2009 Will Be Very, Very Bleak
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:
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).
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.
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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.
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%.
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 rate of unemployment.
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.
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.
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. 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.