Mukund Sheorey President

Transcription

1 7 US Economic Outlook What Time Is It? To everything (turn, turn, turn) There is a season (turn, turn, turn) And a time for every purpose, under heaven - The Byrds, 195 Economic Cycles An enduring characteristic of modern economies is their cyclical nature. Specifically, when we look at the growth rates of prominent macro-economic indicators like GDP, employment, and consumer spending, we observe that they wax and wane over periods of several years. And, periodically economies experience outright contractions or recessions. In spite of the explicit mission that has been entrusted to central banks (the Federal Reserve in the US) of conducting monetary policy in such a way as to promote stable growth without inflation, we have been unable to avoid economic cycles. Chart I shows post-war cycles for a key economic metric the unemployment rate, with the blue-grey shaded areas representing periods of recession as determined by the official arbiter in the U.S., the National Bureau of Economic Research (NBER). Noticeably, recessions have become less frequent and milder over the last quarter century. Unemployment Rate 1 Chart I Jan- Jan-5 Jan- Jan-7 Jan- Jan- Jan-9 Jan- Chart I 7 US Economic Outlook 1

2 What Causes Economic Cycles? While there is little consensus on this subject, actually the empirical evidence is quite clear. Economic Cycles are caused by the delayed response of the economy to Monetary and Fiscal policy. Chart II shows the main cause and effect relationships of the main lever of Monetary Policy, i.e., Interest Rates. Slowing Economy Growing Economy Slowing Economy Falling Interest Rates Credit Boom Rising Inflation Rising Interest Rates Credit Bust Increased money supply Increased demand for credit Growth in borrowing and spending by consumers Increased demand for goods and services Increased prices, especially for homes Increase in cost of living Central Bank tightening Increased Financial Obligations Ratio Deterioration in credit quality Reduced credit growth Chart II Chart III illustrates the close relationship between growth in GDP and the federal funds rate. A rise in fed funds rate is followed by a decline in GDP growth and vice-versa. % 5% % 3% % 1% % -1% -% Jan- Jan-9 Jan-9 Jan-9 Jan- Jan- 1 GDP YoY Federal Fund Rate Chart III 7 US Economic Outlook

3 In an effort to rejuvenate the sluggish or contracting economy, the Fed cuts interest rates. As the price of a commodity (in this case, money) falls, the demand for it increases. Thus credit growth accelerates along with consumer spending. This boosts economic activity in all sectors real estate, manufacturing, services, etc. Escalating demand in turn puts pressure on prices, causing price inflation. In accordance with its charter to control inflation, now the central bank constricts credit by raising its price (increasing short term interest rates) which depresses spending and investment, thus slowing down the economy. Charts IV VII show the relationships (R = correlation coefficient) and time lags between the Fed rate and growth in consumer borrowing, spending, the Consumer Price Index (CPI), and Employment. 1% R=-3.7% Lag=11 Quarters 1 % R=-3.19% Lag = 1 Quarters 1 1% % % % 19Q1 199Q1 199Q1 199Q1 Q1 Q1 Total Consumer Credit (incl.mortgage) YoY Federal Funds Rate 5% % 3% % 1% % -1% 199Q1 199Q1 Q1 Q1 Consumer Spending (PCE) YoY Federal Funds Rate Chart IV Chart V % R=57.9% Lag < 1 Quarter 1 % R=-1.1% Lag=5 Quarters 1 % 3% % % 1% % % -1% % 19Q1 199Q1 199Q1 199Q1 Q1 Q1 CPI YoY Federal Funds Rate -% 19Q1 199Q1 199Q1 199Q1 Q1 Q1 Employment YoY Federal Funds Rate Chart VI Chart VII 7 US Economic Outlook 3

4 You can visually observe the strength of the relationship as well as the regularity of the lag periods. So the cycles are caused by the inability of the macro-economic engineers to administer the Goldilocks treatment not too hot and not too cold but just right! Like a pendulum, the economy swings between too hot and too cold constantly overshooting the target of stable growth with low inflation first in one direction and then in the opposite. Central banks provide the impetus as they lower and raise interest rates in a cyclical manner. What Time Is It? Recognizing the pendulum clock-like nature of the economy, as we stand on the threshold of a new year, it is pertinent to ask the question, where in this economic cycle do we currently stand? A study of previous cycles makes the answer obvious. After steadily raising the Fed rate by 5 BPs over two years starting in mid-, the Fed has been on hold for six months. So clearly, the Fed is at the end of a tightening cycle. Over the past 5 years, whenever the Fed tightened by BPs or more, we have had a recession 75% of the time ( out of times). The only two exceptions were (a) the mid-s amidst the Vietnam/Great Society spending boom and (b) 9-95 when economic growth slowed but then accelerated as the Internet boom unfolded. On the other hand, in 1999, a tightening of just 15 BPs brought on a recession since the Internet stock market bubble was already primed to pop. So we clearly are at a turning point. In fact the distinctly slower growth recorded in the nd and 3 rd quarters of would argue that we are past the growth peak. The only real question is the extent of the slowdown. In other words, will the Fed pull off the ultimate maneuver of central bakers a soft landing like the mid s and mid 9s; or are we going to experience a recession like all the other times? It s Different This Time? History doesn t repeat itself, but it does rhyme Mark Twain The four most dangerous words in the art and science of forecasting are It s different this time. In fact all predictive models are based upon observations of historical relationships among variables and the assumption that these relationships will endure in the future. Einstein expressed this principle by stating his belief that God does not play dice with the universe. Inductive law, the bedrock of the scientific method, enables us to, having observed the sun rise in the East countless number of times, reliably predict that it will also do so tomorrow. Conversely, forecasting errors result from not adequately accounting for variables that are different. So let us review the current situation to see in what ways this cyclical turning point is similar to, or different from previous occasions. 7 US Economic Outlook

5 On the positive side, Unemployment is relatively low compared to similar cyclical points in the past Commodity prices and inflation are falling especially oil as the US experiences one of the warmest winters in memory. This should support consumer spending. On the downside, Housing is in recession with severe volume declines and, for the first time in history, noticeable price drops Due to the previous unprecedented housing price boom, housing affordability is at record lows The preceding borrowing frenzy has left consumers with historically record debt service burdens. In addition, with more adjustable rate mortgages, they are far more exposed to higher interest rates. Compared to the historic low of 1%, Fed interest rates have (relatively) moved much higher in this cycle versus the past both in absolute and % terms. Record current account deficits leave the fates of the dollar, long term interest rates and inflation in foreign hands Energy prices, although easing, are still much higher than in the past. 7 Forecast To briefly look at what analysts are forecasting for 7, Chart VIII shows (1) the consensus forecast of economists polled by Business Week. However, if we take the average forecast of the five economists who were most accurate in, we end up with () which is somewhat more pessimistic. Note that both forecasts call for the Fed to cut rates during 7. 7 End GDP Growth CPI Growth Fed Rate Yr Treasury Unemployment Rate Home Price Growth (1) Business Week Consensus () Business Week Top Five (1.7) (.) (3) Our Forecast (5.) Chart VIII 7 US Economic Outlook 5

6 Our Fearless Forecast is shown in (3) above. The major supporting rationale is Consistent with historical experience, the economy will continue to slow into 7 as higher interest rates bite with a delayed impact Historical comparisons show that the housing bust has significant room before it hits bottom. This means that housing related activity will be in recession throughout 7. Manufacturing in general and the auto industry in particular will not grow in 7 Consumer spending growth will slow in 7 as Mortgage Equity Withdrawals (MEWs) drop. However, the unprecedented housing wealth generated over the past 5 years will put a floor under consumer spending. Also, given our significantly lower than consensus inflation forecast of the GDP deflator at 1%, reported real (inflation adjusted) consumer spending growth will not show much of a decline. Wild Cards Other than geopolitical risk and energy prices, in our view the biggest wild card is Credit Quality. Past experience and all of our models suggest worsening credit defaults. Clearly, as unemployment rises, with little or no measured inflation, the Fed will cut rates. However, consumers and businesses will then be experiencing rising rates due to the increased risk premiums associated with deteriorating credit quality. So the critical question is, will the Fed come to the rescue before rising credit risk cuts off the flow of funds to the marginal borrower (as is currently happening in the sub-prime mortgage market)? If yes, the slowdown will be mild. If no, all bets are off. Given the Fed s current obsession with inflation (just like in ) we don t think it will be able to avoid a significant slowdown in the U.S. Given our estimate of practically no inflation (GDP deflator at 1% growth), reported real GDP growth will remain in positive territory throughout 7, i.e., no official recession. However, it will feel very much like a recession as employment falls due to the recessions in housing and manufacturing, coupled with the significant slowdown in consumer spending growth (as measured in actual or current $) * * * * * Notwithstanding the above less than cheerful forecast, we at Modelytics wish you a Very Happy 7! - Mukund Sheorey P.S. This month we are also publishing a study on the Mortgage industry Mortgage Retention: Predicting Refinance Motivations If that is a topic of interest to you, please take a look. 7 US Economic Outlook