal Collateral Damage

Starting with the Bush Administration’s $168 billion stimulus package in 2008 and ending with the Obama Administration’s $787 billion package in 2009, the federal government has gone all out in attempting to mitigate the effects of the recession and to engender economic recovery. Whether or not the programs work as intended will take time to sort out, but it appears that the increase in spending and tax cuts may have put a floor under last winter’s decidedly weak economy. However the stimulus spending along with an increase in baseline spending and the effects of the recession has caused a decided worsening in the long term fiscal outlook. The administration is now projecting cumulative federal deficits of $9 trillion over the next 10 years. (See Figure 6) To call this collateral damage is to put it mildly; it looks more like a fiscal train wreck that international holders of large dollar balances might seek to avoid thereby triggering a significant devaluation of the currency.

Figure 6. Federal Deficit, Unified Budget, FY 2000 – 2019F
Source: Global Insight and UCLA Anderson Forecast

Programmed deficits averaging $900 billion a year over the next decade are a recipe for higher taxes above the increases already scheduled to take place. For example the $180 billion a year hike in income taxes on high earning households will kick in 2011. Given the fiscal outlook this tax increase looks like a drop in the bucket so sooner or later President Obama is going to have give-up on a host of domestic programs and/or go against his campaign pledge not to increase taxes on households earning less than $250,000 a year. Make no mistake, tax increases on the broad middle class are becoming more likely and that will put more stress on consumption spending later in the decade. The arithmetic is simple. The federal government financing itself, in part, with near zero teaser rates interest cost on the debt is running at approximately $250 billion a year. Add $9 trillion dollars in debt and assume a 4% interest rate, interest costs sky rocket to $800 billion a year, nearly 40% of current receipts.

One modest fiscal effort in terms of dollars that caught the public’s attention and not in the original Obama stimulus package was the so called “cash for clunkers” program where the federal government paid consumers $3500-$4500 a car to trade-in and scrap their older vehicles for new ones. Ostensibly the purposes of the program were to get older low mileage vehicles off the road and to replace them with more fuel efficient vehicles and to explicitly subsidize the automobile industry.

This tiny, by federal standards, $3 billion program accounted for the sale of 700,000 vehicles ($14 billion at $20,000/car) in August thereby increasing the estimated automobile sales rate in the third quarter to 11.8 million units compared to 9.6 million units in the second quarter. Of course it will take time to estimate how many of those cars would have been sold absent the program and how many represent the pulling forward of demand from subsequent quarters. Because we believe that much of the sales represented the pulling forward of demand we have modeled in a drop-off in automobile sales over the next few quarters. (See Figure 7)

Figure 7. Motor Vehicle Sales, 2005:Q1 – 2011:Q4
Source: Global Insight and UCLA Anderson Forecast

We did, however, learn an important lesson from the “cash for clunkers” program. It met the threefold test of being temporary, timely and targeted and it did not require a huge spending program to have a big short term impact. The program mopped-up excess automobile inventories triggering increased production and employment for that beleaguered industry. As mentioned above we don’t know whether or not the program will have long term effects outside of reducing the capital stock of automobiles, but in the short run the real psychological effects on the economy were certainly welcome.

Whither the Fed?

Now that Federal Reserve Chairman Ben Bernanke has been re-nominated the focus will return to the substance of Fed policy. The Bernanke central bank has been perhaps the most activist Fed in its nearly 100 year history. Once the financial crisis was in train, the Fed launched a host of very aggressive and in many cases first time measures to relieve the most seized up lending environment since the 1931-3 Great Depression crisis. Bernanke also dusted off Section 13 of the Federal Reserve Act to directly lend to nonbanks in “unusual and exigent circumstances,” a power not used in over 75 years.

Furthermore the Fed took monetary policy to its zero interest rate bound by targeting the Federal Funds rate at between zero and 25 basis points, again reminiscent of the Great Depression and more recently of the Japanese deflation.
Along the way the Fed for a time tripled the size of its balance sheet. Simply put, in Bernanke’s words, the policy was “whatever it takes.”[iii]

As difficult as it might have been for both the Fed and the Treasury to engage in their unprecedented interventions in the economy, the hard part is now ahead of them. It is one thing to intervene with the goal of saving the economy and restoring growth, it is quite another to take back the monetary stimulus to fight an incipient inflation in an environment of high unemployment. Market participants know full well that there is more than enough liquidity in the system to ignite a persistent inflation; not today but perhaps within a few years.

In order to deal with this threat we believe that the Fed will gradually shrink its balance sheet and begin to slowly move away from its zero interest rate policy in the third quarter of 2010. To be sure unemployment will still be around 10%, but the economy will have been growing, albeit slowly, for about a year by then. The argument for modest rate hikes will be that the financial emergency is over and that modest rate increases would have a minimal effect on the economy. In fact it could be viewed as a sign of strength in light of the fact the financial markets by that time would have returned to normal.

Indeed in late August the Israeli Central Bank became the first official authority to raise rates after two years of declines. We do note that the Governor of the Bank of Israel is Stanley Fischer, Bernanke’s thesis advisor at M.I.T. Remember that if the Fed doesn’t act, the bond market has the potential to make life very unpleasant for the central bank. (See Figure 8)

Figure 8. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2000:Q1 – 2011:Q4F
Sources: Global Insight and UCLA Anderson Forecast

The H1N1 Wild Card

We would be remiss not to note a potential risk posed by the 2009 version of the H1N1 flu, a lineal descendant of the historic 1918-19 pandemic.[iv] Public health authorities have warned that the 2009 version has the potential to infect half the U.S. population, hospitalize 1.8 million and kill 90,000 people.[v] Although this might be viewed as a worst case estimate, these data indicate that we facing something far worse than the garden variety flu season we face every year where about 36,000 people die.

Obviously if the upcoming flu season is anywhere close to the public health prediction economic activity could suffer from plant and office closings as well as sharp reductions in business and leisure travel, further battering the already hard hit transportation and hospitality industries. We have not modeled in a severe flu season, so we would we would warn that it represents a downside risk to the forecast.

[i] Blanchard, Olivier, “Sustaining a Global Recovery,” F&D Magazine, International Monetary Fund, August 2009.
[ii] See Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008 and Koo, Richard, “The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession,” (Singapore: John Wiley and Sons, 2008)
[iii] Wessel, David, “In Fed we Trust,” (New York; Crown Business, 2009) p.7
[iv] For the best history of the 1918-19 pandemic see, Barry, John M., “The Great Influenza,” (New York: Penquin Group, 2005)
[v] Randall, Tom, Alex Nussbaum, “Swine Flu May Cause 90,000 U.S. Deaths, Report Says,” Bloomberg, August 24, 2009.

In the Washington Post, "Economic Growth Yet to Hit Job Market," September 5

2009-09-05T06:11:00.000-07:00

"We've gone 10 years with zero employment growth," said David Shulman, a senior economist at the UCLA Anderson Forecast. "This has been a lost decade."

For full article see, http://www.washingtonpost.com/wp-dyn/content/article/2009/09/04/AR2009090400868_pf.html

Obama's Bad Bill Syndrome

2009-07-18T16:40:00.000-07:00

A disturbing pattern is beginning to emerge with respect to President Obama's relationship with Congress and the American people. It seems that he prefers bad legislation to no legislation, For example he supported the stimulus bill that was weighed down with the Democratic Party's 28 year wish list, but really offered little or no near term stimulus for the economy. He could have exercised leadership, but chose not to. A similar thing happened with the cap and trade energy bill that passed the House. That bill is a long way from an ideal carbon tax and for that matter a pure cap and trade system. Instead of charging for carbon emissions, it mostly gives away licenses to pollute for favored industries and penalizes the unfavored oil refineries. Should it pass in its current form, refineries will close and the U.S. will import even more gasoline and worse it will be a bonanza for Washington lobbyists seeking to bend the permit system in their favor.

Indeed the same syndrome is playing out with the health care bill. As the CBO noted it does nothing for cost control and, in fact, it increases health care costs for both government and the economy as a whole. President Obama surely wants the glory of presiding over national health care legislation, but he fails to realize that a bad bill will soon cause most American to look back with nostalgia at the system we now have. As the good Doctor Hippocrates once said, "do no harm." Bad bills do lots of harm.

Strange Claims Data Offer Hope of Recession's End

2009-07-16T12:25:00.000-07:00

The Labor Department (DOL) reported that new unemployment claims declined to 522k for the week ended July 11 down 47k from the prior week. These data are well below the 650k peak reported in the Spring. DOL noted that the seasonal adjustment factors could be completely out of whack because major auto lay-offs took place in April and May rather than July thereby rendering the seasonals less than accurate. In fact unadjusted claims actually increased by 86k for the week.

Nevertheless with two weeks of claims below 600k it is quite possible that on a GDP basis the recession might have ended this month. In terms of the labor market the recession is still far from over. Although layoffs might be waning, employers remain on strike with respect to hiring.

In the Washington Post, "Job Losses Dampen Hopes for Recovery," July 3

2009-07-03T05:54:00.000-07:00

"This sprayed some Round-Up on the green shoots," said David Shulman, a senior economist at the UCLA Anderson Forecast, using a metaphor for signs of economic improvement that Federal Reserve Chairman Ben S. Bernanke popularized in the spring.
"The economy is in the process of bottoming, but that's different from saying it's recovering," Shulman said.

Full story at http://www.washingtonpost.com/wp-dyn/content/article/2009/07/02/AR2009070200354.html

No Shock in Job Numbers

2009-07-02T09:51:00.000-07:00

The payroll number was no real surprise. The job losses occurred because there was a slowdown in the seasonal hiring college and high school graduates for summer and full-time employment. As someone who is associated with three universities, it was patently obvious to me that the normal hiring of college graduates did not take place this year. Hence when the data went through the seasonal meat grinder of the BLS it showed up as job losses. See post below.

Out of Intensive Care, UCLA Anderson Forecast, June 2009

2009-06-18T06:44:00.000-07:00

" It's very easy to forget, in your iron indignation at the failure of the market, where the true mainsprings of economic growth lie. The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from the private sector, not from the state.” Niall Ferguson[i]

The economy is out of intensive care, but make no mistake, it is still very sick. The free fall stage of the recession appears to be over and in fact we anticipate that the economy will record positive, albeit minimal, growth as early as the third quarter. (See Figure 1) After declining by an estimated 2.9% in the current quarter we forecast that real GDP growth will be zero in the third quarter and 0.6% in the fourth quarter or 2009 and the first quarter of 2010. Thereafter we forecast growth will be in the very modest 2-3% range.

Figure 1. Real GDP Growth, 2000Q:1-2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

However, with the economy growing at such a tepid pace, the unemployment rate will continue to climb well into 2010 where we expect it to peak at a 10.4%. (See Figure 2) Job losses will likely continue for the remainder of the year and we would not be surprised to see the worst data of recession arriving with the June employment report to be released in early July. Why? The seasonal adjustment factors used by the bureau of Labor Statistics look for a large increase in college/high school graduate hiring along with a rise in vacation oriented employment. Because the economy has been so weak the hiring of new graduates has been unusually soft this year. Thus the data will likely show a large decline in seasonally adjusted employment.

Figure 2. Unemployment Rate, 2000:Q1 -2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

As bad as the U.S. Economy has been, the rest of the world has been doing much worse. As we noted last quarter, we are in a truly global slump.[ii] The 5.7% decline in U.S. output in the first quarter pales in comparison to the 25% decline in Singapore, the 22% decline in Mexico, the 15% decline in Japan and the 14% decline in Germany. These depression-like declines were caused in large part by a 30% collapse in year-over-year exports for the 15 largest economies. Because the weakness in trade was exacerbated by the lack of financing, going forward the healing of the financial system will work to mitigate the decline.

The Financial System Heals

Despite all of the controversy, the host of Federal Reserve and Treasury actions to provide liquidity and capital to a severely wounded financial system suffering from the worst crisis since the 1930s appear to be working. In the inter-bank market the three month LIBOR rate has decline from 4.85% in early October to .65% in May. The seized-up commercial paper market has reopened and sparked by a record-breaking rally high yield bond spreads have come in 800 basis points since December. (See Figure 3) Along the way we have witnessed a requitization of the major banks and the real estate investment trust industry.

Figure 3. High Yield Bonds vs. Treasuries Mar 200 – May 2009 (Daily Data)

Source: Barclays Capital

Stocks too have bounced 40% off their March lows and the VIX Index (a measure of stock market volatility) has been reduced from 85% to 30%. (See Figure 4) An improved financial sector alone does not make a recovery, but it is a precondition for recovery.

Figure 4. S&P 500, 2000-29 May 2009, Weekly Data
Source: Global Insight

Housing Bottoming, Commercial construction in Free Fall

The long agonizing decline in the housing market is in the process of ending. To be sure prices already down 31% from the peak are still falling, but the lion’s share of the decline is behind us. (See Figure 5) Indeed house prices have now returned to where they were in late 2002. We are modeling in an end to the price decline late this year or early in 2010. At the end of the day with the Housing Affordability Index improving from 100 mid-decade to 170 recently and an end to employment declines should enable house prices to put in a bottom. Nevertheless because house price bear markets tend to have “long tails” do not expect any swift rise in prices over the next several years. Indeed there are still more “shoes to drop” as a new round of Alt-A mortgage resets hits the market in 2010-11 and foreclosures rise on prime mortgages weighed down by high unemployment.

Figure 5. S&P Case-Shiller Home Price Indices, 1988-March 2009, Percent Change Year Ago.

In terms of activity housing starts likely bottomed in the current quarter at an annual rate just below 500,000, down almost 80% from the peak. (See Figure 6) The recently enacted $8,000 new home buyer credit should help over the balance of the year. Because housing activity will come off a very low base, the recovery we envisage will look steep, but in reality the 1.25 million starts we forecast for 2011 will still be 40% below the 2.07 million units recorded in 2005.

Figure 6. Housing Starts, 2000:Q1 – 2011Q4F, SAAR
Source: Global Insight and UCLA Anderson Forecast

In sharp contrast to residential construction, the decline in commercial construction is only halfway through it contraction. (See Figure 7) Although the bull market in the housing market received most of the press in the mid-2000s, a parallel bull market was taking place in commercial real estate. Paced by over-generous lending standards commercial real estate prices more than doubled from 2000-07. However the onset of the credit crisis in August 2007 quickly and decisively triggered a bear market in commercial real estate. In fact, since 2006 the $250 billion/year issuance market for commercial mortgage backed securities (CMBS) market all but disappeared. It is for that reason the Fed made highly rated CMBS securities eligible collateral for the TALF program. However with rating downgrades in train, the dollar amount of eligible collateral will be severely reduced.

Figure 7.Real Commercial Construction Spending, 2000:Q1 – 2011:Q4F, SAAR
Source: Global Insight and UCLA Anderson Forecast

Furthermore, commercial real estate is plagued by more than a shortage of credit. The onset of the recession brought with it huge declines in office employment and consumer spending, the leading economic drivers of commercial real estate. With that vacancies have increased and rents have fallen. All-in commercial real estate prices are estimated to be off by 30-40% and are likely to fall further.

The Shape of the Recovery

What we are perhaps most concerned about is not the timing of the recession’s end, but rather the shape of the recovery to come. We are forecasting the weakest economic recovery of the postwar era with real growth on the order of 2- 3%. Indeed the unemployment rate could very well be close to 10% by the end of 2011. Simply put, we believe that the economy will be weighed down by newly chastened consumers attempting to increase their saving rate and a wrenching structural adjustment in the financial services, automotive and retail industries. These adjustments are even before we get to energy and healthcare.

Recovery will be inhibited by the legacy of the financial excesses of 2003-07 in the form of millions of foreclosed houses and even more plagued with “underwater” mortgages”, a nationalized domestic automobile industry and a partially nationalized banking system. This legacy is in sharp contrast to the roaring 1920s boom where the economy created such productivity enhancing investments as the national electrical grid, a giant automotive industry, unit-drive motors in factories and witnessed the emergence of electronic technology in the form of radios. Similarly the late 1990s bubble bequeathed to the economy the world-wide web and the flowering of wireless communications.

The rise in savings is being caused by the need of consumers to replenish their tattered balance sheets ravaged by the bear market in housing and stocks and the new lending standards that will make it harder to borrow. For example the quaint 20th century notion of consumers saving money to make down payments on houses will come back into vogue. To be sure the saving rate recently popped to 5%, but a good part of that is a result of the decline in automobile sales. Once automobile sales start to recover the saving rate will naturally drop.

Moreover there will be downward pressure on consumer savings coming from the tax increases on high income individuals scheduled to take effect in the beginning of 2011. Nevertheless by the end of 2011 we forecast that the saving rate will be running at a sustainable 3% rate and rising; a far cry from the zero rate experience a few years ago. (See Figure 8) As a result real consumption spending will increase at a very low 1% rate in 2010 and 2011 compared to the historic 3% increases. (See Figure 9)

Figure 8. Saving Rate, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 9. Real Consumption Growth, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast

Although both monetary and fiscal policy put a floor under the economy, no mean feat, it is also likely that the policies now being put into place may put a ceiling on it as well. How so? First the Fed will likely take away a good part of the monetary stimulus injected into the economy. Failure to do so would run the risk of a substantial inflation a few years out. The removal of the monetary stimulus along with modest economic growth will work to return interest rates to more normal levels. In fact this is the message of the recent run-up in 10 year U.S. Treasury yields from 3% to 3.9%.

In terms of fiscal policy the economy will be faced with trillion and near trillion dollar deficits for as far as the eye can see. With government spending(NIPA basis) estimated to peak out at a postwar record of 24.2% of GDP in 2010, the transfer of resources out of the private to the government sector will be hardly conducive the economic growth. (See Figure 10) Furthermore a new regulatory regime with respect to finance, energy, environment and healthcare will be hardly be a motivator for investment, at least, while the transition is taking place. Thus do not expect the recovery to look like those of 1991-99 and 2003-2007. But then again living without bubble-induced growth will be a new experience.

Figure 10. Government Spending as Share of GDP, 2000 – 2011F
Source: Global Insight and UCLA Anderson Forecast

[i] New York Review of Books, June 11, 2009.
[ii] Shulman, David, “The Global Slump,” UCLA Anderson Forecast, March 2009.

Comment: Meyerson's, "How the Golden State Got Tarnished," Washington Post, May 28

2009-05-28T14:59:00.000-07:00

Like all liberals, Meyerson goes back to Proposition 13 as California's original fiscal sin. To be sure Proposition 13 has a boatload of problems, but the real sin in California is an electorate that wants to spend big bucks on every social program under the sun, while being unwilling to tax itself to pay for them. Like a good friend of mine says, "they want all the lovin without the heartache." The road back for California involves drastic budget cuts to bring spending into line with revenues. Let every constituency scream, and we'll then know whether the California electorate really wants the all the government it is now paying and borrowing for.

I suspect that if every Californian has to bear the burden, they will vote for less government. One last point Meyerson incorrectly notes that California's poor pay more in taxes than California's rich. That is a canard because it assumes that poor renters pay property taxes through their rents. They do not; the property owner bears the property tax burden. This is evidenced by the fact that rents did not go down after Prop. 13 passed; they went up!!

Spraying Round-Up on the Green Shoots of Recovery

2009-05-13T11:51:00.000-07:00

Today the Commerce Department reported that April retail sales declined by 0.4% which followed a downward revised 1.3% drop in March. The data signalled that the consumer rebound of January and February was ephemeral and that despite optimism about the stimulus package and the Obama Administration, consumer spending is being weighed down by rising unemployment and falling asset prices. Put bluntly the data sprayed the weed killer Round-Up on the emerging green shoots of recovery.

As a result real consumption after rising by 2.2% in the first quarter will likely decline in the second quarter thereby marking down GDP projections. Thus it is no surprise that stocks are down about 2% as of 3:00 PM today.

Too Soon to Break Out the Champagne

2009-05-09T07:15:00.000-07:00

From Washington, D.C. to Wall Street too many economists broke out the champagne and toasted the better-than-expected decrease in April payroll employment of 539,000 jobs and smallest monthly drop since October. Almost lost in the apparent glee was a total 66,000 downward revision to the February and March job counts and the fact the the April data was enhanced by the hiring of 62,000 new 2010 census workers. Although there will be more census jobs to come and they are certainly "real," it goes without saying that these jobs are temporary. Thus a better measure of the "true" run rate of job losses in the economy is in excess of 600,000. To be sure the second derivative of the employment decline is negative(falling at a lesser rate), the 5.7 million job losses recorded since the start of the recession in December 2007 remains well on the road to 7.5 million.

Indeed the data for June, which will be reported in early July, could very well be the worst since the recession started. How so? Part of the answer is technical and part of it is certainly real. It is obvious to all that the college hiring season this year was the worst in memory. Meantime the seasonal adjustment factors used by the BLS look for a big increase in employment by new entrants to the workforce. This year it is highly likely that the increase in employment coming from new college and high school graduates will be de minimus. Hence the data could very well show a big drop off in jobs perhaps as high as 750,000.

From a qualitative standpoint our sources tell us that the pasta business is booming. For example the Ragu tomato sauce factory in Owingsboro, Kentucky is running 24/7 and still cannot meet the demand. If this recession has a culinary theme, it is back to cheap comfort food with a high carbohydrate content. Thus we were not surprised to see that only industry in manufacturing that increased employment last month was processed foods.

In the Washington Post, "In Poor Job Numbers, Hints of Improvement," May 9

2009-05-09T05:31:00.000-07:00

"The financial system is healing ahead of the economy," said David Shulman, senior economist with the UCLA Anderson Forecast. "The financial system is in the seventh inning, while the economy is still in the fourth inning."

In Barron's Cover Story, "The Other Shoe," May 4

2009-05-02T06:18:00.000-07:00

The vicious REIT selloff over the past 1½ years has brought belated vindication to former bear David Shulman, a REIT analyst at Lehman Brothers from 2000 to 2005. After his departure from the investment house, Shulman was mocked by Steve Roth, Vornado's longtime CEO, for having "a three-year sell on Vornado with a $43 average target" at a time when the stock was in the 80s. Vornado peaked at $133 in 2007, but plunged as low as $29 in March and now is in the high 40s. It recently sold $741 million of common stock at $43, Shulman's old price target. Roth hasn't apologized in print.
"REITs are a lot more attractive now than they were at the highs in 2007," Shulman said last week from his New Jersey home. "But compared with the rest of the stock market, they don't look so cheap." He notes that most real-estate investment trusts change hands at 10 to 16 times pretax cash flow, while a quality stock such as Johnson & Johnson, which has a triple-A credit rating, fetches 12 times after-tax earnings and seven times pretax cash flow.

Pulte/Centex Merger: Dinosaurs Mating

2009-04-08T06:17:00.000-07:00

The stock for stock merger between Pulte Homes and Centex to giant home builders, announced today represents a continuation of the death spiral the home building industry is in. Simply put the merger these two behemoths is very much akin to dinosaurs mating. Nothing much will come of it as they are on the downside of the evolutionary curve.

A far better strategy would be chop each company up into smaller more focused units. In that way each unit would be less of a slave to Wall Street earnings projections and instead focus on profitability rather than growth. Afterall it was the search for growth at any price that led to the buying huge tracts of land at the top of the market.

The Global Slump, UCLA Anderson Forecast, March 2009

2009-03-25T14:13:00.000-07:00

“By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”

Warren Buffett, Berkshire Hathaway Annual Shareholder Letter, February 2009

From New York on the Atlantic to Tokyo on the Pacific a global economic slump has engulfed the industrialized world. The ancient financial markets of London, Paris and Frankfurt along with the emerging ones of Shanghai, Singapore, Dubai and Mumbai are suffering under the weight of bad loans and a free fall in stock prices with 50+% declines being the order of the day.[i] (See Figure 1) With economic output falling virtually everywhere, the mid-decade global boom has given way to the worst global bust since the 1930s. (See Figure 2)

Figure 1. Global Stock Prices, Recent Peak to March 10, 2009

Sources: Factset and Bloomberg

Figure 2. Global Economic Growth 2007 – 2010F, Annual Percent Change in Real GDP

Most troubling about the global decline in economic activity has been the collapse in international trade. For example in the fourth quarter U.S. real imports to the United States declined at an annual rate of 16%, while real exports declined by an even greater 24%. (See Figure 3) These 20+% or so declines in the real trade accounts are reminiscent of the 27% compounded rate of decline in nominal global trade that occurred from 1929-32.[ii] Thus at least two of the elements necessary for a recovery in economic output will be a revival in world trade and the recognition that national solutions alone will not be sufficient to restore economic growth. Global solutions are essential. Action from Washington will be necessary, but not sufficient. In that light the stimulus packages announced and/or put in place by Europe, Japan and China are certainly helpful as well as the unprecedented quantitative easings by most of the world’s central banks. Thus the outcome of the upcoming London G-20 meeting in early April could very well be critical for the economic outlook for the remainder of the year.

Figure 3. Real Exports and Imports, 2000:Q1-2011:Q4F
Sources: Global insight and UCLA Anderson Forecast

The U.S. Outlook

The economic outlook remains bleak. After declining at a revised 6.1% annual rate in the fourth quarter of 2008, we forecast real GDP to decline a further 6.8%, 4.5% and 1.7% in the first, second and third quarters, respectively. (See Figure 4) Thus, if our forecast is close to the mark, the current recession will last between 19-24 months exceeding the 16 month 1981-82 recession, the longest of the postwar era until now. Nevertheless we do forecast that by the end of 2009 most of the contractionary forces will have been spent and the fiscal and monetary policies discussed below will begin to work leading to average quarterly growth in 2010 on the order of 2.7% and a more robust 4.1% in 2011.

Figure 4. Real GDP Growth, 2000:Q1-2011:Q4F
Global Insight, UCLA Forecast

As a result of the prolonged contraction, the economy will likely lose 7.5 million jobs peak to trough and unemployment will soar. We now forecast that the unemployment rate will peak at 10.5% in mid-2010 versus the 8.1% rate recorded in February. (See Figure 5) Unfortunately, just as the initial recoveries from the 1990-91 and 2000-01 recessions were “jobless”, the employment recovery from the 2007-09 recession will be long and arduous. For example by the end of 2011 total nonfarm employment will likely be four million below the 2007 peak and the unemployment rate will remain above 9% at that time.

Figure 5. Unemployment Rate, 2000:Q1 – 2011:Q4F
Source: Global Insight and UCLA Anderson Forecast
Fiscal and Monetary Policy to the Rescue?

As we have noted in previous forecasts, the Federal Reserve has been engaging in an extraordinary policy of monetary easing by dramatically expanding its balance sheet, purchasing a boatload of private( and risky) assets and bringing the Federal Funds rate down to near zero. These actions along with the TARP program in all likelihood saved the payments system from collapse and reopened the credit channel for high quality borrowers. However, it did not prevent the onset of the worst recession of the postwar era. Over the longer term the Fed’s zero-interest rate policy will enable the banking system to restore its profitability enabling a broad increase in bank lending. Such was the policy during the 1991-93 time period.

Although the Fed’s actions initially had a limited impact on the monetary aggregates, the money supply is now expanding rapidly. M2, a measure of the broad money supply, is now growing at a near 9% annual rate, and if history is any guide that increase will soon be translated to an increase in real economic activity. (See Figure 6) To be sure the velocity of money has collapsed as businesses and consumers have pulled back as the “shadow banking system” based on asset securitization all but disappeared. Nevertheless the expected surge in government spending should ultimately halt the decline in the income velocity of money. (See Figure 7)

Figure 6. M2 Growth, 2000:Q1 – 2011:Q11F
Sources: Global Insight and UCLA Anderson Forecast

Figure 7. Income Velocity of Money, 2000:Q1 – 2011:Q4F
Sources: Global Insight and UCLA Anderson Forecast

Along with the Fed, the Obama Administration, with its $787 billion stimulus package and its near $2 trillion deficit for fiscal year 2010, has adopted an “all-in” fiscal policy. With it comes a 14% federal budget deficit share of GDP, which is on track to be the highest since World War II. (See Figure 8) A feature of the plan is that tax cuts and spending increases come early while tax increases on high income earners and energy come later in 2011 and 2012.

Figure 8. Federal Budget Deficit as a Percent of GDP, 1980- 2011F

Sources: Global Insight and UCLA Anderson Forecast

The Balance Sheet Recession

All of these unprecedented monetary and fiscal policies are designed to overcome what we characterized last quarter as the balance sheet recession.[iii] The economy is being weighed down by the biggest decline in stock and home prices since the early 1930s, a wounded financial system and record high credit spreads. (See Figures 9, 10 and 11) Simply put consumers have lost a total of $14.5 trillion in wealth, $9 trillion in stocks and about $5.5 trillion in home values. Furthermore the S&P 500 Index recently traded at a 12 year low and as of December 2008 stocks recorded their lowest total return for a 10 year period since the late 1930s. In fact a 12 year low in the Dow Jones Industrial Average has only occurred two other times in history (1932 and 1974).

This hit to consumer net worth along with a severe decline in employment has caused consumption to seize up and the savings rate to soar from near zero to over 5%. (See Figure 12) Indeed against this backdrop, the $787 billion stimulus package, although helpful, looks like a drop in the bucket. Thus the recovery we are forecasting will be tepid. It will take time for consumer balance sheets to heal.

Figure 9. S&P 500, 1990-March 2009, Monthly Data
Source: Global Insight

Figure 10. Home Prices, 2000-2008, Case-Shiller 20 City Index

Source: Standard & Poor’s

Figure 11. High Yield Bond Spread vs. Treasuries, 1999 – Feb 2009, Daily Data

Source: Barclays Capital

Figure 12. Savings Rate, 2000:Q1-2011:Q4F
Sources: Global Insight, UCLA Anderson Forecast

Questions About Fiscal Policy

Make no mistake we have our doubts about the full efficacy of the Administration’s policies. To be sure the front loading the stimulus helps “stop the bleeding” in the short run, but individuals and business who tend to think longer term could very well be dissuaded from making purchases and investments today with the full knowledge that their taxes will be higher in the future. A simple example of this phenomenon is the proposal to cut the effective value of top bracket tax deductions to 28% from the proposed 39.6% top rate. Obviously such a change in the tax code would impact the willingness of high income earners to purchase new homes where the tax deductions associated with home ownership would be lower. Moreover a tax increase of this type can hardly be characterized as a shot in the arm for the beleaguered housing industry. Add to this all of the uncertainties associated with healthcare reform, $80 billion a year in implicit energy taxes resulting from the proposed “cap and trade” system for regulating carbon emissions, an end to the deferral of U.S. corporate income taxes on foreign source income and a potential wholesale rewrite of the labor laws, you have a recipe for a very sluggish corporate investment environment.

Moreover, both the Fed and the Bush/Obama Administrations have zigzagged so much on economic policy in recent months, that they have introduced a host of new uncertainties into an already troubled economy. To be sure health and energy policy changes are important to the long term success of the U.S. economy, but the uncertainty associated with the nature and scope of the policies being proposed by the Obama Administration are hardly conducive to making long term investments.

Over the longer term we question the whole consumption orientation of the Obama proposals. The fundamental imbalances of the U.S. economy were characterized by excessive consumption and a large external deficit. In tandem with maintaining global imbalances China’s stimulus package is encouraging investment where it should be encouraging consumption. To correct the imbalances in the U.S. a long term cure would come from a declining consumption share of GDP as evidenced by a higher savings rate and increased exports. In order to achieve that macroeconomic policy should focus on increased exports and improving the competitiveness of import-competing industries. To be sure investments in alternative energy projects and human capital make sense, but perhaps more effective would be a broad investment focused strategy on manufacturing. For example a policy of lower corporate income taxes and some form of investment tax credit would deliver far more benefits than the income transfer elements of the Obama program.

That said we still forecast a tepid recovery in 2010 as the contractionary forces become spent (i.e. housing can’t get much lower) and the near term positive impacts of monetary and fiscal policy take hold. We know that many observers, among them Warren Buffett, have expressed
concern about the long term inflationary consequences of both Fed and fiscal policies. They could very well be right, but for us, if inflation is a problem, it will be late in or after our 2011 forecast horizon.
[i] With apologies to Winston Churchill.
[ii] Calculated from Kindleberger, Charles P., “The World in Depression,” (Berkeley: University of California Press, 1973) p. 172.
[iii] Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008

Wall St. Bonus Tax: Where are the Civil Libertarians?

2009-03-19T13:32:00.000-07:00

"No Bill of Attainder or ex post facto Law will be passed." Article I, Section 9, Para 3, U.S. Constitution

This afternoon the House of Representatives passed a bill imposing a 90% excise tax on income in excess of $250000 for employees of firms receiving in excess of $5 billion in TARP funds. First to note, I have no dogs in this hunt. What House just did was pass a Bill of Attainder (a law singling out an individual or group for punishment without trial) on an ex post facto basis. A twofer violation of the Constitution.

My question is: where are the civil libertarians? What if Congress passed a law taxing the excess incomes of college professors who work at an institution that received federal money? There would howls of protest from civil libertarians. Trust me, this a big deal civil liberties issue. Today the Wall Street bonus babies, tomorrow who knows. Our forebears fought and won a revolution over this issue!!

NJ-Budget/Star Ledger Letter 3/17

2009-03-17T04:59:00.000-07:00

I rise to Treasurer Rousseau's challenge ("Treasurer dares budget critics to offer better plan," Mar 12, p. 1) .Put together with scissors, paste and bailing wire, the governor' budget will not survive the year. The gale force winds of the global economic crisis will render current and out year revenue forecasts as way too optimistic. Indeed it has worsened the long term structural problems facing the budget especially with respect to pensions.

What is needed is a structural change in the budget. In case you have forgotten the governor was very clear about that last year with his "dog and pony" show promoting securitization of our toll roads. My proposals are simple: 1)the governor has to sit down with his buddies in the public employee unions and renegotiate all of the pension plans covering state and local employees and 2) radically change the Abott v. Burke school funding formula. If that means a constitutional amendment redefining "thorough and efficient", so be it.

My proposals may sound radical, but there is no other long term alternative.

Comments on CNBC/Jon Stewart

2009-03-15T17:29:00.000-07:00

1.Stop the cheer leading. Stop the cheer leading. Stop the cheer leading. 2. More reporting and less commentary. 3. In that spirit fire Cramer and Kudlow. 4.More screening of advertisers. Keep the slimeball gold and mortgage ads off the air. 5. Question interviewees in the same manner Jon Stewart questioned Cramer. 6. Screen guests more carefully and keep the obvious jerks off the air.

The Balance Sheet Recession, UCLA Anderson Forecast, Dec. 08

2009-03-08T15:35:00.000-07:00

“The year under review has been one of dramatic occurrences in the whole field
of international finance, credit, monetary stability and capital movements, both
public and private.”

Bank for International Settlements, Second Annual Report, May 1932

The news from the economy is bad. The recession that we had previously hoped to avoid is now with us in full gale force. We now expect that real GDP will decline by 4.1% in the current quarter and decline by another 3.4% and 0.8% in the first and second quarters of 2009, respectively. (See Figures 1 and 2) Because Europe and Japan are already in recession and China and India are suffering from a significant slowdown in growth, the export boom of the past few years will wane. Make no mistake the global economy is in its first synchronized recession since the early 1990s. Moreover with tepid post-recession growth of around 3% the unemployment rate is forecast to rise from October’s 6.5% to 8.5% by late 2009 or early 2010. (See Figure 2) Concomitant with the rise in the unemployment rate will be the loss of an additional two million jobs over the next year.

Figure 1. Real GDP Growth, 2000:Q1 – 2010:Q4F

Source: Global Insight and UCLA Anderson Forecast

Figure 2. Unemployment Rate, 2000:Q1 – 2010:Q4F
Source: Global Insight and UCLA Anderson Forecast

The Financial Crisis of 2007-08

Unlike most recessions whose origins arise from the impact of Federal Reserve tightening on consumer and business spending, this downturn has its origins in a severe asset price deflation that has imperiled the balance sheets of consumers, financial institutions and over-leveraged business entities. The deflation which first manifested itself as a liquidity crisis in the short term money market in August 2007 quickly metastasized into a full-fledged financial panic.

The asset price deflation was triggered by a collapse in the housing market that triggered increased defaults in the mortgage market which in turn threatened first the liquidity and then the solvency of a financial system that grew increasingly dependent upon the easy flow of mortgage credit. From there it enveloped the high yield corporate bond market shooting up credit spreads to an unprecedented 1800 basis points over treasuries (See figure 3) Later investment grade corporate bonds fell under its sway where credit spreads rose to their highest levels since the early 1930s. (See Figure 4) With credit seizing up the $800 billion commercial mortgage securities market ground to a halt further imperiling the value of all commercial real estate, a market that has already declined by 30%. A contributing factor to the mortgage meltdown was Secretary of the Treasury Paulson’s remark on November 12th that the Troubled Asset Recovery Program (TARP) would not buy illiquid mortgage securities as originally contemplated. Within eight days the value of a key commercial mortgage derivative dropped by 24% implying a 17% yield for the “super” AAA tranche.[i]

Figure 3. High Yield Bond Spread vs. Treasuries, Daily Data, Aug 15, 2000 – Nov. 21, 2008
Source: Barclays Capital Markets
Figure 4. Moody’s Baa Bond Spread vs. Treasuries, 1925-Nov 2008, Monthly Data
Source: Federal Reserve Board

In the wake of the financial crisis such hitherto stalwarts as Fannie Mae, Freddie Mac, AIG, Washington Mutual, and Lehman Brothers have either failed or are under Federal supervision. Investment banker Merrill Lynch was forced into a merger agreement with Bank of America and both Goldman Sachs and Morgan Stanley became bank holding companies. Indeed bank shares lead by Citicorp plunged to multi-year lows. Indeed Citicorp had to be rescued by a $27 billion capital infusion by the Treasury and the creation of a “good bank-bad bank structure accompanied with a $306 billion federal guarantee the purpose of which was to keep “bad” assets from coming on to the market.

Even the credit worthiness of the finance-intensive General Electric Company has been questioned. It seems that everything that was once thought of as solid is now a liquid. As we have argued in prior forecasts we believe that out of the current crisis, as in past crises, a new financial architecture will evolve. Whether the reforms will be accomplished formally with the creation of a new national monetary commission or on an ad hoc basis by legislation and rule making remains to be seen. To be sure there will be an international component to any new financial architecture.

Having never declined since the early 1930s, house prices according to the Case-Shiller Index have fallen by about 22% since their 2006 peak accounting for about a $4.5 trillion wealth loss. Perhaps more astonishingly stock prices are on track to either having their biggest decline in history or, if not that, their worst performance since either 1931 or 1937. As of November 21st the S&P 500 was off 45.5%, worse than the 41.9% decline of 1931 and the 38.6% in 1937. In dollar terms stock prices have declined by $7.4 trillion since their historic high in December 2007. Thus it should surprise no one that consumer spending under the weight of a $12 trillion loss in asset values is now in the tank and will likely to remain soft for quite some time to come.

The carnage in the stock market has been amplified by the fact that real stock never really fully recovered from the bull market euphoria of the late 1990s. In real terms stocks did not make a new high in 2007 and the S&P 500 has now fallen back to where it was trading in August 1995! (See Figure 5)

Figure 5. S&P 500 Stock Index, Nominal vs. Real, 1980 –Nov. 2008, Monthly Data

Source: Global Insight and UCLA Anderson Forecast

Thus it is no accident that the industries linked to the two most durable and most tied to wealth and credit of consumer assets, houses and cars, are suffering. Housing starts are forecast to drop to below a 700,000 unit annual rate, the lowest in the postwar history and automobile sales are now running at a 25 year low. (See Figures 6 and 7)Figure 6. Housing Starts, 2000:Q1 – 2010Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 7. Light Vehicle Sales, 1990-2010F, Annual Data

Source: Global Insight and UCLA Anderson Forecast.

A Whiff of Price Deflation

Where only last quarter we were worried about inflation, we are now worried about its very rare opposite, deflation. The record collapse in oil prices has brought with it welcome relief to motorists throughout the country and an effective tax cut of $440 billion in the form of a lower oil import bill. (See Figure 8) Nevertheless the swift fall in oil prices is now lowering the absolute level of consumer prices and bringing with it likely declines in nominal GDP over the next three quarters. (See Figures 9 and 10) Because nominal GDP rarely declines, it conjures up the image of price deflation where the dollar flow in the economy makes it extremely difficult for workers and firms to earn higher nominal wages and profits. It brings to mind the Japan of the 1990s, not a pretty picture.

Figure 8. Oil Prices, WTI, 2000-Nov 2008, $/barrel, monthly Data
Source: Global Insight
Figure 9. Consumer Price Index, 2000:Q1-2010:Q4F
Source: Global Insight and UCLA Anderson Forecast

Figure 10. Nominal GDP, 1959:Q1-2010:Q4F
Sources: Global Insight, UCLA Anderson Forecast

The Monetary and Fiscal Response

The Federal Reserve moved swiftly to save the payments system in September by increasing bank deposit insurance and offering to insure money market mutual funds. Those actions prevented a repetition of the 1930s where a cascade of failing banks crippled the economy for a decade. Well before that the Fed embarked on a record setting easing process in terms of timing by lowering the Fed Funds rate by a total of 425 basis points to 1% within a year. We expect another rate cut to a modern era low of 0.5% in December. Indeed the effective rate where Fed Funds are currently trading is already at 0.5%. In all likelihood that will be the floor because at rates below that the nearly four trillion money market mutual fund industry would cease to function. By dramatically cutting rates the Fed has engendered an upwardly sloped yield curve conducive to recovery. (See Figure 11) Of course, if the credit channel remains blocks and banks refuse to lend then the Fed could find itself pushing on the proverbial string.

Figure 11. 3-Month U.S. Treasury Bills vs. 10 Year Treasuries, 2000:Q1 – 2010:Q4F
Source: Global Insight and UCLA Anderson Forecast

Thus rate cutting is only part of the story. The Fed has also created a host of new lending facilities for banks, nonbank banks (i.e. GE Capital) and broker-dealers that more than doubled its balance sheet in two months from $900 billion to $2.2 trillion. (See Figure 12) Perhaps more striking was the Fed’s late November move to make unsterilized (i.e. printing money) purchases of up to $500 billion of agency backed mortgage securities. That action by itself lowered mortgage rates by 50 basis points to 5.5%, thereby breaking the logjam in the mortgage market. The Fed not only holds treasury securities, but it now owns or lends on all kinds of asset-backed securities and commercial paper. The Fed has certainly taken to heart the central bank playbook of lending aggressively in a crisis. Nevertheless the question remains what is to become of these assets, once the crisis has past and what are the long run inflationary consequences of these very aggressive monetary moves?

Figure 12. Federal Reserve Assets, 10 Sept 2008-19 Nov 2008, In Billions, Weekly Data

Source: Federal Reserve Board

On the fiscal side Congress passed a $168 billion stimulus package last winter. The bulk of the package came in the form of $108 billion in refundable tax credits to consumers. It was not effective as much of it was used to pay for higher gasoline prices and reducing debt. What was spent gave a “sugar high” to consumption in the second quarter and was quickly dissipated. For the purposes of our forecast we are assuming a new $200 billion package to pass in the first quarter that would include increased unemployment insurance benefits, food stamps, rebates, aid to state and local governments and infrastructure spending. Of course this could very well be on the low side and a package two or three times higher than what we are now envisioning should not be ruled out. It is also looking more likely that President-Elect Obama’s campaign promise to increase income tax rates to high earning individuals will be deferred until 2010. Remember the economy will already be benefitting to the tune of $440 billion coming from cheaper oil imports. In any event expect that the deficit will exceed $1 trillion in FY 2009. (See Figure 13) Moreover with $7.4 trillion of asset purchases and loan guarantees the deficit represents only the tip of the iceberg.

Figure 13. Federal Surplus/Deficit, FY 2000-2010F
Sources: Global Insight and UCLA Anderson Forecast

After much consternation Congress passed the Treasury’s $700 billion TARP program which was initially designed to purchase illiquid assets from the banking system. That plan quickly metamorphed into the purchase of preferred stock and equity warrants in the largest banking institutions in the country. In essence the banking system was partially nationalized. Whether or not the TARP funding will be sufficient and in what form it will take in the future remain open questions. After all Secretary Paulson has bequeathed $350 billion (subject to Congressional veto) to the new administration.

Not to be outdone by the banking system Detroit appeared on Capitol Hill in search of loan guarantees to fund their massive losses to enable the auto industry to retool. Although bankruptcy maybe the preferred solution and cannot be ruled out, we suspect that given the fragility of the financial system and the politics involved some form of aid will be granted. Remember the domestic auto companies are huge debtors to the financial system and to a host of suppliers.

Although the financial markets have been encouraged by President-Elect Obama’s appointments to his economics team, there are other issues the new administration is pursuing that will affect the economy next year. Two non-fiscal issues loom large over the economy as well. The first is the new Administration’s plan to impose a cap and trade system for carbon emissions which is effectively a large tax on carbon intensive production. The political process alone could create enough investment uncertainty to delay any economic recovery, much less the impact of a new tax burden on the order of $100 billion.

Second is the prospect of new labor legislation that would eliminate the secret ballot in union organizing elections. Under the proposed “Employee Free Choice Act” a union can be formed a given work site with a majority of employees signing cards affirming their desire to join a union. Needless to say this is a major rewrite of existing labor law and, if enacted, it could lead to widespread labor strife. Going back to another 1930s analogy we note that labor strife in 1937-38 after the passage of the National Labor Relations Act of 1935 was one of causes of the industrial collapse of 1937 that practically wrecked the New Deal.

Conclusion

To summarize, we are forecasting a nasty recession that will be characterized by four quarters of declining real GDP and unemployment rising to 8.5% by late 2009. Because of the severe stress on consumer balance sheets, the savings rate will have to increase and by definition consumption growth will be sluggish. Although we are not forecasting that the savings rate will return from the 0.6% in 2007 to a more normal 4-7%, we can see a return to a level of 3-4%. (See Figure 13) As a result trend growth of 3% with very sluggish job growth won’t resume until 2010. Remember both the 1990-91 and 2000-02 recessions were partially based on balance sheet issues and both times subsequent job growth was very sluggish. Furthermore it will take quite some time for the financial system to heal and as we have argued a new financial architecture will emerge out of the current crisis.
[i] Mulholland Sarah and Jody Shen, “Commercial Mortgage Securities Holders Blame Paulson,” Bloomberg News, November 21, 2008.