The Economy: Slip-Sliding Away

S&P looks at the factors that are driving the worsening U.S. downturn

The 3.8% drop in fourth-quarter real gross domestic product (GDP) was somewhat smaller than we had feared, but the continued job losses — down 3.6 million from the December 2007 peak — and continued slide in housing indicates the worst has not yet arrived. However, we remain optimistic that the economy will find a bottom in the next six months, boosted by the $787 billion stimulus package finally agreed on by Congress.

The major problem remains the credit markets. Although there have been some encouraging signs, quality spreads remain wide and lending activity light. Federal Reserve intervention has opened up the conventional mortgage and commercial paper markets, and highly-rated bond issuance has picked up. However, speculative-grade bond issuance and securitization remain dormant.

The Federal Reserve took the federal funds rate down as low as it can go, and promised to intervene in other markets, including Treasury notes if necessary, to get the economy and the financial markets moving again.

Houses Tumble Further

The housing market continues to decline, with prices and starts both down sharply in the latest reports. The only good news is a recovery in existing home sales and a drop in inventories of unsold homes, perhaps an indication that bargain hunters are trying to take advantage of lower prices and near-record low mortgage rates. Housing affordability is rising to its highest level in history.

The rise in existing home sales is encouraging, although the December data needs to be taken with a large grain of salt because of the seasonal factors — few people buy houses in December. Moreover, the rise only offsets the sharp November drop. Still, indications are that existing home sales are stabilizing. The inventory of unsold homes dropped in December, but that may be because sellers are keeping their homes off the market. We expect inventory will increase when owners realize there are buyers.

The new home market remains depressed, as new home sales and housing starts both dropped to record lows. The drop in existing homes has made it highly unprofitable to build new ones. Builders have cut back to only 550,000 (annual rate) new starts in December, down from 2.1 million in 2005.

Housing prices continue to slide, and prices are depressed by distressed properties (foreclosures and "short sales" priced below the outstanding mortgage). The National Association of Realtors reports that 45% of December sales were of distressed properties.

It isn't over. Although we believe sales and starts are bottoming out, little recovery is likely in 2009. The still-high inventory of unsold homes will likely keep downward pressure on home prices.

The stimulus package does provide some incentives for home sales, which should help later this year. The $8,000 tax credit for new home purchases replaces what is currently an effective $7,500 loan. The low mortgage rates are also boosting sales. How much this will support prices is not clear, but in most of the country $8,000 is most of a down payment on a starter home, and it should convince buyers to enter the market. Unfortunately, it isn't much of a down payment in California, the worst-hit state.

Scared Consumers

Consumer confidence hit a record low in January, according to the Conference Board survey, on falling wealth and rising unemployment. The economy lost 3.6 million jobs since the cyclical peak in December 2007, and we expect it to lose another 3.0 million this year. The unemployment rate rose to 7.6% from 4.4% less than two years ago. We expect the rate to exceed 9.3% by early 2010, which would be the largest increase in the unemployment rate in any postwar recession.

When consumers are scared, they stop spending. Light-vehicle sales fell to a 27-year low of 9.3 million in January, but retail sales bounced up 1.0% in January, as consumers responded to heavy discounts. Although the caution is certainly prudent for the individual household, and indeed long overdue, it is creating major problems for the U.S. economy, which has been dominated by consumer spending (71% of GDP in 2007).

Sources of Growth?

Investment is not likely to accelerate in the near future, even with tax incentives likely to be included in the stimulus bill. Production is far below capacity. If businesses are laying people off and shutting down factories, why would we expect them to spend money on adding capacity? Even productivity-enhancing investments are less attractive in the current low-inflation world. Last year's investment incentives, which accounted for one-third of the tax cuts in the 2008 stimulus package, had no apparent impact on business equipment spending, which plunged 27.8% in the fourth quarter.

In the short run, government spending is likely to be the main driver of economic growth. The stimulus package accounts for about 3% of GDP in each of 2009 and 2010, certainly a significant boost, although less than the Japanese government spent in several years during the 1990s. The budget deficit is expected to climb to $1.6 trillion in fiscal 2009, about 10% of GDP, and drop only slightly in 2010. Much of the money is being spent through state and local governments; it remains to be seen how fast they can spend the funds, especially given their own budget woes.

But the main requirement for revitalizing the economy is reviving the financial system. The new plan for the remaining $350 billion in TARP funds continues the emphasis on providing banks with capital. There are more strings attached, which should encourage the repayment of these funds but could also restrict credit by making banks less likely to take them. Treasury Secretary Timothy Geithner has resisted calls for bank nationalization, which we think should be a last resort.

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