2009 Economic Outlook: Assessing Public Policy and the Loss of Wealth

Summary

• World trade and industrial production declined severely in the first quarter.
• Most economists are looking for recovery in the year’s second half. 
• Public policy, commodity prices, and consumer spending are all required for the recovery to gain traction.
• We are cautiously optimistic, noting that risks to recovery remain considerable. 
• Global economies lag the U.S., as they remain dependent on U.S. demand.

Despite an encouraging start to the first quarter amid expectations for forceful new government policy measures, many subsequent developments have proven disappointing. Late 2008 rallies in equity and fixed-income markets continued into early January 2009 before stalling and eventually reversing. Several key policy initiatives, such as the Treasury Department’s plans to create public-private investment funds, were slow to develop. Globally, economic data released during the quarter revealed a staggering decline in world trade and industrial production.

On a positive note, there were a few encouraging signs amid the generally poor economic data. Retail sales exceeded consensus expectations in both January and February, despite weak car sales. Consumption data also stabilized, showing that consumer spending has increased from the fourth quarter of last year. In the financial sector, several large banks indicated that profitability in their core businesses was improving. These reports should be regarded carefully, especially as further write-downs are inevitable and unsubstantiated statements from bank officials remain suspect. However, it stands to reason that banking profitability will gradually improve with the help of central bank measures to reduce funding costs.

Additionally, the indecision displayed at times by policymakers did not prevent a series of stimulus measures from being enacted:

1) The Federal Reserve began purchasing mortgage-backed securities and federal agency debt in early January and later expanded this program in both size and scope, announcing plans to purchase $300 billion in long-dated Treasury securities.

2) A fiscal stimulus package estimated at $787 billion was signed into law on February 17.

3) The Federal Reserve began to fund new issues in the asset-backed securities market through its Term Asset-Backed Securities Loan Facility (TALF), which was launched in the third week of March.

4) Through February and March, the Treasury Department outlined several features of its financial stability plan, including its Capital Assistance Program (CAP) for large banks, its mortgage loan modification plan, and its Public-Private Investment Program.

These measures have met with a mix of support and criticism. The effects of the TALF and the financial stability plan are especially uncertain, since their successful implementation relies on private market participants. Nonetheless, as policy announcements accumulated during the quarter and more details became available, markets eventually responded positively. In the latter half of March, equity and fixed-income markets recovered a portion of their earlier losses.

Most economists continue to expect a recovery in the latter half of the year, although the forecasted strength of the recovery has been downgraded. According to the consensus view, third-quarter growth will be a slightly positive 0.4% annualized, while fourth-quarter growth is expected to reach 1.6% annualized.¹

Our View

We expect the economy to contract through at least the first half of the year as severe business retrenchment offsets modest growth in consumer spending. Consumer spending will be lifted by the tax cuts and transfer payments contained in the fiscal stimulus package, which are likely to have their greatest effect in the second quarter and early third quarter. Falling mortgage rates will also help, as borrowers reduce their payment obligations through refinancing. Consumption growth in the first half of the year will create a better environment for business spending in the second half of the year. Furthermore, the stimulus provided by the government spending component of the fiscal package will build gradually through the year. Our central outlook calls for positive growth by the fourth quarter.

The risks to our outlook remain high, especially as business and consumer confidence have yet to improve meaningfully. There are a number of developments that could prolong the recession into 2010, including delays or failures of key policy initiatives, adverse commodity price trends, or further increases in the savings rate. Below we consider conditions for a late 2009 recovery.

Conditions for Recovery

#1: Public policies must gain traction and promote risk-taking.

Federal Reserve Chairman Bernanke recently cited a potential lack of political will as the greatest threat to an economic recovery. Based on the policy twists and turns of the past several quarters, it has become more apparent that political measures must also meet the tests of clarity and collaboration. Clear policies are needed to reduce uncertainty, as uncertainty can delay investments and prevent the risk-taking that keeps the economy growing. Collaboration is important to ensure that government initiatives are not disconnected from market realities.

Our analysis suggests that recent policy actions have affected the economy both positively and negatively. As noted above, we expect the fiscal stimulus package to help fuel economic growth for the balance of this year and much of 2010. The Fed’s quantitative easing policy should reduce the “crowding out” effects of additional government debt issuance, which could otherwise push up interest rates and render fiscal measures ineffective. Actions to prop up institutions that are “too big to fail” have prevented widespread banking failures that would almost certainly have occurred without government intervention.

The effects of other measures are less clear, especially those that require private market acceptance. Policies targeted towards the financial sector, such as the Treasury Department’s financial stability plan, have yet to restore normal functioning and liquidity in key markets. Market participants have cited flaws in policy details, while delays in the release of other details have contributed to the uncertainty that has roiled the markets. Although it is difficult to quantify the effects of uncertainty, anecdotal evidence suggests that businesses and consumers have delayed spending and shunned risk-taking, choosing instead to wait until they know the parameters of the government’s new programs.

Another worrisome development is an increasingly political atmosphere that has threatened the private sector’s participation in key programs. Threats of strict oversight of emergency funding recipients, including congressional efforts to tax bonus payments retroactively, have led to a degree of distrust as well as questions about the government’s support of free and competitive markets. Many large banks are developing plans to return bail-out capital earlier than expected on the basis that government interference is hindering their ability to compete.

Considering the stakes at hand, we expect the public and private sectors to work together more effectively as the year progresses. Further establishment of President Obama’s administration should help. Time and experience should also contribute to a stronger policy mix, as officials such as Treasury Secretary Geithner address the flaws that have been identified in critical initiatives. Nonetheless, our outlook for a late 2009 recovery is conditioned on further progress towards clear policies with strong private market support.

#2: Commodity Prices Need to Remain Subdued.

Without sharply falling commodity prices in the third and fourth quarters of 2008, real consumer spending probably would not have stabilized as it did. Commodity price declines allowed consumers to purchase more goods without increasing their dollar expenditures, mitigating an increase in household savings. Real wages grew at a stellar 23% annualized rate in the fourth quarter of the year.

Since December, however, the decline in commodity prices has stalled. In January and February, real wages fell at an annualized 2.1% rate as inflation picked up. While two months do not make a trend, commodity price developments bear watching. Should rising commodity prices continue to lift consumer price inflation above wage inflation due to supply/demand imbalances, geopolitical risks, or other factors, the benefits of tax reductions could prove short-lived.

#3: Consumers Need to Tap Rainy-Day Savings.

National accounts data suggest that the economy’s deterioration can be largely attributed to a change in consumer behavior. Consider that disposable personal income, adjusted for inflation, increased at a respectable 1.7% annual rate from the official start of the recession in December 2007 until February 2009. Over the same period, real consumer spending fell at a 1.2% annual rate. The disparity between disposable income and consumption is explained by an increase in the personal savings rate, which grew from 0.4% in December 2007 to 4.2% in February 2009. On a year-to-year basis, the increase is the largest since the Korean War. It has reduced consumer spending directly and business spending indirectly, as companies have been forced to adjust production schedules and investment plans for unexpectedly low consumer demand.

The savings rate, highlighted in Exhibit 1 on the following page, is now a few percentage points below its post-war average of about 7%. Its direction for the balance of the year could determine whether the economy recovers in late 2009 or continues to contract. The pessimistic view is that savings rates will continue to increase as consumers react to falling wealth. While this view may prove correct, our central outlook is premised on the correction in consumer behavior being nearly complete.

We expect the savings rate for 2009 to remain below its 7% long-term average. There are several factors underlying our outlook:

1. Setting aside cyclical factors, the current savings rate should be low relative to historical levels because of the way that pensions are classified. Pension contributions are recorded as income, while pension distributions are excluded from income. When pensioners spend their distributions, they are assumed to be drawing down wealth. Therefore, the secular decline in the savings rate over the past 25 years is explained partly by an increasing number of pensioners drawing on a larger pool of pension assets than existed in the early 1980s. 
2. The growing unemployed portion of the labor force can also be expected to spend more than their income, since they will be forced to draw down wealth to cover basic living expenses. Consider that the savings rate fell from 3.8% in 1929 to -0.5% in 1932 in the depths of the Great Depression when unemployment soared to nearly 30%. 
3. Consumers have already increased their savings at an extreme pace unmatched in the post-war period. If confidence improves later in the year, then pent-up demand could limit further growth in savings or even reverse a portion of the recent increase. Some reversal of the jump in savings would be consistent with the historical pattern of mean reversion around a slowly moving long-term trend.

Exhibit 1: Personal Savings as a Percentage of Disposable Personal Income

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Source: Bureau of Economic Analysis

Perhaps the greatest challenge in forecasting the savings rate is gauging the effects of declining wealth. With few clear precedents for simultaneous and severe busts in real estate, equity, and credit markets, it is difficult to assess the implications for consumer behavior. However, by contrasting wealth levels with other economic indicators, we can put the downturn in perspective while highlighting a few guideposts for recovery.

Alternative Perspectives on Wealth

Consider first the growth of household net worth in relation to inflation and population, as shown in Exhibit 2 on the following page. The figure shows that wealth has increased over time as real net worth per capita has grown. Furthermore, the long-term growth rate remains intact. Net worth has fallen within the upwards-trending range but not below it. From this observation, we conclude that volatile asset prices have not prevented a steady increase in wealth, nor has the common perception of the U.S. as a nation of spenders, not savers.

Exhibit 2: Households and Nonprofit Organizations Net Worth Per Capita

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Source: U.S. Federal Reserve, Bureau of Economic Analysis, SEI

Exhibit 3 tracks the ratio of household net worth to disposable personal income. It shows that net worth fluctuated between 400% and 500% of disposable personal income until the late 1990s. As of the end of 2008, the ratio was in the upper half of that range. The implication is that the current level of net worth is not unusual by long-term historical standards, despite the sharp drop in the last 18 months. Past economic recoveries have occurred with net worth at similar or lower multiples of disposable personal income.

Exhibit 3: Household and Nonprofit Organization Net Worth

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Source: U.S. Federal Reserve, Bureau of Economic Analysis, SEI

In addition, the last expansion showed that the economy can recover even as net worth falls. That expansion began in November 2001, nearly a year before net worth stopped dropping in relation to disposable personal income. Because of the similarities in the level of net worth and the pace of decline, the 2000-02 period could be the best guide to the effects of falling wealth in today’s economy. The potential for economic recovery despite falling wealth is reinforced by a recent International Monetary Fund (IMF) study that considered all recessions in developed countries since 1960². Among its conclusions, the study found that economic recoveries tend to occur several years before house prices reach a nadir.

While analysis suggests that recovery is possible despite falling wealth, economic developments will be influenced as much by future wealth changes as by the past changes captured in Exhibits 2 and 3. Home prices, in particular, will likely drop further judging by inventory levels, which, as Exhibit 4 shows, remain high in relation to sales.

Exhibit 4: Month’s Supply of Unsold New Homes

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Source: U.S. Census Bureau

However, we are increasingly seeing indications that the housing bust is reaching its late stages. Consider the steady reduction in new-home sales since the sales peak in July, 2005, as shown in Exhibit 5.

Exhibit 5: New-Home Sales

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Source: U.S. Census Bureau

If we extrapolate the rate of decline by just one more year, new-home sales would reach zero by the first quarter of next year. In other words, the data shows that the rate of decline is guaranteed to lessen at some point in the next 12 months, since there is no such thing as a negative home sale. As home sales stabilize, the inventory ratio in Exhibit 4 will gradually return to more typical historic levels. Recent increases in home sales and prices in some of the nation’s harder-hit markets, including areas of California and Arizona, provide further evidence that housing markets are gradually improving.

Economic Challenges in the Next Expansion

Although the current fiscal and monetary policy mix should help the economy recover from recession, the dramatic increase in government spending creates significant risks for the next expansion. Stimulative fiscal policies will need to be removed as the government deficit balloons. Likewise, the Federal Reserve’s quantitative and credit easing policies eventually will need to be reversed as they become inconsistent with a growing economy.

Our analysis suggests that the next expansion will likely be choppy at best, and could be short-lived at worst. We are especially concerned about the future tax hikes and/or spending cuts that will be required to slow the growth in government debt. Tax hikes included in President Obama’s proposed 2011 budget, together with the expiration of measures in February’s fiscal package, could be enough to tip the economy back into recession after a short recovery.

In addition to the risks of a saw-toothed recovery, stimulus measures have also increased inflation risks. However, in our view, inflation risks remain secondary to the deflation threat. For inflation to supplant deflation as the principal threat to price stability, we believe excess capacity would need to be removed. Capacity measures such as unemployment rates, capacity utilization, and output gaps have approached or exceeded historical extremes and continue to increase. Normalization of these measures will require a period of several years during which economic growth is significantly faster than the potential long-term trend. Should this above-trend growth scenario occur, policymakers would be faced with a difficult balancing act between managing inflation risks and sustaining a recovery.

While the long-term outlook may be fraught with risks, we do not believe that the future is as gloomy as the post-bust periods of the Great Depression or the Japanese Lost Decade might imply. In an upcoming report we will compare and contrast today’s economic and financial setting against those two earlier periods. For now, we will simply point out that the policy response to the current crisis has been a forceful one, and tentative signs of recovery in the U.S. and elsewhere have begun to accumulate.

Global Economies Remain Dependent on U.S. Demand

Prior to the onset of recession, many analysts suggested that weak U.S. demand would be offset by strong growth in other regions. Asian domestic demand, in particular, was expected to counteract U.S. weakness and fuel the global economy. In hindsight, this hypothesis could not have been farther from the truth. Consumer spending slumps in countries that experienced housing booms and low savings rates, such as the U.S. and U.K., have led to a sharp contraction in production and growth in countries with high savings, such as Japan and Germany. Globalization appears to have bound together the world’s economies as tightly as ever.

However, while the global economy has contracted, there are important differences from one country to the next. Below, we contrast countries according to the excesses that developed prior to recession, the sensitivity of the local economy to global demand, and the policy response to recession.

Excesses Prior to Recession: Who partied the hardest?

As suggested by two recent studies by the IMF³ linking severe recessions to declining home prices and financial distress, excesses in the housing and financial sectors can be especially painful to correct. The premise is that the countries that demonstrated the greatest excesses prior to the recession will have particular challenges in engineering a sustainable recovery. Of the six countries considered, the U.S. is joined by the U.K. as the countries for which imbalances had developed in housing markets, financial markets, banks, and consumer debt. Japan and Germany appear to have experienced fewer excesses leading into the global recession, while Canada and France fall somewhere in between.

Sensitivity to Global Demand: Who provided the party supplies?

Despite the challenges of working through the excesses, these factors did not determine relative economic performance in 2008. Rather, the depth of recession up until early 2009 appears to have been determined by the degree of dependence on the most volatile economic activities, namely manufacturing, business investment spending, and exports. The most extreme contractions in economic activity have been concentrated in Asia. As shown by the growth rates in Exhibit 6, countries that experienced the deepest contractions in 2008 included Japan (-4.3%), Hong Kong (-2.4%), and South Korea (-3.4%). Each of these countries is highly sensitive to global demand due to reliance on manufacturing, business investment spending, and exports. Within Europe, Germany has been among the weakest economies, based partly on the fact that exports constitute more than 50% of total economic output.

Exhibit 6: 2008 Output Growth for the 16 Largest Economies

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Policy responses: Who is spending the most on the clean-up?

The policies adopted to combat recession are perhaps the best guide to which economies will recover earliest. The U.K. is notable in this regard. The U.K. government has implemented aggressive fiscal stimuli and its central bank began purchasing government debt in early March. Its business sector has been assisted by sharp currency declines against virtually all of its major trading partners, which have made UK goods more competitive. Its consumer sector is benefiting from the prevalence of adjustable-rate mortgages, which have become less expensive as short-term policy rates have fallen to close to zero.

Compared to the U.S. and U.K., the policy response in the Eurozone and Japan has been weaker. Monetary policy changes in the Eurozone have been limited by the European Central Bank’s concerns about money supply growth and inflation, while fiscal stimulus has been constrained by the European Union’s Stability and Growth Pact. Japan appears to have less room for policy stimulus because of the policies pursued over the past 15-20 years. Leading into the recession, official interest rates in Japan were already below 1%, while high government debt levels imply considerable risks to a looser fiscal stance.

China stands out for its continued growth, although its annual growth rate fell considerably from 11.2% in 2007 to 6.8% in 2008. The Chinese economy has benefited from a variety of official actions to support lending and investment, which have leveraged the vast resources China has accumulated as one of the world’s largest exporters.

Conclusions

First quarter economic data confirms that the global recession is the worst since the Great Depression. In response, policy makers have reacted much more forcefully than in past recessions. According to our central outlook, unprecedented amounts of monetary and fiscal stimulus should promote recovery in most countries within the next 6-12 months. However, the cost of the stimulus is that the next expansion will be difficult to sustain.

The U.S. and U.K. are especially well-placed for an earlier recovery, fueled by aggressive policy measures coupled with consumption growth and some improvement in housing markets. Economies that have contracted more severely, such as Japan and other exporting economies in the Asian bloc, have the potential for a stronger recovery as global demand stabilizes.

There are a variety of risks that could lengthen the global downturn beyond a 6-12 month time frame, including those specific to the U.S. as well as those risks specific to other countries and regions. The global nature of the recession leaves no doubt that further difficulties in any one region can have a strong effect on the rest of the world. The world’s economies are bound together not only through trade and investment links, but also by contagion, which can transfer confidence crises across national borders while impacting capital markets globally.

Of the regional risks, developments in China and the Eurozone merit particular attention. Although data shows that the Chinese economy is growing, policymakers are struggling with a unique set of challenges including over-investment, weak domestic consumption, and high sensitivity to the sharp downturn in global trade. The Eurozone is especially vulnerable to the poor financial situation in Eastern Europe. Hungary, Poland, and the Czech Republic are among emerging Eastern European economies that are at risk of further de-stabilization due to current account deficits and reliance on foreign capital, the same factors that devastated the Asian region in the late 1990s.

Market Implications

Equity fundamentals should improve in the latter half of the year with a stronger economy. However, as long as confidence remains shaky and the health of global banks uncertain, risks are unusually high. Furthermore, an economic recovery fueled by policy stimulus may be less bullish for equities than a recovery that doesn’t require such extreme measures, since the stimulus will eventually need to be removed.

On balance, we don’t expect equity markets to climb a wall of worry without setbacks. We plan to maintain a neutral equity weight, while continuing to monitor developments for indications of a better environment for risky assets. Equity markets remain mired in a vicious circle of declining earnings and tight conditions in the credit markets. We will not move to an overweight equity position until we see evidence of improving earnings and credit fundamentals and some mitigation of the economic risks.

Our analysis suggests that return/risk opportunities are more favorable in the credit markets. Judging by current credit spreads, many areas of the credit markets appear to be anticipating default losses not seen since the Great Depression. Default losses will certainly rise as the global recession continues. However, we believe that default risk is amply compensated by the spreads currently offered by high yield bonds, investment-grade corporate bonds, mortgage-backed bonds, and other structured securities.

Emerging market debt is a notable exception. The market for tradable emerging market debt, which was created in 1989 by then-Treasury Secretary Nicholas Brady’s plan to restructure defaulted bank loans, has never been tested in a global recession as severe as the current recession. With spreads for the emerging market bond index currently tighter than most U.S. corporate bonds rated BBB or below, we believe that relative value favors the corporate and high yield markets in the U.S.

¹According to a March 9, 2009 survey conducted by Consensus Forecasts, Inc.
²Claessens, Stijn,M., Ayhan Kose, and Marco E. Terrones, 2008, “What Happens During Recessions, Crunches and Busts?,” IMF Working Paper 08/274. (Washington: International Monetary Fund).
³Claessens, Stijn,M., Ayhan Kose, and Marco E. Terrones, 2008. Also Cardarelli, Roberto, Selim Elekdag, and Subir Lall, 2008, “Financial Stress and Economic Downturns,” IMF World Economic Outlook, October, 129-158. (Washington: International Monetary Fund).

This material is provided by SEI Investments Management Corp. for educational purposes only and is not meant to be investment advice. The reader should consult with his/her financial advisor for more information.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

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