From the July-August 2009 issue of Treasury & Risk magazine

Is Getting Back to Normal Possible?

Economists Milton Ezrati of Lord Abbett, David Levy of the Jerome Levy Forecasting Center and John Lonski of Moody's Investors Service look at what comes next for the economy.

Nothing lasts forever, and some recent economic reports suggest the U.S. economy's tumble may be nearing an end. Although GDP contracted 6.3% in the fourth quarter and 5.5% in the first quarter, some analysts think it will resume growing later this year. Treasury & Risk asked economists John Lonski of Moody's Investors Service, David Levy of the Jerome Levy Forecasting Center, and Milton Ezrati of Lord Abbett to discuss some of the key factors in the
outlook for U.S. growth. Inflation warnings will prove unwarranted as high unemployment and weak pay raises are expected to continue for several years, writes Levy. Ezrati sees encouraging signs in the residential housing market signaling the beginning of a modest recovery, while Lonski predicts more tough sledding for consumers but a mildly better corporate credit outlook.

Weak Labor Market Caps Prices

By David Levy

The chorus of inflation warnings in recent months may have seemed persuasive, but they miss the most important points about the outlook for price trends. In the years ahead, chronic high unemployment will weigh heavily on pay rates; chronic economic weakness will keep profit margins under pressure and firms focused on cost control; and global instability and depression will generally keep commodities and imported manufactured goods cheap. And while investors will find reasons to worry about the dollar, they will find similar or stronger reasons to worry about the euro, yen, pound sterling, Swiss franc, Canadian and Australian dollars,and just about every other currency.

In the long run, the dominant influence on inflation is labor costs. Labor costs are the biggest component of prices. In addition, because labor costs are influenced by compensation rates, which affect personal income and consumer spending, labor cost increases are correlated with business's ability to pass on inflationary price increases.

The conditions necessary to cause compensation inflation to rise include a tightening labor market and a falling unemployment rate that at some point will trigger inflationary pay increases, with the trigger point varying depending on economic circumstances. Conversely, an unemployment rate that is substantially above such a trigger point indicates excessive competition for jobs and a tendency for pay raises to shrink.

For at least the next five years and probably much longer, it will be extremely difficult for the economy to generate any acceleration in worker compensation rates and, therefore, any meaningful inflation. It will take a long time for unemployment to fall to levels where labor markets are no longer slack. Over the past quarter century, that point has ranged from 6.5% to 4.5% unemployment; let's assume conservatively that the unemployment rate only has to fall to 6.5% before compensation inflation begins to accelerate. Let's also assume optimistically that the rise in the unemployment rate slows significantly for the balance of 2009, peaks at 10.3% in the first quarter of 2010, and falls a percentage point every year--faster than it did during either of the past two expansions. Even with these assumptions, unemployment will not hit 6.5% until January of 2014.

And the recovery in employment could easily take years longer. Whether or not the end of the recession is near, the economy is still in the early phase of a much longer period of economic weakness that will almost surely transcend two or more business cycles. The economy has entered a type of depression, a long period during which it must reverse decades of overexpansion of private sector balance sheets.

The depression would have become a great depression had not the United States and foreign governments intervened to rescue the financial system and pump in massive fiscal stimulus; instead it is a contained depression. Nevertheless, a long, transitional period of debt reduction and asset deflation has begun, which will last at least several years and perhaps a decade. It will be characterized by severe recessions, spotty recoveries, poor profits and chronically high unemployment as the economy undergoes a painful healing process. The fact that private balance sheets must contract means the private economy will be unable to generate profits for many years. Only with the help of government deficits will profits remain positive.

The recent economic green shoots likely represent either a false bottom for the recession or the beginning of a feeble, jobless recovery that will run into trouble in 2010 without more fiscal stimulus. GDP growth may or may not be positive in the middle quarters of 2009, but either way growth will be disappointing--and possibly fleeting--over the next four quarters. Unemployment, now widely expected to be near 10% at year-end, will most likely peak at around 11% in 2010 before gradually turning down. The possibility of new financial crises and renewed recession leaves open the prospect of an even more onerous peak unemployment rate.

Under the circumstances, no matter how large bank reserves or federal spending become, inflation will keep fading under the weight of poor business conditions, overcapacity and high unemployment. Deflation will be a legitimate concern, but not inflation.

A Real Estate Recovery of Sorts

By Milton Ezrati

Now that investors seem to have thrown off their worst forebodings about the economic and financial future, any further market lift will depend on a continuation of the recent healing in credit markets and the economy's ability to make headway out of the recession. And though risks still abound, prospects look good. Financial flows should continue to improve and the appetite for risk should grow gradually, as it has of late. The economy should begin an upturn, albeit a modest one, before the year is out. Aside from any distortions due to inventories, the gross domestic product could rise better than 2.0% during the fourth quarter.

Key to this improvement is a change in the residential real estate market, where the trouble began. There are encouraging, if tentative, signs that the correction in housing has run its course, that the downward pressure on real estate prices should dissipate soon, and that cutbacks in new construction will cease, even if the sector will wait a long time before it can resume a growth path.

The real estate debacle developed with easy credit conditions between 2003 and 2006 that so drove up residential real estate prices that housing became less widely affordable. Former sales levels became unsustainable, and as sales fell, a huge inventory of unsold homes grew into a glut that drove down prices by almost 25% over the last two years (see the accompanying chart) and prompted a sharp 70% cutback in new construction, a direct and major drag on overall economic growth. The financial repercussions, especially the defaults on subprime mortgages and the fear of future defaults, eroded confidence and destroyed liquidity so thoroughly that financial problems also become a major impediment to economic performance.

But through this economic and financial carnage the market worked, and residential real estate is finding an equilibrium. Past price declines have restored the affordability of home ownership. The median price on existing homes-- as high as 4.1 times median annual household income in 2006--now stands at 2.8 times that income measure, about where it was before the housing boom and where it hovered through much of the 1990s. The 100 basis point decline in mortgage rates over this same time has enhanced affordability that much more.

Sales have responded to this improvement, at least partially. Despite the severe blow to confidence and credit crisis-recession fears, sales of existing homes actually began to stabilize late in 2008. Since January, these sales have shown hints of expanding again. Though the flow of buyers is still far from strong, the inventory of unsold homes has dropped down from its high of over 12 months' supply about a year ago to barely over nine months' supply of late. This inventory improvement, though still not back to historic norms, seems to have relieved at least some of the downward pressure on real estate prices, which have actually risen since January by a moderate 3.2% or nearly 10% at an annualized rate. The broad-based price statistics from the National Association of Realtors used here differ from the still weak Case-Shiller real estate price index, which focuses on just 20 volatile metropolitan areas and that makes it a dubious representative of the national situation.

Now, with a measure of confidence returning to markets and the economy, the still affordable housing prices should allow a pickup in sales even though mortgage rates have ticked up recently. Provided mortgage rate increases remain moderate, continued sales should reduce the inventory of unsold houses still further. Prices will stabilize more securely and perhaps even show some mild appreciation. By the end of the summer, if not sooner, these changed circumstances will likely end construction cutbacks. Even if it takes some time for growth to resume in housing, the economy will at least find relief from the major drag of the past year. Since at the same time, stability in real estate pricing should at last enable financial markets to value mortgage-backed debt, the subsequent improvement in confidence and liquidity should feed back positively to the economy, allowing at least modest growth as the year progresses into 2010.

Corporate Credit Improves Slightly

By John Lonski

Amid an anemic economic recovery, the outlook for credit is mildly positive. As long as 30-year mortgage rates avoid a repressive climb, the recession should end by October, with GDP expected to rise 1.5% in the third quarter and 2.6% in the fourth. In addition, the default rate on U.S. high-yield bonds ought to peak by November, which is noteworthy because the default rate's two previous tops occurred several months following the end of the two previous recessions.

Downgrades in U.S. corporate credit ratings dropped from a record 396 in the first quarter to 353 in the second quarter. A second straight quarterly decline in downgrades would suggest a bottom for the credit cycle is near. Meanwhile, upgrades jumped from 55 in the first quarter to a record 121 in the second quarter, 110 of which involved high-yield ratings, mostly because of a surge in debt refinancings that followed a turnaround in investors' risk aversion. However, the seemingly good news of an unprecedented number of high-yield upgrades was undercut by the comparatively few upgrades stemming from improved earnings fundamentals.

An extraordinarily deep yearly contraction in corporate profits should bottom in the third quarter. Throughout 2010, the much faster growth of profits vis-?-vis corporate debt will help to thin corporate bond spreads considerably. A material underutilization of resources favors a further deceleration in core inflation. Not only is the unemployment rate, now at 9.5%, likely to reach 10% by year-end, but the industrial capacity utilization rate ought not rise much above May's record low of 68.3%.

Looking ahead, the consumer's worst income expectations on record signal an impending disappearance of wage growth. The latter may enhance corporate creditworthiness by widening profit margins, but the softness in wages also threatens companies' ability to repay their debts by extending the stretch of below-trend retail sales and putting added stress on the servicing of household debt.

Given the weak outlook for employment income, tight lending standards and the unprecedented contraction of household wealth, any recovery in consumer spending will be muted. Nevertheless, household expenditures have probably bottomed in the hard-hit industries of housing and motor vehicles.

Stabilizing the housing and auto industries would help considerably. Excluding sales of auto dealerships, gas stations and housing-sensitive retailers, retail sales posted a year-over-year decline of just 0.6% from January through May, which is much shallower than the 10.2% plunge in total retail sales over the same time period.

Much lower than anticipated revenues are at the core of what ails corporate credit. In the first quarter, business sales fell by a record 14.5% year over year. Business sales were recently on track to drop by 18% in the second quarter, but the contraction is expected to subside in the third quarter. The slide in sales during the first half prompted businesses to slash both staff and capital outlays. However, recent surveys suggest companies are moderating planned cutbacks in staff and capital spending.

The expectation of a slight firming in economic activity suggests corporate bond spreads should thin somewhat by year-end. What should still be relatively wide corporate credit spreads at the start of next year enlarges the prospective scope of spread narrowing over the next 12 to 18 months, provided that the economic recovery fills out in 2010.

Mostly because of a narrowing of spreads, average corporate bond yields are projected to decline. And spurred by declines in bond yields, corporate bond issuance is expected to rise sharply in the second half from the atypically low amounts of a year earlier.

The primary driver of bond issuance in the second half will be the refinancing of outstanding debt, so the offerings will add little to outstanding corporate debt, on balance.

The outlook may be uninspiring, but progress in moving closer toward normal seems attainable, especially as more businesses and consumers become convinced that the worst has passed. For now, the biggest concern is that such progress might be squandered by too steep of a climb in the 10-year Treasury yield.


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