Economic Insights - December 07 |
| Posted on Dec 01 2007 at 12:00 AM |
| Articles >> Articles |
ECONOMIC INSIGHTS
Frederick T. Dixon, Chief Economist
In the December issue of Economic Insights…
DOMESTIC BUSINESS CYCLE DEVELOPMENTS
The Fed Cuts Interest Rates Again But… - The credit markets are hardly cured. It is
possible that monetary ease may not have the same positive impact as in the past,
at least within the usual time frame.
Extending The Outlook To 2009: Go, Slow Go Or No Go? – The headwinds remain
unrelenting in their presence. They sound like a train wreck that will derail the
economy. EI see another outcome.
GLOBAL DEVELOPMENTS
The Dollar Decline: Getting Beyond “Picture Perfect” – The big risk of more
weakness in the dollar combined with the subprime mess is that foreign investors
could become increasingly skittish over buying dollar-denominated financial
assets.
INDUSTRIAL HIGHLIGHTS
A Profits Recession? – S&P 500 company earnings fell in the third quarter ending a
remarkable winning streak. Wall Street now expects another modest decline in the
fourth quarter. This represents an abrupt deterioration in earnings expectations.
Is
commercial building sector has been in sharp contrast with the housing market.
But EI believes it is getting ahead of itself.
Forecasts For 2008 And 2009
ECONOMIC INSIGHTS
DOMESTIC BUSINESS CYCLE DEVELOPMENTS
The Fed Cuts Interest Rates Again But… - The financial markets did not breathe a sigh of relief. They hoped for more than a ¼ point cut in the federal funds rate and the discount rate. There seemed to be a feeling that the Fed lacked a sense of urgency given that GDP growth was slowing toward zero. Even the follow-up plan to keep the international banking system liquefied has not been greeted initially with a great sense of confidence that central banks are getting ahead of the curve. There is a disconnect between how the bond market views the situation and how the Fed views it. Bond investors see little inflation threat but they are concerned about the possibility of a recession. The Fed admits there is more uncertainty over economic growth but it continues to be concerned about inflation even though it acknowledges the economy has slowed noticeably.
EI is monitoring the credit markets closely and we will give details on the progress or lack of it in next month’s report. For now, suffice to say the credit markets are far from functioning normally despite a 100 basis point cut in the federal funds rate over the past three months. At a time when the economy has slowed sharply it is a headwind that is certainly not needed. It is possible that interest rate cuts may not have the same positive impact as in the past, at least within the usual time frame. This is highlighted by the fact that many credit indicators have not improved since the first cut in interest rates in September. It is another reason why EI believes we are in for an extended period of sub-par growth.
We all know that housing is at the core of the economy’s problems. Until stability in housing is restored the economy will suffer. The money that fueled the housing bubble came from investors who bought the subprime debt. The wave of ratings downgrades, the rise in mortgage delinquencies plus the prospect of a further climb in delinquencies in 2008 have spooked those investors. They are not likely to return just because the Fed lowers the federal funds rate. They need to see some semblance of security and stability in the more risky type of debt. That could take time.
Extending The Outlook
To 2009: Go, Slow Go Or No Go? – In the past, EI has commented on the
surprising resiliency of the
The headwinds have been well documented in the financial press and they remain unrelenting in their presence. The most prominent problem is housing. It will not abate until prices bottom out and that will take time. In the new home market, inventories are a big problem. Although housing starts have plunged 48% since their peak in January 2006, sales of single-family homes have declined even faster so companies cannot trim their inventories. Ditto for the existing home market where inventories are being bloated by the growing number of foreclosures being dumped onto the market. The Mortgage Bankers Association estimates 1.35 million homes will enter the foreclosure process this year and another 1.44 million in 2008, twice the number in 2005. A vicious circle is underway. If potential home buyers hear that a deal today is better than the one a few weeks ago, they become hesitant to buy. They would rather wait until they feel prices stabilize fearing further price depreciation. But their hesitancy creates more downward pressure on prices. Home prices in the third quarter were down 4.5% from the year earlier period according to the widely followed S&P/Case-Shiller index which tracks prices of single-family homes in 20 major metro areas.
Housing is a $21 trillion asset class for households, twice as great as stocks. For a long time, the record surge in prices made households feel richer and more willing to spend. No other cycle saw consumer spending exceed personal income growth by such a wide margin – by one percentage point over the six years from 2000 to 2006 as housing wealth expanded an average of $1.77 trillion or 12.2% per year over that span. Now that process is reversing as home prices fall. It will be a multi-year adjustment.
The other part of the housing headwind is the related subprime credit mess which will also take time to play out. That is because a lot more mortgages have yet to go bad than already has been the case. Defaults will rise as more of the low-interest “teaser” mortgages held by borrowers with poor credit move up. The dollar amount of ARM’s that are scheduled to reset in each quarter of 2008 is twice the average amount during the first three quarters of 2007. According to the Bank of America, the total will be $362 billion with another $152 billion of jumbo mortgages of more than $417,000 and Alta-A loans (i.e., a category between prime and subprime) also resetting. As write-downs from bad mortgage lending mount from the more than $50 billion already announced by big financial institutions, bank capital will shrink and that will affect lending. Particularly hard hit will be home-equity loans and that will affect consumer spending. Credit is a huge driver of growth and there will be a slowdown in the amount of credit extended.
With oil still near $90 a barrel, prices at the pump are holding at about $3 a gallon. That is close to the $3.06 in the second quarter that helped to slow consumer spending to just a 1.4% rate. No matter how you downplay the impact of high oil prices, they are equivalent to more than a $100 billion tax on consumers.
All of this may sound like the type of train wreck that will derail the economy. That is certainly possible. But EI sees another outcome. If it is a train wreck, it is a slow moving one that has been underway for a considerable period of time. Yet, the economy has not capitulated. Housing has been falling for nearly two years and oil prices seem to have been moving up forever. The subprime mess is relatively new but it has been front page news since early August. If the economy has not yet capitulated, why should it now given that there has already been so much bad financial news and the Fed is cutting interest rates?
Credit events often take longer to play out than initially expected. This one seems to fit that profile. The housing problem and its effect on the credit markets will take more time to work out because of the sheer complexity of the situation. Until the mess is cleaned up, investors and banks will remain jittery and that will affect lending. A number of indicators suggest that, despite the Fed cutting short-term interest rates 100 basis points, the financial markets are still under a great deal of stress.
EI sees the economy as being in an extended “growth recession.” How does this differ from a recession? Recessions are usually characterized by V-shaped moves in GDP. Growth drops sharply perhaps close to zero or below over a short span and then rebounds to above trend. In a growth recession, growth does not drop as sharply but stays below trend for a longer period of time. The net effect in terms of lost GDP can work out to be about the same in both cases.
With trend GDP growth generally thought to be in the 2½% to 3% range, EI expects growth to be below trend in 2008 for the second straight year and near that level in 2009. That would qualify as a growth recession. “Slow go” is not as good as “go” but it is better than “no go.” This is not a gloomy scenario but it portends an atypical period for the economy. The risk is that, with growth sub-par for such an extended period, the economy would be susceptible to another headwind that it might shrug off with growth at a higher level. But, under these circumstances, another headwind would be enough to push it into a recession. Stay tuned!
GLOBAL DEVELOPMENTS
The Dollar Decline: Getting Beyond “Picture Perfect” – Back in June, EI described the dollar’s slide as “picture perfect” largely because it helped to prop up growth through its positive impact on trade. While the fall in residential construction has directly subtracted 0.8 of a percentage point from GDP growth over the past year, the fall in the trade deficit has added 0.9 of a percentage point to growth over the same period. Look for a further boost to growth from a narrower trade deficit in the fourth quarter when the rest of GDP will turn in a performance that is dangerously close to a recession.
Between February 2002 and June 2007 the dollar fell 20% on a trade weighted basis against a broad basket of currencies. Since EI’s commentary on the dollar in June it has fallen another 5%. Enough is enough! We now believe the dollar’s decline is beginning to move beyond picture perfect. The weak dollar is having a significant impact on reducing the trade deficit. But more weakness could run the risk of doing more harm than good.
EI does not believe the major risk of a weaker dollar is more
inflation. International competition is so intense that foreign exporters have
not been hiking the prices of the goods sent to the
The bigger risk is that the combination of the subprime mess and an associated lack of confidence in the value of some complex financial instruments plus the weakening dollar could cause foreign investors to become increasingly skittish over buying dollar-denominated assets. That would crimp capital inflows, turning what has been an orderly weakening in the dollar into a disorderly rout. That type of dollar slide would panic stocks and cause the type of bear market that is often associated with recessions.
If the dollar continues its slide there could be an
international loss of confidence in
As far as OPEC is concerned, because oil is traded in
dollars, as the dollar falls OPEC is earning less on every barrel. That
provides them with the incentive to restrict supply to prop up prices. In the
case of
So far, there has been nothing more than talk. The problem is that it is impossible to identify the elusive point at which talk leads to action. Then it becomes too late.
EI does not believe a doomsday scenario over the dollar is in
the cards. A dollar rout is not imminent. An important factor behind the
dollar’s depreciation since 2002 has been the fear that runaway trade and
current account deficits could not be financed indefinitely and a falling
dollar was necessary to force
Another factor that could restrain the dollar’s fall is that
other major industrial economies such as the euro-zone,
INDUSTRIAL HIGHLIGHTS
A Profits Recession? – The economy is not in a recession but corporate earnings may be very close to one. Largely because of steep loses by financial firms and home builders, S&P 500 company earnings fell 4.4% in the third quarter from the year-ago period. This ended a remarkable five year run of expanding profitability when pretax corporate profits rose from 7.6% of GDP to 11.7%. According to Wall Street analysts, S&P 500 company earnings are expected to fall 0.8% in the fourth quarter led by a 35% plunge in results for financial firms. If the fourth quarter turns out to be the second straight quarter of falling profits, it would constitute an “earnings recession.” The last time there was such a profit downturn it lasted more than a year from the beginning of 2001 into early 2002. The overall economy also briefly fell into recession.
The deterioration in earnings has been remarkably abrupt given Wall Street expectations. In early October, analysts expected a 3.8% improvement in the third quarter and an 11.5% gain in the fourth quarter even though the liquidity squeeze was well underway at the time. What has occurred has dramatically reversed the pattern in recent years when actual results have usually exceeded expectations.
Two quarters of modest declines in S&P 500 company profits are not a dire situation given the still extremely high level of profitability. Also, the broadest measure of profits which appears in the government’s national income data has yet to turn down. It recorded a 1.9% increase in the third quarter. The river of cash flow has hardly dried up but it is flowing less freely. But if a “profits recession” continues into 2008 it would have negative implications for hiring and investing. Weaker profits ultimately translate into lower stock prices. That would be particularly troublesome because consumers are already feeling less wealthy with their home values falling and fuel costs so high. The credit squeeze would compound the problem.
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EI believes commercial building is getting ahead of itself and a period of consolidation is coming. Given a slowdown in employment and consumer spending, commercial building cannot continue at anywhere near its current pace without excess supply occurring. Also, commercial building often moves in sync with some lag with what is occurring in the residential sector. The current divergence is unusual. But a correction may not occur immediately given that office vacancy rates have been falling and rents rising providing the financial incentive for more building. Nationwide, the office vacancy rate is the lowest since the second half of 2001.
The subprime mess will have an impact given the growing reluctance of lenders to extend credit for anything related to real estate. Property values will be affected by the high cost and declining availability of financing. Given the higher cost of debt, buyers will have to pay less for properties to get the return on equity they want.
The retail sector has been a pillar of the commercial real estate industry but that may be changing. Strip mall vacancy rates are rising matching the level in early 2002 which was an 11 year high. The fall in housing will have a spillover effect on demand for new shopping centers. At the very least, commercial building will not continue to have anywhere near the expansionary effect that it has in 2006 and 2007.
FORECASTS FOR 2008 AND 2009
ANNUAL PERCENT CHANGE
Est. Forecasts
2007 2008 2009
Real GDP +2.2 + 2.2 +2.3
Manufacturing Production +2.1 + 1.9 +2.5 Chemical Production +0.5 + 1.4 +2.6
Inflation - Consumer Prices +2.9 + 2.2 +1.9
Among The Highly Cyclical Markets
Total Construction (current $s) -2.5 +1.5 +10.7
Housing Starts -26.0 -14.2 +19.6
Commercial Construction (current $s) +15.6 +4.7 +1.0
Motor Vehicle Sales -2.7 +0.5 +1.2
Appliance Production -4.5 -1.9 +9.8
Furniture Production -3.1 +0.9 +4.0
December 18, 2007
Coming Up: Is the consumer running on empty? Update on
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