The Economy in Q3 2009

By Jeff Harding.

Every commentator is teasing the positives or negatives of recent data to justify his or her prognostications as to whether or not we are in a recovery. I think most forecasts are worthless because economists forecast the future by assuming what happened last week will happen next week, maybe a little better or maybe a little worse. Very few got it right for this cycle so I don’t believe most of them now.

Having said that, I have analyzed recent data and have come up with an assessment, not a forecast. The difference between me and the other guys is that I know that I’m pretty much guessing. They don’t.

Let’s start from the top.

Ben Bernanke came out and declared the recession to be over:

Federal Reserve Chairman Ben Bernanke said Tuesday that the recession was “very likely over,” as consumers showed some of the first tangible signs of spending again. … Mr. Bernanke, who had become cautiously more upbeat in recent weeks amid signs of third-quarter growth, said for the first time that forecasters agree “at this point that we are in a recovery.” … The rebound, he added, would likely be so moderate it wouldn’t produce many jobs.

This, coming from the world’s most powerful central banker, is what is called a “ringing endorsement.”

Far be it from me to question the Chairman, but forecasters don’t agree at all. If one expects GDP to bounce back to pre-crash levels, then the recession is not over. I have written about the fact that fiscal stimulus will have an impact on the economy in Q3 and Q4. But when the stimulus stops, the economy will fall back again. I believe that the data points to a bottoming out but the economy just won’t snap back to the good old days.

Let’s look at the data. The numbers are getting better, there is no question about that.

Housing:

It appears as if home prices are bottoming out. While there is a lot of conflicting data every month, the trend is obvious.

The most important piece of housing data is housing inventory. Nationwide, the supply of homes for sale is down to an 8.5 months supply for all product. This is down (by 16.4%) from a high of 11 months which shows that inventory is working its way through the economy. About 31% of sales are foreclosures and short sales which is to be expected. While sales of existing homes were off 2.7% last month, prices are still declining:

The median price of a new house fell 9.5 percent from the prior month, the biggest decrease since records began in 1963, as homes selling for less than $150,000 took a bigger share of the market. The median price decreased to $195,200, the lowest level since October 2003.

The median price nationwide for existing homes was $177,700 in August, 12.5% lower than the same month a year earlier.

People are looking for deals, and, with mortgage rates relatively low, they are finding them. While the reports point to the $8,000 first time home buyer credit as the cause, the major factor driving sales is that prices are down and the affordability index is rising. Not everyone is unemployed. However, if the buyer credit ends November 30, then, obviously, sales will drop off somewhat.

Also there is still a lot of inventory overhang from the shadow market: homes that are in foreclosure (1.2 million) or that are behind in making payments (1.5 million). Ivy Zelman of Zelman research firm Zelman & Associates believes three million to four million foreclosed homes will come on the market in the next several years. This will keep negative pressure on prices.

Don’t look for a rebound in home prices, that will be many years in the making if past cycles mean anything.

Consumer Spending:

Check this poll taken by Bloomberg:

Americans plan to refrain from boosting their spending even after the biggest drop in consumption since 1980, signaling concern about the direction of the economy over the next six months.

Only 8 percent of U.S. adults plan to increase household spending, almost one-third will spend less, and 58 percent expect to “stay the course,” a Bloomberg News poll showed. More than 3 in 4 said they reduced spending in the past year.

Respondents were divided over whether the economy will get better or stay the same in the next six months; only 1 in 6 said things will get worse. More than 40 percent of those surveyed said they feel less financially secure than they did when President Barack Obama took office in January, outnumbering 35 percent who said they feel more secure.

In the poll, conducted Sept.10-14, 40 percent of those questioned said they have experienced one or more problems from the banking crisis. In the most-often cited repercussions, 27 percent said their credit-card interest rates have risen dramatically and 15 percent report that they couldn’t get a home-equity, car, or other kind of consumer loan.

Underscoring consumers’ austere attitudes, 77 percent of respondents said they have cut back on spending during the past year, 59 percent said they have made a bigger effort to pay off debts and 48 percent have put more money aside as savings.

Consumer spending dropped in four of the past six quarters, and is down 1.9 percent from its peak in July-to-September 2007, the biggest retrenchment since 1980.

The Fed’s quarterly flow of funds report said that while household net worth was up 3.9% it was still down almost 19% from the $65.3 trillion peak in the third quarter of 2007. How did households do it? They trimmed their debt by 1.7%, or by about $100 billion. The Fed said home-mortgage debt fell an annualized 1.5% during the quarter. They also cut their borrowing and spending: consumer credit fell at a 6.5% annualized pace after declining 3.7% in the first quarter, the Fed said. The stock market rally also helped.

Unemployment:

The national unemployment rate is 9.7% and is rising, although at a slower rate. 14 states had rates of 10% in August, and California reached a 70-year high of 12.2%. Bernanke and the Federal Reserve Open Market Committee both said that unemployment would continue to rise. That makes people insecure. Next week we’ll see more data come out on this (ADP and BLS reports).

Commercial Real Estate:

The  commercial real estate market is a disaster.

The drop in sales activity and commercial property pricing re-intensified in July after a slight respite in June, according to the Moody’s/Real Commercial Property Price Indices, or CPPI. The all-property-types component of CPPI, a collaboration of Moody’s Investors Service and Real Estate Analytics that tracks repeat property sales, fell 5.1 percent to 117.56, following a 1 percent drop in June and a 7.6 percent fall in May. The all-property index, as of June 30, was down 30.8 percent from the year before and 38.5 percent from its peak in October 2007.

Only 74 transactions were used to calculate the CPPI in July, making it the latest in a string of low-volume months. June saw 87 deals, May had 52 and April had 67. To calculate the CPPI, a minimum of 40 transactions need to be recorded for the annual all-property-types component. The 74 deals that took place in July totaled $1.2 billion. June’s transaction total was $1.1 billion.

As previously reported, property pricing for the year ended June 30 was down for all property types, led by multifamily, down 24.4 percent, and industrial’s 23.1 percent decline. Office and retail were both down 21.2 percent.

Moody’s, S&P, and Fitch downgraded a total of 3,405 commercial mortgage backed securities bond classes during the first half of the year and upgraded only 82, the most lopsided upgrade-to-downgrade ratio in their history. The rating agencies aren’t going to be caught looking the other way as they were with residential mortgage backed securities.

The commercial real estate market is turning very ugly and I suspect that it will take many banks down with it. Most commercial real estate loans are held by bankers in their own portfolios and have heavy exposure in a downturn.

Since late 2007, a total of 47 banks and savings institutions have failed, of which a dozen or so had unusually high commercial-mortgage exposure. Foresight Analytics in Oakland, Calif., estimates the U.S. banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn. The research firm projects that more than 700 banks could fail as a result of their exposure to commercial real estate. …

Of $154.5 billion of securitized commercial mortgages coming due between now and 2012, about two-thirds likely won’t qualify for refinancing, Deutsche Bank predicts. Its estimate assumes declines in commercial-property values of 35% to 45% from the peak in 2007. That would exceed the price drops in the downturn of the early 1990s.

The bank estimates the default rates on the $700 billion of commercial-mortgage-backed securities could hit at least 30%, and loss rates, which figure in the amounts recovered by lenders, could reach more than 10%, the peak seen in the early 1990s.

Besides securities backed by commercial real-estate loans, about $524.5 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012. Nearly 50% wouldn’t qualify for refinancing in a tight credit environment, as they exceed 90% of the property’s value, estimates Matthew Anderson, partner at Foresight Analytics. Today, lenders generally won’t loan over 65% of a commercial property’s value.

In contrast to home mortgages — the majority of which were made by only 10 or so giant institutions — hundreds of small and regional banks loaded up on commercial real estate. As of Dec. 31, more than 2,900 banks and savings institutions had more than 300% of their risk-based capital in commercial real-estate loans, including both commercial mortgages and construction loans.

Manufacturing and Industrial Production:

Manufacturers’ durable goods orders, an indication of firms’ capital spending, declined in August by 2.4% to a seasonally adjusted $164.44 billion. This was unexpected and was the biggest drop in seven months. The result came from a big drop in aircraft orders. Apart from aircraft, durable goods orders were flat.

Unfilled factory orders dropped again, now 11 months in a row, falling 1.3%. This is the longest streak since they started keeping statistics on this (1992). Also, shipments of durable goods were down 1.4%, after two months of increases.

These numbers conflict with the manufacturing shipments and trade sales data for July which were up 0.1 percent from June 2009 and down 17.8 percent from July 2008. Manufacturers’ and trade inventories were down 1.0 percent from June 2009 and down 11.8 percent from July 2008. Manufacturers continue to cut inventory.

The production of capital goods, such as durable goods, is necessary for a recovery. Manufacturers of capital goods require a substantial time to complete production, unlike the production of consumer goods, and they are reluctant to take risks until they see economic recovery.

Corporate Debt:

About 40 percent of all U.S. junk bonds outstanding in late 2008 will likely default by 2013 as government aid measures end and a wall of corporate debt comes due, Bank of America Merrill Lynch said on Thursday.

By contrast, the cumulative five-year default rate was about 30 percent in the last two default cycles, Bank of America said in a report.

The worst recession since the 1930s has already pushed defaults to double-digit rates. According to Standard & Poor’s, the default rate rose to 10.4 percent in August from less than 1 percent in 2007 as the recession and credit crunch left companies unable to pay off debt.

Deleveraging by consumers and financial institutions and fiscal problems at federal and state governments will slow the economic recovery, keeping defaults high, Bank of America said. Failure of the “shadow banking system” to reinvent itself will also contribute to high defaults, it said, referring to hedge funds and other non-bank institutions that fueled the last credit boom.

Defaults will also be triggered by hundreds of billions of dollars of debt coming due, especially in 2013 and 2014, Bank of America said. About $361 billion of high-yield loans come due in those two years alone, or 72 percent of the total outstanding, the bank estimated in an earlier report.

Bank of America in December had forecast that the junk bond default rate could peak at 17 percent in the second quarter of 2010, the worst since the Great Depression. Thanks to numerous government lifelines, including near-zero interest rates, it now expects the default rate to peak at 12.8 percent in the fourth quarter this year.

However, defaults will remain higher than normal and peak again at 8.5 percent in late 2012, the bank estimated. Even by 2013, the default rate will still be around 6 percent, much higher than the sub-4-percent levels usually seen at the end of a default cycle, Bank of America said.

Consumer Credit and Money Supply:

A Fed report released last week shows banks had $6.85 trillion of loans and leases outstanding to businesses and households as of Sept. 9, down for a fifth straight week and below the record $7.32 trillion in October 2008 [down 14%]. … The Fed’s second-quarter survey of senior loan officers, released Aug. 17, showed U.S. banks tightened standards on all types of loans and said they expect to maintain strict criteria on lending until at least the second half of 2010.

In July consumer credit decreased at an annual rate of 10.5%, the sixth straight monthly decline.

 

Money supply in the economy has been shrinking.

The Fed’s second-quarter survey of senior loan officers, released Aug. 17, showed U.S. banks tightened standards on all types of loans and said they expect to maintain strict criteria on lending until at least the second half of 2010. Banks have plenty of reasons to hold back on lending, analysts say. Americans fell behind on their mortgage payments at a record pace in the second quarter, with delinquencies rising to 9.24 percent, according to an August report by the Mortgage Bankers Association. “Consumers aren’t necessarily that creditworthy a proposition right now,” said John Ryding , chief economist and founder of RDQ Economics LLC in New York.

Economic Impact:

The FOMC was quite correct when it said that we had little to worry about inflation. What we do have to contend with is deflation.

Bernanke and others are pointing to positive numbers that are transitory effects of various fiscal stimulus programs. For example, retail sales were up 2.7% in August after falling 0.2% in July. Auto sales from the Cash for Clunkers program was the main driver. Ex auto sales, there was a 1.1% increase. It appears that much of the activity was back to school buying (though it was reportedly a bad season) and people looking for bargains in heavily discounted goods. Overall, retail sales are down 5.3% from last year.

Bernanke can also point to the stock market as a leading indicator of future business activity but, in my mind, that is mostly a result of speculation rather than hard economic data. According to David Rosenberg at Gluskin Scheff: “The S&P 500 is trading north of a 26x P/E multiple on trailing operating earnings and history shows that at these high valuation levels, the market declines in the coming year 60% of the time.”

The Cash for Clunkers program is dead and by all accounts will have no lasting effects as dealers report that all it did was borrow against future sales. There is no lasting impact from such stimulus as history has shown. I fear that the tooling up for more production by automobile manufacturers is misguided and will backfire on them.

There will be growth in Q3 and Q4 GDP from fiscal stimulus. If you take many billions of dollars out of the economy and give it to someone else to spend, the dollars spent will create economic activity but won’t create lasting wealth necessary for economic recovery. Economic growth only comes from real savings and real savings may be deteriorating.

The government can’t spend forever. National debt is growing so large that it will cause the dollar to to fall, crowd out capital available for private enterprise, and result in higher taxes, all of which will act as a drag on the economy.

When the Fed and others state that the economy has turned the corner they seem to be talking about another country. They boast that they prevented a worldwide economic collapse and that government efforts have turned the economy around. There is no valid evidence that their efforts have cured anything. But, even assuming that is true, we are experiencing continued rising unemployment, collapsing prices, very tight credit, and stubborn consumers who haven’t read Keynes’ General Theory about the evils of “hoarding.”

Let’s face it, the Fed and the Treasury have been wrong, have no real control over the economy, and can’t stop deflation or stimulate the economy. If they could, they would. If the billions spent for fiscal stimulus were working, then why aren’t we seeing that show up the in the broad data? If they understood the underlying causes of the crisis, why didn’t they prevent it?

By studying the experience of Japan during their lost decade (actually, their lost 14 years) and during this crisis, we find ourselves in a very familiar situation. Japan tried and is still trying everything we are doing (actually we are trying what they tried, down to Cash for Clunkers), and they continue to experience deflation and sluggish growth. Their result is that their average GDP growth for the past 19 years has been flat — 0.6%.

Japan’s exports fell for an 11th month in August as the economic recovery struggled to gain traction. Shipments abroad dropped 36 percent from a year earlier compared with a 36.5 percent decline in July, the Finance Ministry said today in Tokyo. From a month earlier, exports fell 0.7 percent, the second straight decrease.

Today’s report suggests the boost in overseas demand that helped the economy expand in the second quarter may be moderating as governments exhaust stimulus spending. New Prime Minister Yukio Hatoyama meets his counterparts from the Group of 20 nations in Pittsburgh today to discuss how to sustain a recovery from the worst global recession since the 1930s.

“Even with all those global stimulus measures, the recovery in exports has been extremely slow,” said Seiji Shiraishi, chief economist at HSBC Securities Japan Ltd. in Tokyo. “Final demand worldwide remains weak.”

I believe that economies eventually pull themselves out of cycles without any help from government. We are seeing some of these effects now as the housing and commercial real estate markets correct themselves from the excesses of this first decade of the new century. There is nothing that the government can or should do to stop this corrective process.

The question is whether or not the massive stimulus spending and resulting debt will harm the economy enough to delay a recovery. Certainly it did so in Japan. I believe it will harm our economy, but it’s difficult to predict what future government policy will be and how it will impact the shorter term. Unlike some deflationists, I think that, contrary to the experience in Japan, the government can and will create inflation once bank balance sheets are repaired and consumers feel more comfortable about the economy. The Japanese didn’t let banks and companies fail; we do. I believe that our dynamic economy will recover at some point and the government will inflate. Long term trends point to tepid growth. In a word, stagflation.