Wednesday, July 08, 2009

Roubini Still Has Lingering Concerns About the Economy

In conclusion, the outlook for the U.S. economy remains very weak. The recent rally in global equities, commodities and credit may soon fizzle out as worse-than-expected earnings and financial news take their toll on this rally, which has gotten ahead of improvements in actual macroeconomic data.

Source: RGE Monitor Newsletter
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Lingering Concerns:

Labor market conditions are still quite dire, more than 3.4 million jobs have been lost in 2009 and about 6.5 million have been lost since the beginning of the recession. Compare this with the 2.5 million jobs lost in the recession of 2001; 1.5 million lost in the recession of the early 1990s; 3 million in the one of the early 1980s; 2.2 million in the one of the 1970s.

The pace of job losses has fallen from the 600K plus per month registered between December and March 2009 to about 350K in May and 467K in June; the average monthly job losses in this recession is now at about 360K. While the recent slowing of losses is a positive development, we have to put this in perspective: in previous post-war recessions, average monthly job losses have ranged between 150 thousand and 260 thousand. Moreover, average weekly hours in private nonfarm payrolls are at the lowest since 1964, as employers have cut employees’ hours. Job openings and turnover openings continue to fall and are at the lowest levels since 2000, indicating continued weakness in the economy.

The U.S. consumer is still the engine of U.S. growth, and contributes to over 70% of aggregate demand. While saving rates are headed for the high single digits and high oil prices together with long-term rates keep putting a dent in personal consumption, the over-leveraged consumer is finding some support in the tax breaks of the fiscal stimulus package. Yet the over-indebted U.S. consumer – whose deleveraging process yet has to start – will likely continue to put the brakes on consumption, while the savings rate continues to creep up. While this will encourage a rebalancing in the U.S. and global economy, in the medium-term it isn’t likely to support strong U.S. and global growth.

Housing starts appear to have stabilized and will likely move sideways for quite some time. However, housing demand is not yet improving at a pace that can guarantee that the lingering inventory overhang will dissipate. This implies that home prices will continue to fall. RGE Monitor expects home prices to continue to fall through mid-2010.

U.S. industrial production has been contracting for 17 months in a row – with a short break in October 2008. Industrial production usually finds a bottom shortly after the ISM manufacturing index does. While the index probably found its bottom back in December 2008--at depression levels of 32.9--industrial production remains in a mode of contraction that started in January 2008.

Financial conditions are showing some improvement. Banks are borrowing at zero interest rates and higher net interest margin can definitely help rebuild capital. Regulatory forbearance, changes in FASB (Financial Accounting Standards Board) rules and under-provisioning might enable banks to post better than expected results for a few quarters. However, relaxation of mark-to-market rules reduces the banks’ incentives to participate in the Public-Private Investment Program (PPIP) and therefore reduces the likelihood that the program will succeed in clearing toxic assets from banks’ balance sheets. The muddle-through approach might be successful in a scenario in which the U.S. and global economy recover soon and go back to potential growth during 2010, but according to RGE’s forecasts, this is highly unlikely. While we might have positive surprises coming from the banking system in the next couple of quarters, the situation could turn around again after that, jarring confidence in financial markets in a way that would spill into the real economy. Increases in the unemployment rate, well beyond the rates envisioned by the adverse scenario of the recent bank stress tests, imply that recapitalization needs are larger than what the too-lenient stress test prescribed. The U.S financial system – in spite of the massive policy backstop – thus remains severely damaged, and the credit crunch remains unlikely to ease very fast.

A sharp rise in public debt burden – the U.S. Congressional Budget Office estimates that the public-debt-to-GDP ratio will rise from 40% to 80% (in the next decade), or about $9 trillion – will also put a dent on growth. If long-term rates were to increase to 5%, the resulting increase in the interest rate bill alone would be about $450 billion, or 3% of GDP. The implication is that the fiscal primary surplus will have to be permanently increased by 3% of GDP, which could constitute further pressure on the disposable income of the U.S. consumer.

Not only does the U.S. economy face downward risks to growth in the medium-term, but potential growth might fall as well. The U.S. population is aging. With employment still falling – and another jobless recovery on the horizon – the rate of human capital accumulation will fall. Moreover, workers who remain unemployed for a long period of time lose skills, while young workers that enter the workforce, but don’t find a job, don’t acquire on-the-job skills. Reduced investments in worker training and education, coupled with lower capital expenditure, are a recipe for lower productivity ahead.

Deflationary pressures are still present in the U.S. economy. Demand is falling relative to supply and excess capacity is still promoting slack in the goods markets. Moreover, the rising slack in labor markets, which is pushing down wages and labor costs, implies that deflationary pressures are going to be dominant this year and next year. This implies that the Fed will keep monetary policy loose for a while longer. However, discussion of an exit strategy has to start now as investors’ concerns about the Fed’s ballooning balance sheet and expectations of inflation both mount.

There are also signs that a double-dip recession could materialize toward the second half of next year, or in 2011. If oil prices rise too much, too fast, too soon, that’s going to have a negative effect in terms of trade and real disposable income in oil-importing countries. Also, concerns about unsustainable budget deficits are high and are pushing long-term interest rates higher. If these budget deficits are going to continue to be monetized, eventually, toward the end of next year, there is a risk of a sharp increase in expected inflation that could push interest rates even higher. Together with higher oil prices, driven up in part by this wall of liquidity rather than fundamentals alone, this could be a double whammy that would push the economy into a double-dip or W-shaped recession by late 2010 or 2011.

In conclusion, the outlook for the U.S. economy remains very weak. The recent rally in global equities, commodities and credit may soon fizzle out as worse-than-expected earnings and financial news take their toll on this rally, which has gotten ahead of improvements in actual macroeconomic data.

Bob DeMarco is a citizen journalist and twenty year Wall Street veteran. Bob has written more than 700 articles with more than 18,000 links to his work on the Internet. Content from All American Investor has been syndicated on Reuters, the Wall Street Journal, Fox News, Pluck, Blog Critics, and a growing list of newspaper websites. Bob is actively seeking syndication and writing assignments.

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