The economy has cooled this summer as the weather has heated up. Problems in the credit markets are translating into fears for consumer spending as well as increased worries about housing. The 3% growth rate of the past four years has slowed to 1.9% over the last four quarters. Although we still expect the economy to avoid recession, the odds that the current slowdown will turn into a downturn are increasing.
The economic weakness also changes the outlook for interest rates. Both the European Central Bank (ECB) and the Federal Reserve (Fed) have added reserves last week, with the ECB doing most of the work. The injections suggest that the ECB will forgo its expected September rate hike and implies that the Fed will lower rates sooner than we had anticipated.
Moving Houses
Housing remains the major weak spot in the U.S. economy, subtracting 0.9 percentage point from growth over the last four quarters. In other words, if housing had just remained flat, economic growth would have remained near 3% rather than slowing. The slowdown was no surprise; we have been writing about the housing bubble for two years and have been expecting home prices and housing starts to decline. However, as Professor Rudy Dornbusch said, "Corrections always come later than you expect, but when they come, they come faster."
We continue to believe that housing starts will bottom out over the next few months, declining about another 10% from recent levels. However, home prices will continue to drop through next spring (at least on a seasonally adjusted basis). The Standard & Poor's/Case-Shiller index of home prices in the 20 major metropolitan areas was down 2.8% from a year earlier in May. We expect it to drop another 5% by next spring. The decline should be kept in perspective. In 2005, the average home price rose 20%; we expect owners to give back only five months' appreciation. The problem is for the homeowners who bought or refinanced at the peak and who are looking at actual losses. Many of them are also looking at higher monthly payments, although mortgages refinanced in 2005 and 2006 were already paying well above the lows that adjustable-rate mortgage rates hit in 2003 and early 2004.
Prices will continue to decline even after housing starts level off because of the large overhang of unsold houses on the market. Sellers have been reluctant to accept lower prices for their homes, instead just keeping them on the market at the price they hope to get. The inventory of unsold existing homes is now at an 8.8 months' supply, almost double the level of two years ago. Six months is considered normal. The supply of unsold new homes has not risen as far, to 7.7 months, because builders have been more realistic about pricing.
Even though prices are expected to level off next spring, losses in mortgage markets usually trail by a year and may not peak until early 2009. So far, the actual losses remain small, because even homes in foreclosure have yet to complete the process. The lag in losses adds to the uncertainty in the secondary markets as investors are unwilling to buy until the actual risk becomes clear.
There has been much less impact on construction employment than would be suggested by the drop-off in housing starts. The primary reason is the strength in nonresidential construction, which has absorbed many of these workers. Even though the data for residential subcontractors has been stronger than expected, our suspicion is that these contractors are now doing more nonresidential work but are still classified based on what they were doing last year. Renovation activity remains strong, up 8% from a year ago in the second quarter. Many homeowners have delayed projects because of a lack of availability of contractors—contractors are now returning phone calls. Contractors also prefer to keep skilled labor during downturns and tend to cut hours rather than employees. Finally, how many undocumented workers have moved back to Mexico?
Chart 1
Consumer Impact
Consumer spending has held up better than expected despite higher oil prices and lower home prices. However, in the past two months some cracks are appearing, especially in the auto market. Whether this is caused by home or oil prices is unclear, but gasoline seems the most likely culprit.
The upward revision to personal income and the downward revision to consumer spending in the annual revision have swung the saving rate back into positive territory. The only significantly negative saving rate is in the third quarter of 2005, which was distorted by the accounting for Hurricane Katrina. (Uninsured property losses are considered negative income.) The positive saving rate implies that the consumer isn't quite as stressed as we thought, although remember that the saving rate is only marginally positive and that household debt remains at a record high relative to income.
The drop in auto sales is the major sign of trouble so far. Sales were only 15.5 million (annual rate) in June and 15.3 million in July, down from 16.6 million in 2006. The end of the model year is often very volatile, and the weak data reflect, in part, less attractive incentives and lower fleet sales from the U.S. manufacturers, which are less eager to lose money on each sale to maintain volume.
Ford and
GM both showed profits in their second quarters, but the share of the three U.S.-based automakers fell under 50% in July for the first time ever.
Last year, homeowners took $640 billion out of their homes in the form of home equity loans or cash-out refinancing. Although, in total, homeowners still have substantial equity—the loan-to-value ratio in the housing market was 48% in the first quarter, about the same as 10 years ago—it is more expensive to access that equity and lenders are getting more reluctant to approve the loans. We fear that this will slow spending, particularly on home improvements—the largest use of these funds.
We had expected consumer spending to slow because Americans were outspending their incomes. The revised national income data suggest that the problem is smaller than we thought, although the saving rate remains very low. We also anticipated that consumers would be affected by higher gasoline prices. These corrections haven't occurred yet, but see Professor Dornbusch's quote above.
Chart 2
What Should The Fed Do?
The considerations for the Fed are changing. The disorder in financial markets has caused both the Fed and the ECB to inject liquidity into the system. Regardless of issues of the economy and inflation, the first priority of a central bank is to maintain orderly financial markets. Without orderly markets, the central bank has no direct or indirect control over the economy in any event.
Under current circumstances, it seems incumbent on the Fed to cut rates sooner rather than later. We expect the Fed to wait until its September meeting, but an earlier cut is possible, especially given the ECB's injections of cash. It is still possible, however, that the problems will ease after August vacations have ended. The Fed may then elect to stay where it is rather than cut rates.
The long-term Treasury yields have dropped in response to the worries about the economy and the expectation of Fed rate cuts. In addition, the flight to quality that has raised yields on private bonds has lowered yields on Treasuries. So far, the yield spreads have only widened to normal for corporate securities. The widening resembles the move that occurred two years ago, when the downgrades of Ford and GM led to a sudden widening of spreads from 300 basis points (bps) to 400 bps between speculative-grade bonds and Treasuries. Spreads gradually narrowed over the next six months.
International Fears
One added worry is that the U.S. has become so dependent on foreign capital that any fears in the U.S. bond market could lead to currency declines that could end up in a vicious spiral. There has been little sign of that so far; the dollar has been relatively stable against the euro in recent weeks. Certainly, however, rumblings of risks are being heard in the international markets.
The stock market decline and widening of spreads has occurred around the globe, not just in the U.S. The ECB has been more active in injecting reserves than the Fed, perhaps partially because more European risk is concentrated in commercial banks rather than in hedge funds and other nonregulated entities.
But the more likely conclusion is that we are seeing a basic reassessment of risk in the financial markets. Investors are getting more nervous about the possible negative outcomes in the economy and demanding more reward to balance the risk. When these reassessments occur, the market tends to overreact for a while, because investors are no longer certain about what are the correct prices. In the past, markets have usually settled down within a few months. We hope they will do so this time as well.
Standard & Poor's Economic Outlook: August 2007
2007
First quarter
Second quarter
Third quarter (f)
Fourth quarter (f)
2005
2006
2007f
2008f
2009f
2010f
2011f
Percent change
Real GDP
0.6
3.4
2.8
2.6
3.1
2.9
2.0
2.7
3.2
2.7
2.3
Consumer spending
3.7
1.3
2.7
2.8
3.2
3.1
2.9
2.8
3.1
2.9
2.7
Equipment investment
0.3
2.3
5.2
7.1
9.6
5.9
1.0
5.6
7.0
3.6
3.9
Nonresident construction
6.4
22.1
3.2
2.4
0.5
8.4
9.8
1.0
-0.7
0.3
0.3
Residential construction
(16.6)
(9.3)
(12.2)
(15.3)
6.6
(4.7)
(15.1)
(8.7)
5.1
4.9
1.6
Federal government
(6.3)
6.7
3.0
2.5
1.5
2.2
1.5
2.0
0.1
0.1
(0.4)
Savings and loans government
3.0
2.9
1.6
1.5
0.3
1.6
2.1
1.6
1.5
1.2
1.0
Exports
1.1
6.4
8.4
10.2
6.9
8.4
6.8
9.0
8.5
7.2
6.3
Imports
3.9
(2.6)
4.5
4.9
5.9
5.9
2.3
4.8
5.9
5.3
5.1
CPI
3.8
6.0
1.5
0.9
3.4
3.2
2.6
2.1
2.0
1.8
1.9
Core CPI
2.3
1.9
2.1
2.0
2.2
2.5
2.3
2.1
2.2
2.0
2.0
Nonfarm unit labor costs
3.0
2.1
2.2
1.7
2.0
2.9
3.7
1.7
1.8
2.2
2.3
Nonfarm productivity
0.7
1.8
1.8
2.3
1.9
1.0
1.1
1.9
2.0
1.8
1.9
Levels
Unemployment rate (%)
4.5
4.5
4.6
4.7
5.1
4.6
4.6
4.7
4.5
4.4
4.5
Payroll employment (mil.)
137.4
137.9
138.3
138.7
133.7
136.2
138.1
139.7
141.9
143.6
144.7
Federal funds rate (%)
5.3
5.3
5.3
5.1
3.2
5.0
5.2
4.7
4.5
4.5
4.5
10-year Treasury yield (%)
4.7
4.8
4.9
5.2
4.3
4.8
4.9
5.3
5.6
5.8
5.8
AAA corporate bond yield (%)
5.4
5.6
5.7
5.9
5.2
5.6
5.6
6.1
6.6
6.8
6.9
Mortgage rate (30-year conventional, %)
6.2
6.3
6.6
6.8
5.9
6.4
6.5
6.9
7.3
7.4
7.4
Three-month Treasury yield (%)
5.0
4.7
4.8
4.8
3.1
4.7
4.8
4.4
4.4
4.4
4.4
S&P 500
1,425
1,496
1,484
1,509
1,207
1,311
1,479
1,560
1,640
1,716
1,825
Standard & Poor's operating earnings ($/share)
22.39
23.70
23.89
23.47
76.45
87.72
93.45
99.73
106.88
106.55
106.49
Current account (bil. $)
(770)
(764)
(802)
(793)
(755)
(811)
(782)
(779)
(785)
(773)
(769)
Exchange rate (maj trade part)
81.0
78.0
76.0
76.0
82.0
81.0
78.0
74.0
72.0
73.0
74.0
Crude oil ($/bbl, WTI)
58.09
64.96
74.83
71.83
56.56
66.12
67.43
73.79
72.97
71.73
70.74
Saving rate (%)
1.1
0.5
0.8
1.1
0.5
0.4
0.9
1.3
1.9
2.2
2.3
Housing starts (mil.)
1.46
1.46
1.38
1.31
2.07
1.81
1.40
1.40
1.62
1.71
1.70
Unit sales of light vehicles (mil.)
16.4
16.0
15.9
16.5
16.9
16.5
16.2
16.6
16.8
16.9
17.3
Federal surplus (fiscal year, bil. $)
(178)
$137
(54)
(77)
(321)
(248)
(175)
(215)
(243)
(243)
(243)
f--Forecast.
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