Fwd: RGE Monitor - 2009 U.S. Economic Outlook: Q1 2009 Update

RGE Monitor's Newsletter Greetings from RGE Monitor! RGE Monitor's team of analysts is in the process of producing updates to the RGE Monitor 2009 Global Economic Outlook published in January 2009. The updated global outlook will be released for RGE clients in the first half of April. Today we discuss some elements of the U.S. economic outlook. Before putting 2008 behind us, it is worth taking one last look at economic activity in the last quarter of the year. As RGE Monitor forecasted, the contraction in real U.S. GDP in Q4 2008 (-6.2%) was the most severe since the early 1980s and pushed yearly growth for 2008 down to 1.1%. The U.S. is most likely only half way through a severe recession. RGE Monitor is forecasting four quarters of negative growth in 2009 and a yearly real GDP contraction of around 4%. The fiscal stimulus package passed in February 2009 will not be large enough to bring aggregate demand back on a path of positive growth before Q1 2010. In other words, even if the second derivative of economic growth were to turn positive throughout 2009, which would mean that the pace of contraction will progressively slow, the contraction will stay with us at least until the end of 2009. The contraction in output throughout this recession will result in cumulative output losses of 6%, making this the sharpest output loss in post-war U.S. history. Though RGE projects positive growth – year over year – for 2010, growth will remain significantly below potential and job losses will continue well into 2010. RGE expects that the NBER will put the official end to the recession around mid-2010. However, growth might very well be subdued for years to come. Personal Consumption A shopped-out and debt-burdened U.S. consumer lost his resilience and started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up for 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. 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 starting 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 1990s, to 100% in 2000 to 140% now). This structural – as opposed to cyclical – retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will raise the savings rate above 8% and a cumulative contraction of personal consumption close to US$600bn throughout the duration of the recession. Housing Sector The fourth year of housing recession - and the worst housing recession since the Great Depression - is well on course. Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 466 thousand SAAR of January 2009 (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 81% from their Q1 2006 peak (since seasonally adjusted data is not available, we performed our own seasonal adjustment). On the demand side, new single-family home sales are down 76% 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. The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side of housing is bound to persist and we believe that supply will have to fall further, given the great wave of foreclosures that is adding to the excess of supply in the market. We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen over 27% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.) Labor Market The pace of lay-offs and rise in the unemployment rate reveal the combined impact of financial crisis and reduced demand on firms, forcing them to cut 4.4 million jobs from the beginning of the recession in December 2007 through February 2009. The pace of job losses will continue in to be strong in H1 2009 and will ease only in H2 2009. We expect job losses to continue through early 2010 as firms restructure and cut costs amid deflationary pressures. The unemployment rate will touch 9% by mid-2009 and close to 9.9% by 2009-end. The long-term unemployment rate – that includes part-time as well as discouraged workers – reached a record high of 14.8% in February 2009; we expect this figure to rise significantly through the cycle. Capital Expenditure Given that contraction in consumer spending and downturn in exports expected until early 2010, firms will witness a sharp fall in sales in the coming quarters. As exports and consumer spending fell more than expected in Q4 2008, firms are also running high inventory levels. Therefore, they will have to work out the inventories of unsold goods before they can increase production and capex plans, though this will be challenging as sales continue to plunge at a faster rate. As a result, inventory drawdown at the wholesale, factory and retail levels will remain large, especially in early 2009, thus reducing the inventory contribution to GDP growth. The global supply chain and manufacturing activity in export markets especially in EU and Japan will also remain subdued in 2009. Due to these factors, the ongoing contraction in industrial production will gain pace in the coming months and will continue through most of 2009. This will accentuate the decline in employment and labor work hours in the manufacturing sector leading to a fall in capacity utilization from close to 75% in Q4 2008 to below 68% by 2009-end through most of 2010. Continued excess capacity will thus add to deflationary pressures in the economy.The blow to earnings along with continued credit constrains and sluggish demand recovery will lead to double-digit contraction in business investment throughout 2009 with some weakness even in early 2010. Trade While the slump in industrial production and contraction in consumer spending led to a sharp reduction in imports from mid-2008 on, exports started contracting at a faster rate in late 2008 as the global economy worsened. As a result, the contribution of net exports to GDP growth which had been positive since Q1 2007 turned into a negative 0.5% in Q4 2008. In 2009, we expect this trend to persist – the downturn in global manufacturing activity and even greater slowdown in consumer spending in some countries than in the U.S. will lead exports to contract sharply, including to major export markets like the EU and Japan as well as recent high export growth markets in emerging Asia and Latin America. As recovery of the rest of the world in most cases will lag the U.S. recovery, again with downside risks, exports will continue to decline in double-digits through the rest of 2009 and will remain very weak even in 2010. Also, low oil prices and sluggish domestic demand and activity will lead imports to contract in double-digits through most of 2009, containing risks to the trade deficit. Imports though will contract less than exports. While the 'Buy American' clause in the fiscal stimulus package will restrict the import of iron and construction related materials for government infrastructure projects, imports might still get a small boost especially if low and middle-income households getting tax cuts spend them on imported goods. On the other hand, as more and more countries around the world implement fiscal stimulus packages, boosting infrastructure spending and tax cuts for consumers, U.S. exports might also get a boost. However, most of the import/export dynamics related to the fiscal stimulus will depend on the trends in savings rate in the U.S. and globally as well as the protectionist clauses in the stimulus packages. U.S. Dollar Outlook After a brief rally in risky assets earlier this year, the dollar has resumed its safe haven status once more. Dollar shortages for funding needs and deleveraging of cross-border USD-denominated liabilities is also still providing juice for the dollar against G10 currencies (except yen and Swiss franc). Against the euro, the U.S. dollar will likely remain strong in the near-term on expected ECB rate cuts, intensifying Eastern European financial turmoil and Eurozone sovereign credit risk. Against the yen, the U.S. dollar will likely stay around 100 yen in the near-term as markets focus on Japan's deteriorating economic fundamentals. The dollar will re-test its 2008 highs against other G10 and emerging market currencies but could back down on the expansion of U.S. quantitative easing to government debt. In general, the dollar will benefit in the short-term from U.S. government interventions if they appear to put the U.S. ahead of the curve in fighting recession. By the same token, any scent of increased Treasury borrowing needs on top of already all-time high levels of issuance could turn investors' noses up at the dollar in the long-term. Outlook for Treasuries Rising sovereign default risk and market dilution due to increased issuance will frequently plague the Treasury market in 2009, but the lack of safer alternatives during turmoil in private sector asset markets will keep benchmark yields low on average for the rest of the year. Except for a short flirtation above 3% on February 19, the 10-year Treasury yield has remained below 3% and will largely stay there if the Fed buys Treasuries to lower long-term interest rates. Inflation/Deflation U.S. inflation will remain below the 2% comfort zone for the rest of 2009 – likely posting a negative rate for the year – and probably most of 2010 as well, barring a commodity supply crunch due to production cuts and investment delays. Though consumer inflation expectations and breakeven inflation rates in TIPS have moved up, the low resource utilization and large stock of excess homes means the risk of technical deflation turning into genuine deflation has not gone away. Core inflation will be slower to budge but even it has succumbed to the growing slack in labor and product markets, sliding to 1.7% y/y in January while headline inflation has already flattened. The housing glut will weigh on owner's equivalent rent, the largest portion of core CPI. Steep discounts by retailers trying to lure in shoppers besieged by rising unemployment and falling household wealth will keep a lid on inflation in consumer discretionary items, such as apparel and automobiles. Falling import prices and producer price deflation throughout the production chain suggests further downward pressure on consumer prices is in the pipeline. Upward pressure may be seen in healthcare costs, public funding for which was cut by the last administration. Credit Losses Still Ahead RGE Monitor estimates suggest that total losses on loans made by U.S. banks and the fall in the market value of the assets they are holding will reach about $3.6 trillion. The U.S. banking sector is exposed to half of that figure, or $1.8 trillion. Even with the original federal bailout funds from last fall, the capital backing the banks' assets was only $1.4 trillion, leaving the U.S. banking system about $400 billion in the hole. Two important parts of Geithner's Financial Stability plan are (i) "stress testing" banks to separate viable institutions from bankrupt ones and (ii) establishing an investment fund with private and public money to purchase bad assets. These are necessary steps towards a healthy financial sector. According to Nouriel Roubini, unfortunately, the plan won't solve our financial woes because it assumes that the system is solvent, while nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and allow lending finally to resume. Fiscal Policy Amidst the liquidity trap, a lot of hopes have been placed on the $787 billion fiscal stimulus package to prevent the contraction in GDP growth in 2009. However, our analysis suggests that in spite of being well-targeted, less than one-third of the tax cuts for households will be spent (and leakages via imports will occur) with the rest saved, used to pay off debt or spent only with a lag when economic uncertainty diminishes given that households face sharp erosion of wealth, slower compensation growth and tighter borrowing conditions. Even tax incentives for firms will be largely ineffective in stimulating hiring or investment in new capital amidst the ongoing contraction of domestic and global demand and sluggish recovery in 2010 along with tight credit conditions for businesses. Transfers for states many of which are in recession with large deficits and severe financing crunch will help funding government needs as well as unemployment insurance, infrastructure and public services. But given the time lags in transferring funds from the federal to state and local governments and our estimates for state fiscal deficits for 2009-10, we believe states will need additional federal funding by mid-2009. Also, in spite of having high multiplier effects, over 55% of government spending will impact the economy after 2009-10. Since large spending on infrastructure, renewable energy, technology, health care and education will rightly boost the potential growth in the long-run, these expenditures should have been part of a recovery package in 2010 rather than a stimulus package. Given that the GDP growth contraction will be most severe in Q4 2008 and Q1 2009, the stimulus is certainly not that 'timely'. Also, starting in Q3 2008 when the economy fell off the cliff until early 2010, we forecast that private demand will decline by over $1 trillion. We estimate that out of the $787 billion fiscal package, only around $364 billion of stimulus will actually kick-in during 2009-10, thus being insufficient to offset the contraction in private demand. The stimulus will not be sufficient to lead to positive GDP growth in H2 2009 or prevent below potential growth in 2010. Moreover, banking sector recapitalization, unclogging the credit markets and greater measures to reduce foreclosures are necessary conditions to restart private demand. For the impact of individual stimulus measures on the economy and on GDP growth rate during 2009 and 2010 see U.S. Fiscal Stimulus Package: High Fiscal Cost For Little Bang For Buck? On a quarterly basis, many households will receive tax credits from tax filing, some shovel-ready infrastructure projects will start at the federal and state levels, and states will use federal transfers to fund immediate needs in education, Medicaid, transport and unemployment benefits – these factors might temporarily boost spending in Q2 and Q3 2009. But as the impact fades and private demand fails to recover, the economy will weaken again starting Q4 2009 until mid-2010 – thus leading to a W-shaped stimulus effect, just like during Q2 and Q3 2008. In fact, much of the impact on growth in 2009-10 will come from automatic stabilizers such as unemployment benefits, food stamps, Medicaid, and transfers to states. Therefore, the stimulus should have allocated more funds to these sources and cut back spending on several government projects that have high short-run fiscal costs but impact growth only in the long run. While bank bailouts and stimulus spending are already raising the budget deficit, need for additional funds for these two sources and also to deal with foreclosures will continue to put pressure on government spending during 2009-10. The actual deficit is veiled by the fact that costs borne for Fannie and Freddie are not included in the budget, and funds for banks via TARP and the additional $700 billion that President Obama proposed in his FY2010 budget are accounted in the budget based on the present value of the expected future earnings from investment in the banks, estimates which are again subject to risk. Taming the Foreclosure Problem The over-correction in home prices will increase the number of homeowners with negative equity from close to 12 million currently and add to the foreclosures and excess overhang of houses. Treasury measures to tackle the housing crisis by stimulating home demand by buying MBSs and reducing mortgage rates will become less effective as households facing wealth erosion, job losses and tighter credit lending standards step back from taking a mortgage or purchasing a home. As such, mounting job losses will make defaults and foreclosures more likely in the coming months. The Obama administration recently emphasized on supply side measures to reduce foreclosures in the Homeowner Affordability and Stability Plan. For an analysis of the plan, see: Obama's Homeowner Affordability and Stability Plan: A Band-Aid for the Foreclosure Crisis? While this plan improves on the shortcomings of previous government programs, especially by increasing monetary incentives for lenders and servicers and the governing sharing the cost of modifying the mortgagees with lenders, the refinancing plans laid out and the funds allocated are still inadequate. The plan helps only homeowners facing 'temporary' difficulty in making monthly payments due to falling home prices and short-term liquidity crunch due to the recession while ignoring bigger problems of the current crisis - those with negative equity and who cannot afford to make payments in 'any' scenario. The plan reduces monthly interest payments by extending mortgage maturity and reducing interest rate but keeps principal reduction only as the last resort, thereby just delaying the risk of re-default or foreclosure which runs as high as 45-55%. However, the bill currently being debated in the Congress to allow bankruptcy courts to modify mortgage terms for homeowners in bankruptcy while giving legal protection to lenders and servicers from lawsuits might help increase lender and borrower participation. There have been other proposals to adopt an across-the-board mandatory program to reduce foreclosures rather than voluntary and case-by case approaches tried so far. Such a measure would reduce the principal for 'qualifying' homeowners with negative equity using some parameter (by the extent of home price decline according to zip code as suggested by many is an attractive option) and refinance the loan at a fixed interest rate with the government sharing this cost with lenders (greater than what is under the current program), and the government also offering guarantees to share the cost of default or profit from future home appreciation. For more on the proposals for mortgage modification, see: U.S. Housing Sector Far From Bottoming Out Needs Greater Government Intervention Monetary Policy With inflation rendered a moot concern by the prolonged recession and anemic recovery ahead for the U.S., the Federal Reserve will keep benchmark interest rates where they are for the next 2 years and focus on its plethora of alternative monetary policy tools. Aside from direct loans to various ailing financial institutions and an alphabet soup of passive lending facilities, the Fed has resorted to quantitative easing by purchasing private sector assets. Should Treasury yields shoot above 3% and stay there, the Fed may also purchase public U.S. debt. The Fed balance sheet shrank in January and February due to the end of year-end funding demand and a decline in foreign central bank demand for dollar funding. The shrinkage should prove temporary if the Fed keeps buying MBS (and possibly Treasuries) and implements TALF and MMIFF. The resulting increase in assets and deposit liabilities will more than offset further decline in foreign central banks' use of the currency swap lines. RGE clients: Stay tuned for a much more detailed and thorough analysis of the U.S. and global economy in our forthcoming RGE Monitor 2009 Global Economic Outlook update. This message sent to daniel.penaflor@gmail.com by info@rgemonitor.com. RGE Monitor - 131 Varick Street Suite 1005 - New York, NY 10013-1417 You opted in to this list from: RGE signup (More info...) Unsubscribe | Update Profile/Email Address | Forward To A Friend Nouriel Roubini Chairman Christian Menegatti Managing Editor & Lead Analyst US and Global Macro Arpitha Bykere Lead Analyst International Trade, US, Asia Kavitha Cherian Lead Analyst Geopolitics Ayah El Said Lead Analyst Middle East and North Africa Italo Lombardi Lead Analyst Emerging Markets Elisa Parisi-Capone Lead Analyst Finance and Banking, Western Europe Mikka Pineda Lead Analyst FX, Bonds, Equities, Commodities Vitoria Saddi Lead Analyst Latin America Mary Stokes Lead Analyst Northern/Eastern Europe, Turkey, Japan Jelena Vukotic Lead Analyst Political Risk Rachel Ziemba Lead Analyst China and Oil Exporting Economies Solomon Zirkiyev Lead Analyst Financial Markets Editorial Suggestions editor@rgemonitor.com General Information info@rgemonitor.com Technical Support technical support form Contact RGE Sales Phone: 212.645.0010 E-mail: sales@rgemonitor.com RGE Monitor | 131 Varick Street, Suite 1005 | New York, New York 10013 Tel: 212.645.0010 | Fax: 212.645.0023

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