commissioner.org
| Source | Jim Devine |
| Date | 09/01/08/11:57 |
| 2009 Will Be Very, Very Bleak
Nouriel Roubini IT IS clear that 2008 was not a very good year, and it is official that the current recession started in December 2007. So how far are we into this recession that has already lasted longer than the previous two (the 1990 and 2001 recessions lasted eight months each)? I believe the U.S. economy is only half way through a recession that will be the longest and most severe in the post-war period. U.S. gross domestic product will continue to contract throughout 2009 for a cumulative output loss of 5% and a recession that will last close to two years. Let us look at the picture in detail: Personal Consumption The resilient U.S. consumer started to give up the ghost in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009. In my view, personal consumption will continue to contract quite sharply throughout 2009 as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000, to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the savings rate of a decade ago. The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall -- eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500 billion. And negative wealth effect from fall in equity prices -- on the wake of a bleak 2009 for corporate profits -- will also contribute to the contraction in personal consumption by an estimated $100 billion (compatible with a 25% contraction in the stock markets). Housing Sector The fourth year of housing recession is well on course. Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate peak of January 2006 all the way to the 625,000 SAAR of November 2008 (the last data point available), an all-time low for the time-series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak. On the demand side, new single-family home sales are down 65% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply, which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing. Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales is at levels that cannot promote a fast work-off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all-time high. In the decade between 1985 and 1995, it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures. The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side is bound to persist, and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. I see starts falling another 20% from current levels and believe that home prices will not bottom out until the middle of 2010. Labor Markets With the continued credit crunch and significant cut-down in consumer and business spending, the monthly job losses will continue in the 400,000 to 500,000 and 300,000 to 400,000 range during the first two quarters of 2009 respectively, bringing the unemployment rate to 8% by mid-2009. The severe contraction in private demand until early 2010 will keep layoffs high and the unemployment rate elevated over 8%. [I'd add that the human impact of higher unemployment is larger than it was 20 or 30 years ago. People are more dependent on their jobs for medical insurance, have more debt, etc. So an 8% unemployment rate might have the impact of a 11% unemployment rate back in 1982. -- JD] Economy-wide job cuts are expected, with big corporations and small enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover, with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local government, job losses at the government level will also gain pace. In turn, income and job losses will further push up default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high-paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years. Layoffs are bound to continue thereafter as cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010. Even as consumer demand might show some signs of recovery, firms, as in the past, will begin by hiring only part-time and temporary workers initially. The unemployment rate might peak at close to 9% in Q1 2010, almost two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010, causing discouraged workers to leave the work force and containing the extent of the spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural [sic] rate of unemployment. [On the other hand, the NAIRU or inflation barrier (more scientific terms for the "natural" rate) has been steadily falling because of the destruction of labor unions, etc. Worker desperation helps avoid inflation.] Capital Expenditure Firms have been drawing down inventories beginning in Q4 2008. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in the red through 2009. Moreover, with a sluggish recovery in private demand even during 2010, firms will start building inventories and contemplate capital expenditure plans only at a slower pace. Trade Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trends in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth. Dollar Outlook The fate of the dollar in 2009 rests on the global growth outlook. After profit-taking on long dollar positions ends, and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe-haven status in H1 2009. [H1??] Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer than expected recession outside the U.S. Further de-leveraging of dollar-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond-yield outlook could be a further source of strength: While the Fed is already at a zero interest rate policy, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, and 2) the inability of the market to absorb increased Treasury supply at low yields. -------------------------------------------------------------------------------- Inflation/Deflation Annual U.S. inflation, as measured by official producer and consumer price indexes, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% -- a technical deflation, which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1% to 2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Loose labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Risks to the outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in commodity prices and 2) an earlier than expected global economic recovery. Credit Losses Still Ahead Back in February 2008, I warned that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial write-downs was finally reached. Given that national house prices are expected to drop another 20%, we expect credit losses of $1.6 trillion. The cycle has also turned in the commercial real estate arena with the traditional lag of around two years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch, assuming a 25% fall in prices ($142 billion out of $2.4 trillion.) In the consumer loan area, we estimate the credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252 billion out of $1.4 trillion. Based on my calculations, I expect total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The International Monetary Fund assumes that the U.S. banking system carries about 60% to 70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying the remaining TARP funds towards recapitalizing the banking system would still be warranted. The Disconnect Between Bond and Equity Markets U.S. government bonds were on a tear in 2008, while equities plummeted in a nasty bear market. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only Treasury Inflation-Protected Securities suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: Dow Jones Industrial Average lost 34%, and S&P 500 was -38.5%. At its 2008 low on Nov. 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December, though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009, while stock markets have been gaining since late November. This disconnect may vanish in 2009, though, if the stock market rally was really just a bear market rally due to portfolio rebalancing and thin year-end trade volumes. However, there have been intimations that the bond market is in a bubble about to burst in 2009. Indeed, with ultra-low bond yields, investors may be tempted to switch into higher-yielding equities -- which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation ahead, bonds should be a better bet than equities for some time. I see meaningful downside risks to stock prices as bad macro news -- worse than expected -- continues to dominate in 2009. Using the S&P 500 as the benchmark, earnings per share will stay in the $50 to $60 range -- and earnings will fall further. If -- and it is not unusual during recessions -- the price-to-earnings ratio falls in the 12 to 14 range, we could see another 25% slide in stock prices. Fiscal and Monetary Policy 1. Fiscal Policy A lot of hope is being placed on the expected fiscal stimulus package of around $750 billion spread over 2009-10, including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick in starting Q2 2009 and through 2010. But this will fall short of the pullback in private demand of close to $1 trillion during this period. Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100 billion of infrastructure investment might be able to kick in during 2009. Moreover, job creation in infrastructure might be overestimated, given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing layoffs. Given the drawback of the "spending" component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand, given a secular rise in the savings rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective, since businesses see little viability in doing so during a slump in domestic and export demand. At the most, a tax stimulus, in spite of being timely and well-targeted, will cause only a temporary rebound in the economy for a month or a quarter, merely shifting the spending-decision period just like tax rebates did in second-quarter 2008. Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 billion for state and local governments to meet their severe budget shortfalls, including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, and investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags. Fiscal stimulus, TARP spending, government-sponsored-enterprise-related expenditures, along with further slowdown in corporate and individual income tax revenues, will push the fiscal deficit to around $1.3 trillion in fiscal year 2009. 2. Monetary Policy The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate down to 0% to 0.25% but, more importantly, it has created currency swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen. Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com. A number of analysts at Roubini Global Economics assisted in the writing of this week's column. |
Copyright (c) 1998, Joongpil Cho