Sunday, March 8, 2009

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

“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.


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.

No comments:

Post a Comment