The ALM First Quarterly Economic Outlook provides financial institution management concise and relevant economic data that has both a direct and indirect impact on the institution’s financial well-being. Clients often find the information useful in planning balance-sheet strategic action plans for the upcoming quarter.
Year-End Review
Last year at this time we said
good riddance to 2008, but as we start a new decade how much better off are we? With a return to positive economic growth in the third quarter, a decline in monthly job losses, low interest rates and stable financial markets, the outlook has improved steadily since last summer. Corporate earnings were far stronger last year thanks to aggressive cost-cutting. U.S. firms have already generated three quarters of strong earnings increases, which have pushed profit margins back toward long-term norms. Consumer spending has been a surprise on the upside over the past few months. Holiday-season sales were better than in 2008, but remained far below the level seen in 2007. However retail sales for the month of December were disappointing as some of the Christmas sales occurred early in the season.
The road from recession to recovery is rarely smooth, and as we climb out of the deepest downturn in decades, we are still losing jobs, consumers are jittery and cautious, and banks are still reluctant to lend. The percentage of the employed who are working part-time for economic reasons has doubled over the course of the recession, supporting the view that an unusually large share of workers have been temporarily put on short hours.
After the Lehman collapse policy makers around the world abruptly changed their stance and did whatever it took to stabilize the economy and the financial markets. As a result money markets, credit markets and stock markets have recovered, but banks remain in consolidation mode with tight lending restrictions and the housing market is moving slowly. The Obama administration implemented a huge stimulus plan and has repeatedly supplemented it with target aid programs such as Cash for Clunkers, extended unemployment benefits and the homebuyer tax credit.
More than a year after Lehman Brothers, AIG, Fannie Mae and Freddie Mac either collapsed or were saved by government bailouts, it is remarkable how little on Wall Street has changed. Some significant changes have occurred, such as slashing Wall Street’s debt, compensation scrutiny, simplification of financial products and the potential for increased surveillance of financial markets. But many other issues that came to light last year remain unchanged. Credit-rating companies that were vilified for giving top-tier ratings to what turned out to be toxic debt still face the same potential conflicts of interest they always faced. They are still paid by the very debt issuers for which they provide ratings.
There have also been few changes in the markets for derivative securities, such as credit-default swaps. One proposal to force trading onto public exchanges where it can be monitored has yet to be implemented. Nor have rules been changed to increase the amount of capital that U.S. banks must hold, despite a range of recent proposals.
Financial Markets
Financial markets staged a remarkable recovery in 2009 after a disastrous 2008, thanks to unprecedented rescue efforts by governments around the globe. After tumbling 25 percent to a 12-year low in March, the Dow Jones Industrial Average rebounded to finish the year at 10,428, a gain of 18.8 percent. Nonetheless, the Dow still remains 26.4 percent below its all-time high of 14,164, and what’s worse, it is down 9.3 percent from 10 years ago.
In fact, in nearly 200 years of recorded stock market history, no calendar decade has seen such a dismal performance as the 2000s. Since the end of 1999, stocks traded on the New York Stock Exchange have lost an average of 0.5 percent per year and the Standard & Poor’s 500 stock index lost a average of 3.3 percent per year on an inflation-adjusted basis thanks to the two bear markets that occurred during the decade.
Treasury bonds fell in 2009, sending yields higher for all but the shortest maturities as the flight to quality of the previous year reversed itself and investors moved to riskier assets. Meanwhile, corporate bonds, mortgage-backed securities and leveraged loans soared back to levels unseen since before Lehman Brothers collapsed as investors gained confidence throughout the year that the worst of the credit crisis had passed.
Many lenders borrowed money by selling securities under the Federal Reserve’s Asset-Backed Securities Loan Facility, which supported investors demand for securities backed by consumer loans like car loans or credit-card debt. This helped drive up the prices of these securities, causing their yields to fall to just one to two percentage points over the risk-free Treasury bonds.
Yet these markets are still shrunken compared with pre-crisis levels. Issuance of asset-backed debt last year was 23 percent lower than in 2008 and there have been virtually no new deals backed by nonconforming mortgages. There is also less demand for credit as households and companies repair their balance sheets, spending less and increasing savings.
First Quarter Outlook
As we start a new year and a new decade, the economy seems to be showing enough momentum that most investors no longer fear a double-dip back into recession, but neither do they expect a stellar recovery. Lifted by enormous policy support, the longest and deepest economic downturn since the 1930s appears to have ended. In response to massive policy easing, the global economy started to stabilize in the third quarter 2009 and is now climbing out of the recession. The third quarter saw real GDP growth in the U.S. rise at a 2.2 percent annualized rate, and it seems likely that the economy posted another solid increase last quarter. In the year ahead, we expect a weaker than normal recovery. The economy has avoided a number of pitfalls this year that threatened to produce an even deeper and longer-lasting recession. However, growth has yet to produce a shift in private sector behavior sufficient to generate the job gains necessary for a self-sustaining expansion. Policy tightening will depend on the speed and magnitude of economic and financial sector growth.
Despite the return to positive growth in the third quarter, businesses remained in retrenchment mode. Private payrolls declined an average 171,000 per month in the third quarter and another 88,000 this last quarter. Moreover, the number of those employed includes an increased share working part-time for economic reasons. However, there is good reason to think that business behavior will shift soon. Profits are rising. A broad-based increase in corporate earnings began in the second quarter and now reflects not only cost control but also rising revenues.
Financial markets have improved greatly since their lows of last March. The rebound in stock prices has been accompanied by a marked reduction in corporate bond yields and in spreads over Treasuries. There were concerns that huge government funding needs might drive up longer-term interest rates and cut off the burgeoning economic recovery. So far this has not happened, and the increase in market interest rates over the next year is expected to be manageable.
A muted recovery in 2010 should lead to low core inflation and a steep yield curve. The speed of the recovery will dictate policy tightening, and with the economy operating under massive spare capacity most central banks should be on hold through at least the first half of the year. Longer-term rates should rise due to the pressure of heavy supply and fiscal sustainability concerns.
So will the prolonged easing of monetary policy raise the specter of inflation? Monetary policy easing does not directly cause prices to rise. It actually initiates a process whereby excess bank liquidity causes a surge in bank lending, driving up spending and eventually prices. However at this point bank liquidity is not leading to a surge in lending as banks are rebuilding their balance sheets. This process is likely to continue for some time, therefore central banks should have plenty of time to tighten before inflation becomes a real issue.
It is interesting to note that coming out of a recession, consensus forecasts nearly always underestimate the recovery and wind up being revised higher. In the four quarters after a major recession, GDP typically rises 6.9 percent. Inventories alone account for 1.5 to 2.5 percentage points of this growth. Another regular feature of recent business cycles is that the financial markets and press repeatedly “jump the gun” in expecting rate hikes from the Fed. We believe that in this cycle the Fed can afford to be patient. Before hiking rates the Fed wants to be confident that a sustainable recovery is in place that will eventually push the unemployment rate (and other measures of spare capacity) back to normal. If anything the Fed will want to be more patient than normal; spare capacity is at or near its highest level in modern history, the capital markets despite their rebound are in worse shape than usual at the end of a recession and inflation is below the Fed’s 1.75 to two percent target and core inflation is drifting towards zero.
A forecast shift in inventories from massive liquidation over the past few quarters to a marginal increase in the second quarter 2010 would provide a major lift to activity, directly boosting annualized real GDP growth by an average of 1.5 percentage points per quarter.
While households are expected to remain cautious, the healing in the financial markets and the return to a sense of normalcy is allowing for some lift in housing and consumer spending from extremely low levels. Most forecasts look for real consumer spending to grow more slowly than real GDP and for the household saving rate to drift higher. Spending on housing and consumer durables have already fallen to their lowest level in relation to disposable income since World War II.
New home sales, for example, surpassed 1.2 million in both 2005 and 2006 but declined to a pace of only 338,000 in the first quarter of this year, more than 30 percent below the lowest point in any prior recession on a per-household basis. A similar story applied to the auto industry, where sales declined from a pace of 16.5 million per year through most of the expansion earlier this decade to only 9.5 million in 1Q09, nearly 25 percent below the lows reached in prior deep recessions on a per-household basis. The average selling pace of 10.7 million in October-November, after the Cash for Clunkers program had expired, is very low in absolute terms but is more than 10 percent (not annualized) above the first quarter 2009 average.
During the heart of the financial crisis and the recession in the fourth quarter 2008 and first quarter 2009, there were genuine concerns of a possible financial industry collapse, an extended and deepening recession bordering on depression, and an equity market that might drop indefinitely. There were legitimate concerns that home sales and house prices might be in a sustained downward spiral, even after house prices fell to levels that looked attractive against prior norms. Home sales have rebounded impressively in percentage terms since the first quarter even if prices were lower. Activity and prices are still very depressed relative to levels a few years ago, but risks of a continued downward spiral from here are dissipating.
Although we have avoided the forces promoting a downward spiral, there remain significant headwinds that will temper growth for some time to come. Credit remains tight, particularly for small businesses. Consumers are unlikely to return to previous spending patterns. Severe budget problems for state and local governments are likely to mean cutbacks in real spending and employment.
The unemployment rate is forecast to end 2010 at 9.7 percent and 2011 at 9.1 percent, a jobless rate that would still be extraordinarily high relative to historical norms. Over the 20 years from 1989 to 2008, the unemployment rate averaged 5.5 percent and in the 10 years through 2008, it averaged only five percent. Elevated levels of unemployment will mean historically low average levels of household income and spending, extreme hardship for many long-term unemployed, and anxiety for those working but worried about the possible consequences of losing a job.
Inflation, as measured by the core PCE price index, the Fed’s preferred measure, is already low and is likely to go lower. The decline in core inflation to date largely reflects the effects of the deep recession and the developing supply/demand imbalances. It is actually quite normal for core inflation to recede during recessions. In fact, it typically continues to slow through the first two years of economic expansion. Therefore core inflation is likely to remain low into 2011.
There are however two possible threats to the low-inflation scenario. The first is a spike in the price of oil, the commodity with by far the largest influence on overall inflation so it cannot be ruled out. But oil inventories are still very high and there does not seem to be the kind of tightness in the market that would cause a spike. The second threat to inflation comes from a weaker dollar. However, likely effects on core inflation appear to be limited as there is great excess capacity.
The economic landscape will be marked by tension between sustained elevated growth and depressed levels of activity over the coming quarters. As the healing process continues, the risks of a relapse into recession will slowly diminish.
The Fed will begin to unwind some of the measures intended as emergency supports for the economy, including the purchase of Treasuries and mortgage-backed securities. The Fed will also be working to wind down its balance sheet and reduce the size of excess reserves in the banking system. Most of the special liquidity programs –including the Commercial Paper Funding Facility, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, and the reciprocal currency swap lines – are set to expire at the beginning of February. In addition, the asset purchase programs are scheduled to be completed at the end of March. This poses a potential risk of rising mortgage rates relative to benchmark yields as demand for securitized debt declines.
There are risks to both sides of the forecast. On the positive side, we could get a more normal business cycle recovery than is currently predicted. On the negative side, a renewed bubble in the oil market or premature policy tightening could occur. Longer-term, attacks on the independence of the Federal Reserve are a concern. There are bills before Congress that would allow audits of the Fed’s monetary policy decisions and weaken the Fed’s role in regulating capital markets. If successful, this trend could seriously damage the dollar and the bond market as an independent Fed is the best defense against inflation.
The combination of aggressive policy stimulus, the dramatic improvement in financial markets, higher prices for risky assets, and the recent slower pace of bank lending standards should increase the chances for a sustainable recovery. Fiscal policy will continue to support growth in 2010. Infrastructure outlays are just now starting to show improvement and Congress has enacted further stimulus. They extended and expanded the first-time home buyer tax credit through April, and increased jobless and COBRA benefits.
Historically bond markets sell off three to six months before the start of the tightening cycle. Therefore given expectations of a rate hike in the fourth quarter, we can expect a large increase in rates to occur around the end of the second quarter, or at the latest in the third quarter.
This recovery will likely be weaker than what is typical coming out of a major recession. The Fed will be closely monitoring the evolution of the housing market and inflation expectations. Furthermore, if there are more hurdles than expected for growth the Fed could well delay tightening into 2011.
Policy makers will also continue to react to any signs the economy is faltering. Some of the possible policy initiatives include a jobs bill to help the labor market, additional efforts to stimulate the housing market and prevent foreclosures, and aid to state and local governments that are strapped for cash.
The biggest risk to the recovery is policy mistakes, which seems pretty unlikely. A double-dip in growth is unlikely as policy makers will undoubtedly respond to weakness with further stimulus. The Fed is going to err on the side of inflationary behavior rather than throw the economy into a tailspin and we have established that inflation should remain muted in the near term.
This report is for informational purposes only. Neither the information nor any opinion expressed is intended as an offer or solicitation for services. While the information presented is believed to be reliable, we do not guarantee its accuracy.
