A Deep and Long RecessionDavid Wyss
For economists, projections are a stock in trade. At Standard & Poor's Ratings Services, which operates independently of S&P Equity Research, we publish monthly our economists' best estimates of where the U.S. economy could be heading.
Beyond the projection of GDP and inflation, we include outlooks for other major economic categories, such as home and auto sales, employment, and oil prices. We call this forecast our baseline scenario, and we use it to inform all areas of our credit analyses.
However, we realize that financial market participants also want to know how we think things could go worse — or better — than what our baseline scenario calls for. We also offer two additional scenarios, one worse than the baseline and one better, both of which have an estimated 20% chance of occurring (in the sense that reality will look more like them than like the baseline).
Baseline Case: A Deep and Long Recession
The January baseline forecast is for the recession to be deep and long, with a recovery beginning in mid-2009. Although lower oil prices are relieving the squeeze on consumers, financial markets have tightened much more than many anticipated. The inability to borrow money has hurt investment more than expected, while consumers suffer from both loss of wealth and increased difficulty borrowing.
Although the underlying problems that led to the recession are in some ways similar to those of the 1991-1992 recession (during which the gross domestic product (GDP) fell 1.2% from peak to trough), we think that the financial problems could make this recession deeper.
The cyclical peak of the latest expansion was December 2007, and the trough will likely come in June 2009. This 18-month recession would be longer than both the 50-year average of 10.7 months and the longest recessions, which were in 1975 and 1982 and lasted for 16 months each.
We’re forecasting negative GDP growth for the second half of 2008 and the first half of 2009, with a total decline of 3%. The business tax credits should boost fourth-quarter results somewhat, though business borrowing restrictions have made the credits less effective than we originally thought.
The Downside Case: Into the Depths
In our deep recession scenario, financial markets remain frozen, cutting capital spending and consumer purchases. Consumer and investor confidence weakens further, resulting in a recession that lasts through 2009. The deeper foreign downturn keeps exports weak. The result is the deepest recession in postwar history, with a peak-to-trough decline in real GDP of 4.5% and an unemployment rate of 10.4% in mid-2010, near the postwar record of 10.8% set in the 1982 recession.
In this scenario, consumer spending drops more sharply as households try to rebuild the wealth lost to weaker home and stock prices. As a result, the downturn would be longer (24 months) than the 18 months in the baseline projection.
Housing remains the weakest sector of the economy. Housing starts tumble to a record low of 540,000 in 2009, down from their 2005 peak of 2.07 million.
In addition, average home prices (S&P/Case-Shiller house price index) drop 43% by early 2010 from their recent peak compared with a 32% drop in the baseline forecast. The weak home prices hit consumer wealth and spending; wealth drops 22% from its peak compared with 18% in the baseline. The saving rate holds at 3.8% in 2011 compared with 2.6% in our baseline projection. Weaker employment and tougher credit standards hit light-vehicle sales hard, cutting them to 8.5 million in 2009 compared with 10 million in our baseline.
In the downside case, capital spending suffers from the weak economy and borrowing difficulties. Spending on capital equipment falls 17.9% in 2009. Companies also cut back on employment. Nonfarm employment drops 4.3 million during 2009.
The Upside Case: Maybe as Good as it Gets
As already confirmed by the National Bureau of Economic Research, the U.S. economy is in a recession, but an improving housing market, growing confidence, and a more rapid calming of financial markets could still keep the recession relatively mild. At the same time, a revival of productivity increases could keep inflation under control despite stronger economic growth.
In our optimistic projection, the housing sector contracts by less than in the baseline scenario because of lower mortgage rates and a stronger economy. Starts fall to 800,000 in 2009 (compared with a drop to 650,000 in the baseline) from 910,000 in 2008. Starts reach 1.60 million, near their pre-boom average level, in 2011. The result is a mild recession, equivalent to the one in 2001, with a peak-to-trough decline in real GDP of 1.9%. Unemployment still rises to a 7.9% peak in the third quarter of 2009 from its current 7.2% rate as real GDP growth recovers after reaching bottom in the first quarter.
In the upside case, capital spending benefits from a recovering economy and improving credit conditions. Although business borrowing restrictions continue to weigh on spending in the optimistic scenario, the credit market problems improve faster than in the baseline forecast, with a larger boost to spending. The business tax credits provide an additional boost to the fourth quarter, though business borrowing restrictions cap the upside potential.
Spending on capital equipment falls 6.4% in 2009 (compared with a 13.1% drop in the baseline). While companies also cut back on employment, nonfarm employment loses 1.9 million jobs in 2009, which is much less severe than the 3.1 million jobs lost in the baseline forecast. More hires support nonresidential construction spending, which falls 8.3% in 2009 under this scenario (compared with a 12.2% drop in the baseline).