Call it a slowdown, call it recession, but don’t call it a depression. Not yet, anyway. In the first quarter of 2008, real U.S. gross domestic product increased by 0.9%, beating initial estimates of 0.6%, according to the Bureau of Economic Analysis. And while that is far from stellar performance, it could help to undermine the persistent pessimism that has dogged the United States and hammered the greenback.
“While the latest employment report showed a big jump in the unemployment rate, the details behind the rise, with some of it due to stronger labor force growth, were not quite as alarming. Meanwhile, Q1 GDP was slightly positive and the ISM reports have not been as weak as expected. So the overall economy has not collapsed yet,” says James O’Sullivan, senior economist for UBS. He expects to see continuing weakness in U.S. economic data for the next few months, and expects that this will qualify as a mild recession.
While the data is soft, Action Economics’ managing director of global fixed income Kim Rupert says she does not anticipate a U.S. recession. Her forecast is for 2% growth in the third and fourth quarters, and with the risk to the upside. “For one, we think that retail sales are ready to jump pretty high over the next several months. Both because of the stimulus package being spent but also because of gas prices. Even though it is a hardship on the pocketbook it will make the data look good. And corporate earnings have not been as bad as expected and it doesn’t sound like there is a lot of terrible angst among companies other than airlines and truckers.” But for the skeptics, not being able to see the recession in the numbers is part of the problem and a drag on growth.
“We are in a tug of war between the real economy and the statistical measures of the economy,” says Mike Kimbarovsky of Advocate Asset Management LLC. While the Bureau of Labor Statistics (BLS) defines a recession as two consecutive quarters of negative GDP growth, he says the definition is meaningless because of the department’s ability to tweak data (see “Futures Interview,” page 32). “Recession is better defined anecdotally as a loss of economic power, whether it is spending or wealth,” he says.
And the loss of economic power is becoming more evident. “You probably have more moving factors going on in this recession than any I can think of since 1980,” says Carey Leahey, managing director of Decision Economics Inc. Factors include high gasoline prices, falling housing values and the largest financial sector shocks since the Depression, including the subprime lending crisis and the resulting destruction of Bear Stearns. “It seized up the entire credit market and I would consider that to be the single biggest market event since the 1930s. And the fact that the Federal Reserve, for the first time since the 1930s, had to bail out an individual institution shows you how bad things got.”
With crude oil trading above $130 per barrel, gasoline prices at a national average of $4 per gallon and agricultural commodities trading near all-time highs, inflation is clearly on the rise. In the minutes from the April Federal Open Market Committee (FOMC) meeting, the consensus was that higher oil and food prices would “continue to boost overall consumer price inflation in the near term,” before moderating.
“The consumer is just starting to cut back now after many years of shop till you drop, spend till the end,” says Dan Seiver, economics professor at San Diego State University. Consumer spending is responsible for about 70% of U.S. GDP, he explains, and how we respond to the slowdown will determine the positive or negative growth of the economy. And consumers do seem to be suffering from their consumption induced hangover. In May, the University of Michigan consumer sentiment index fell to 59.8, its lowest point since 1980.
And it is not just the sentiment numbers that that are showing dimming prospects for the near future. Also in the Fed minutes was the observation that while core consumer price inflation had slowed in recent months, overall inflation remained elevated.
“Inflationary pressures are going to continue to rise, if not in the statistical world, then in the real world,” Kimbarovsky says. “The Federal Reserve lowered their expectations for inflation, excluding food and energy, to the 2.2% to 2.4% range. How does that make any sense? If you continue to exclude the segments of inflation that are rising, that’s a true statement,” he says, adding that the components of CPI that are falling, such as apparel and recreational goods, are doing so not because they are cheaper to produce, but because of price wars. “There is no mechanism for fighting inflation because the pricing mechanism is exogenous,” he says, and the only affect the Fed can have on those prices is by raising interest rates.
Another cause for pessimism is the U.S. housing market, which is central to understanding the current economic slowdown. The boom and bust of the housing sector has had an enormous impact on banks, lending practices, mortgage based securities and led to the credit crunch (see “Wicked Housing Market Spins Economy,” Futures, January 2008). The easy lending standards that contributed to the problem are being reversed (see “Tighten up”). In addition, the resulting decline in home values has had a negative wealth effect on consumers, who had been habituated to double-digit increases in home values and home equity loans.
According to the S&P/Case-Shiller Home Price Indices data, home prices are down about 15% from their peak so far, and projections are for an additional 10% decline. “The economic effects of that are still playing out,” O’Sullivan says. “We have already seen the biggest drop in home prices since the great depression; and it’s not over yet. First quarter, the Census Bureau reported a new record high of inventories of vacant homes for sale. That number is probably going to stay high due to all the foreclosures.”
In May, the number of foreclosures climbed to the highest level since 1979, according to the Mortgage Banking Association (MBA), and the types of loans defaulted on are changing as well. “Out of the approximately 516,000 foreclosures started during the first quarter, subprime ARM (adjustable rate mortgage) loans accounted for about 195,000 and prime ARM loans 117,000,” said Jay Brinkmann, MBA’s vice president for research and economics in a press statement. However, the number of foreclosures on prime ARM loans is growing more quickly, increasing by 29,000 over the past quarter, substantially exceeding the increase in subprime ARM foreclosures, which increased by 20,000 in the same period.
There also is a new class of mortgages that are about to go bad en mass: Alt-A mortgages, or pay-option ARMs. “You don’t even have to pay the interest at the beginning,” Seiver explains. “You can make some nominal payment and you get negative amortization, so it adds to how much you owe. But once the mortgage debt goes to say 115% of what you started with it suddenly converts to a regular mortgage and so your payment goes way up.”
With the housing sector representing 5% of gross domestic product, the decline has had a significant effect on U.S. employment, Kimbarovsky explains. “Construction in April dropped to its lowest level in 17 years. Builders started 692,000 single-family units — at an annual rate — the lowest since 1991,” he says, and multi-family units, condos, town homes, apartments, the rental units, were 30% below April 2007. “Normally housing is up 40% in the first year of an expansion and even if the next 12 months are not recessionary, how do you get back to 4% growth?” Leahey wonders.
In May the unemployment rate increased half a point to 5.5%, and private payroll employment fell for the fourth straight month. According to the Fed minutes, the job losses were widespread, but more pronounced in construction, manufacturing and professional and business services sectors. Employment in the nonbusiness services sector, including health care, rose. “You don’t see the recession in the GDP data, but we have had a six- month decline in payrolls and whenever you have had that, you have had a recession. So for the moment, it appears to be pretty shallow and may even be short,” Leahey says.
O’Sullivan says unemployment will continue to rise for months, but one bright spot on the horizon for tax payers and businesses is tax rebates and the economic stimulus checks that are now arriving. “If you assume a 26% spend-out rate into December, which is fairly consistent with what we have seen in past episodes, as well as what surveys are suggesting, it boosts the annual rate of growth in consumer spending by about one point in Q2 and one point in Q3,” O’Sullivan says. However, in the fourth quarter, as the payouts dwindle, he would anticipate a one-point decline. “We don’t think that is enough to prevent weakening in this quarter.” For the second and third quarters, he says that GDP will decline to -1%, and by fourth quarter unemployment will rise to 6%. “If unemployment is going to 6%, there is more easing coming,” on the other hand, if the unemployment rate stops rising after a few more tenths of a percent, then the economy should hold up.
“We still haven’t seen jobs numbers or claims numbers that have been the equivalent of the numbers we’ve seen in recession times,” Rupert says. “That’s another factor in our belief that the economy isn’t in and isn’t heading for a recession.” She acknowledges that the job market is weak and likely to stay that way, but she does not anticipate declines in the range of 100,000 to 300,000 per month. “We didn’t have a lot of hiring in the mid 2000s when the economy started to recover, so there are not a lot of excess or redundant jobs that we have to get rid of. Of course, the housing and financial areas have shed a number of workers, and until those sectors start to come back, those areas will remain weak.”
While the Federal Reserve has been very accommodative so far, lowering interest rates and creatively adding liquidity to the financial markets, the specter of inflation or worse: stagflation, is on the rise. And because of that, Leahey says that over the course of 2008 he expects 100 basis points of tightening in the Fed funds rate. “Everybody was talking gloom and doom and it turned out the bottom-up earnings analysts talking about market strength — which people like me pooh-poohed — were right and we in the macro economic community were generally wrong,” Leahey says, noting what happened following the October 1987 stock market shock.
Rupert says that a series of rate hikes is likely to begin by the end of the year, after the election cycle. By then, she says the Fed will have a solid reading that the economy is doing well enough to withstand rate hikes. “Once the Fed starts hiking rates, they will get interest rates back to the 5% area pretty quickly,” she adds.
Seiver agrees that the Fed has shown a proclivity to change rates rapidly. “When they go up, they will go up pretty fast,” he says, wondering if Wall Street will be ready. “If the market really does sell off, then they will create opportunities for the next bull market,” he adds.
Kimbarovsky isn’t as optimistic. “A lot of the excess will be wringed out and then we can improve. The Fed will have to raise rates. They haven’t really been focused on inflation. Their monetary policy has been rationalized by focusing on the immediate financial crisis rather than on the inevitable inflation crisis,” he says.
O’Sullivan stands alone in his outlook, and says that the Fed has made good decisions. “In the end, growth is clearly the issue, not inflation. And if anything, they will have to do more. If we see growth weakening and unemployment rising, there will be pressure on them to ease a bit more.” He is forecasting another 50 basis points of easing in June and August.