Thursday, June 18, 2009

Out of Intensive Care, UCLA Anderson Forecast, June 2009

" 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.