Great Roubini prognosis

RGE - RGE Monitor - 2009 U.S. Economic Outlook

RGE Monitor - 2009 U.S. Economic Outlook
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RGE Lead Analysts | Jan 13, 2009

It is clear that 2008 was a dismal year for the economy and financial markets and it is now official that the current U.S. recession started already in December 2007. So, how far are we into this recession that has already lasted longer than the previous two (the 1990-91 and 2001 recessions lasted 8 months each)? We forecast that the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout all of 2009 for a cumulative output loss of 5% and a recession that will thus last about two years. Our forecast is much worse than the current consensus forecast expecting a growth recovery in the second half of 2009; we also predict significantly weak growth recovery – well below potential - in 2010.

One final look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.

Personal Consumption

A shopped-out, saving-less and debt-burdened U.S. consumer lost its resilience and started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.

In our view, personal consumption will continue to contract quite sharply throughout 2009 as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008 on, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the household saving rate of a decade ago to increase the now sharply depleted net worth of the household sector.

The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 20% contraction in the stock markets from the level at the beginning of 2009.)

This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.

Housing Sector

The 4th year of housing recession – and the worst housing recession since the Great Depression - is well on course.

Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).

On the demand side, new single-family home sales are down 70% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.

Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.

The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side of housing is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.

We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)

Labor Markets

With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-600k range during the first two quarters of 2009, pushing the unemployment rate to over 8% by mid-2009. The severe contraction in private demand through 2009 will keep lay-offs high so that the unemployment rate will reach 9% by the end of 2009.

Economy wide job cuts are expected, with big corporations and small and medium enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover, with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services, and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local governments, job losses at the government level will also gain pace. In turn, income and job losses will further push up the default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.

As cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010, lay-offs are bound to continue. Even as consumer demand might show some signs of recovery at some point in 2010, firms will most likely begin by hiring only part-time and temporary workers initially. The unemployment rate might get close to 10%, peaking in the middle of 2010 over two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).

Capital Expenditure

Firms have been drawing down inventories beginning in Q4 2008 given the build-up of inventories of unsold good; this process will continue in 2009 dragging down production. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in the high double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and increase capex plans only at a slower pace.

Trade

Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.

Dollar Outlook

The fate of the U.S. dollar in 2009 rests on the global growth outlook relative to the U.S. downturn. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in part of H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields; 3) massive quantitative easing by the Fed; 4) large twin fiscal and current account deficits; 5) a worse than expected recession in the U.S.

Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.

Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation – which has already waned on the reversal of capital flows – to finance the large U.S. current account deficit. Yet, continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.

Inflation/Deflation

Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Rising slack in labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Upside risks to the inflation outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in oil/energy and commodity prices and 2) an earlier than expected global economic recovery.

Credit Losses Still Ahead

Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion on unsecuritized loans alone, much larger if we include mark-to-market losses on securitized instruments.

An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF Global Financial Stability Report, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Federal Reserve Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($144bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($105bn out of $3,800bn).

The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($142bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)

The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.

Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying all the remaining TARP funds – and much more – towards recapitalizing the banking system would be warranted as the expected credit losses imply that the U.S. banking system (commercial banks and broker dealers) is effectively insolvent as a whole.

The Disconnect Between Bond and Equity Markets

U.S. government bonds were on a tear in 2008, while equities plummeted in the worst bear market since the Great Depression. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have gained since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.

However, there have been intimations that the bond market is a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation and deflationary forces ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings have further to fall. If, as is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 20% slide in stock prices from the level at beginning of 2009.

Fiscal and Monetary Policy Fiscal Policy

A lot of hope is being placed on the expected fiscal stimulus package of around $775 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.

Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.

Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.

Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.

Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.

Taming the Foreclosure Problem

There have been growing calls in the Congress recently to use some of the remaining TARP funds to refinance mortgages for homeowners facing foreclosure or default due to negative home equity and unaffordable monthly interest payments.

Given the excess supply of homes in the market, home prices will fall at least 15% (from current levels) by 2010, pushing the number of homeowners with negative home equity from over 12 million currently to over 14-19 million. While price correction can help stimulate home demand and pave the way for market clearing, the ongoing credit crunch and consumer wealth erosion will continue to constrain home demand in the short-term. Households are facing tighter credit conditions, higher lending standards and mortgage terms (such as higher credit scores requirements, income requirements and down payments) due to the credit crisis. All these factors along with mounting job losses, falling wage income, negative wealth effect from the stock market and rising saving rate will keep home demand subdued and will indeed increase mortgage default and foreclosures in the coming months. Foreclosures will continue to increase the stock of home supply leading home prices to overcorrect and preventing market clearing. This might push over 25 million homeowners into negative home equity creating a vicious circle of foreclosures and downward spiral in home prices, bank losses and consumer-led recession.

As stated above, we believe home prices are still overvalued based on the price/rent and price/income ratios. But we are concerned that the possible overcorrection in home prices and increase in the excess home supply will prolong the recession and the contraction in consumer spending. This calls for greater government intervention on the supply side of the market to close the excess supply gap. The government recently announced plans to buy MBSs to help reduce the interest rate on the 30-year mortgages and stimulate home demand. However, demand-side measures will be largely ineffective and insufficient to deal with the increasing foreclosures. Reducing mortgage rates and offering tax credits are a smaller factor in determining home demand relative to credit conditions and lending standards. Moreover, many potential buyers are reluctant to step into this market while expecting further prices correction.

Since 2007, the government has introduced several programs to modify loans: The Hope Now Program (Oct 2007), the Housing Retention Bill (Oct 2008), IndyMac loan modification by FDIC (2008), FDIC and Federal Housing Finance Agency (FHFA) program (Nov 2008). However, these programs have rather suffered from slow implementation and have ended up modifying a lesser number of mortgages than initially estimated and also relative to the total ‘at-risk’ mortgages. This is because the voluntary nature of most programs has restricted lender and borrower participation. Moreover, a large share of the modifications was carried out via interest rate reduction or maturity extension, rather than via principal reduction – therefore not solving the inherent problem of high debt/income ratio and insolvency of households. These factors, added to the increasing financial headwinds faced by households, have led to a default rate of up to 40-50% on the refinanced mortgages. Also, around 80% of the troubled loans have more than one lender or rather a pool of lenders with varying degrees of flexibility in loan modification – with any modification requiring consent by at least 60% of the lenders. Problems of securitization of mortgages and disagreements between first and second-liens, where a homeowner has two mortgages, have tended to restrict lender participation.

Recently, many banks including JPMorgan, Bank of America and Citigroup have begun to modify loans as they realize that the costs from foreclosure runs much higher than losses from loan modification, and also that inaction will only lengthen the housing crisis and bank losses. As a result, they have been targeting the “at-risk” groups: homeowners with high debt-income ratio in states most affected by the housing crisis and rising unemployment. However, loans modifications are still mostly being done via lowering of interest rates, replacement of ARMs with fixed-rate loans or by extending the maturity period – rather than by reducing the principal.

To make government intervention more effective, several proposals have been made recently. These include: Congressional intervention to allow bankruptcy judges to change mortgage terms and reduce the mortgage principal. The government should refinance the mortgage into a longer term mortgage at a low and fixed interest rate. The reduction of the mortgage principal can be based on the extent of decline in home prices in a given region. The new interest rate can be based on the 1.6% spread between the 30-year fixed rate mortgage and the 10-year Treasury bonds. Monthly payments can be “interest-only” payments for the first few years. This would help establish positive equity for the homeowner and fix the problem of insolvency thereby making the monthly payments more affordable and reducing the risk of default on refinanced mortgage.

To increase participation, the program would be mandatory for lenders. Government can also condition capital injection into banks and purchase MBSs on banks’ willingness to modify mortgages. Also to attract lenders, the government should share the cost of modifying the loan with the lender by matching the cut in principal or interest rate by a proportionate or less than proportionate amount. As an incentive, the lender will be entitled to a share in profit from home appreciation if the homeowner sells the house in the future. The refinanced mortgages will be a ‘full-recourse’ loan. Or the government can share any losses due to default by homeowners on the modified mortgage.

Estimates suggest that a program to help those with negative home equity currently will cost over $600 bn. However, as prices overcorrect, more homes fall into negative equity and defaults on the refinanced mortgages continue, the cost would exceed a trillion. But in order to reduce the fiscal costs, the government should be the senior debt holder of the modified mortgage. With an equity position, it can benefit from the future home appreciation.

The eligibility criteria to qualify for the government program will be stringent: The homeowner should have a high debt/income ratio, the current mortgage should have a high interest rate or a high outstanding principal relative to the current home value; or the homeowner should be facing legal action for mortgage default or foreclosure. The program should target first-time homeowners in regions/states that are witnessing the largest home price correction and foreclosure rate. Those unable to meet monthly payments due to interest rate re-sets or facing higher monthly payments due to the recession (credit constraint, unemployment, falling wage and asset incomes) can also be targeted.

However, homeowners who won’t be capable of servicing the monthly payments even after modifying the loans can be converted into tenants for the same house for a given period of time under an agreement with the lender. The lender would release the homeowner from the mortgage obligations and will require the homeowner to just pay the rent during the given time period. At the end of the period as the homeowner’s income position and financing options improve, he will have the option to re-acquire the house from the lender at the then market value of the house, or even take a new mortgage to finance the house based his ability to pay. Hence, rather than forcing foreclosure on homeowners who fail to qualify for the government program, this alternative will prevent further foreclosures and excess home supply in the market. Moreover, it offers at least some cash flow for the lenders and avoids any fiscal risk for the government.

Monetary Policy

The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate to 0-0.25% (essentially ZIRP) but, more importantly, it has created swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen. Since the problems of the private sector – households, financial institutions and corporate firms – are most of insolvency (excessive debt) monetary policy and liquidity support – even of a non-traditional form cannot resolve fundamental credit issues that require debt restructuring and reduction.

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