Wednesday, December 9, 2009

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

“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


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.

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