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United States Playing the Double-Dip Recovery United States Review and Preview View GEF Archive

		The Global Economics Team

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Source: Morgan Stanley Research    E = Morgan Stanley Research Estimates

Recession has arrived, in our view, heralded by intensifying weakness in incoming data, and the economy faces a rocky road ahead.  In the current quarter, we see GDP running at -0.7% — about the same as in the forecast we published last month.  Another outright decline in activity is expected in Q2. But the policy cavalry has arrived and reinforcements are coming, in the form of the aggressive monetary and fiscal stimulus put in place or announced in the past fortnight.  Consequently, we’ve raised our US growth forecasts.  We think that the price of risky assets already includes a significant chance of recession, so it’s time to look ahead to recovery.  The questions now are what will it look like and how to play it. 

The key feature of the coming recovery will be its seesaw pattern, primarily because the coming fiscal boost will not sustainably prime the economic pump.  It will give a strong summer boost to growth from tax rebates, but that will fizzle in the fall, and the payback in early 2009 likely will cast doubt on the rebound.  The fluctuations in growth — starting with the spring quarter of 2008 we expect -0.9%, 4.5%, 2.3% and 1.3% respectively — may offer challenges and risks for investors and policymakers alike.

We’ve revised our baseline forecast for US growth higher; we now see 2008 real growth at 1.3%, compared with 1.1% a month ago; over the four quarters of the year, the revision is more pronounced, from 0.5% to 1.3%.  However, growth over the four quarters of 2009 likely will be half a point weaker than we thought a month ago, at 3.2% vs. 3.6%.  Our prognosis for either core or headline inflation over the four quarters of this year is little different from before at 1.9% and 2.2%, respectively. 

But beneath that new baseline scenario, there are three sources of downside risk.  There is still a valley of economic weakness of uncertain depth and duration to cross, as the forces that have dragged the economy down — housing imbalances, tighter financial conditions, and the spillovers from them to other parts of the economy — are far from spent.  Second, we can’t rule out further financial shocks.  Third, support for US output from the strength of overseas demand may already be starting to fade.  Emerging markets may decouple from the US slump, but we think the spillovers from the US downturn to the industrial economies and their own homegrown headwinds to growth will sap the vigor of that external prop. 

Despite those considerable headwinds, we see the glass half full: In our view, it is early days, but investors and policymakers should look through the coming erratic pattern of growth to a more sustainable, stronger 2009.  The investment and policy focus may eventually return to inflation rather than growth.  It’s not too soon to prepare for that shift.  Here’s why. 

There’s no mistaking the weakness in incoming data.  We think they confirm that recession arrived late in 2007 or last month, as evidence of tighter financial conditions continues to take its toll on housing and consumer spending.  The drop in new, 1-family home sales to a 12-year low in December and record-high inventories of unsold homes signal that the trough in housing activity is still off in the future.  Tighter lending standards have so far negated the effects of lower rates and lower home prices on affordability, and buyers may stand aside until prices stabilize.  Thus, the key to future stability in home prices depends on a further aggressive supply response from homebuilders.  Although they have cut one-family starts in December by 57% from their peak two years ago, we think they must slash activity by a further 35-40% to reduce inventories and realign supply with demand. 

For consumers — already under pressure from slipping home prices, higher rate resets on adjustable-rate mortgages, tighter lending standards for non-mortgage borrowing, and little relief from surging food and energy quotes — the worst is yet to come.  Real consumer spending was flat in December, and, with vehicle sales dropping to a 15.2 million annual rate, a level last seen in the immediate aftermath of Hurricane Katrina, such outlays probably contracted in January. 

Most important, the economic slowdown is finally weakening job and hours growth, thus undermining gains in consumer income and spending.  Nonfarm payrolls contracted in January for the first time since September 2003 (assuming that the preliminary figure is not subsequently revised into positive territory), and private hours worked have declined by ¾% annualized over the past three months.  The weakness was widespread in January, and the dip in the diffusion index of payroll change on a three-month basis to just above 50% aligns precisely with its position as the 2001 recession began.  Correspondingly, we estimate that real “core” wage and salary income contracted over the past three months, and with slack in labor markets increasing, wage rates are likely to decelerate further, eroding prospects for income growth.  Indeed, the disappointing motor vehicle sales in January could be an early reflection of the moderation in income growth.

A partial offset is coming: Lower mortgage rates are triggering a refinancing boom, freeing up discretionary income and providing partial relief from the slowing in income growth.  The Mortgage Bankers’ Association (MBA) refinancing applications index has more than doubled in the past four weeks. In the current environment of tightened lending standards, we suspect that this gauge is being distorted by multiple applications. Still, with rates for 30-year fixed rate conforming mortgages hovering in the 5.25% to 5.50% range and with 15-year fixed rate products a tad below 5%, there is clear potential for a significant wave of refinancing activity.  However, it’s worth noting that even with some upside bias from multiple applications, the level of the refi index is still only half that attained during 2003  the mother of all refi booms.  Then, the Fed estimated that refis reduced mortgage interest payments by $31 billion or 0.4% of disposable income.  To realize an equivalent decline in mortgage interest payments would require refinancing a third of mortgage debt at rates 100 bp lower than those currently carried.  Since conforming mortgages account for about 55% of all mortgage debt outstanding, and we estimate that less than half of these are currently carrying rates above 6.25%, it will be a bit of a stretch to reach the 2003 threshold absent a further leg down in rates.

To be sure, a proposed temporary hike in the Conforming Loan Limit (CLL) to as much as $729,750 may enable some consumers to refinance mortgages larger than the conforming limit of $417,000 on attractive terms. However, declining home prices in many areas will limit the scope and magnitude of any refi boom; by comparison, in 2003 home prices were rising.  To refinance in the current environment, some lenders will require already stretched borrowers to add equity. 

Against this backdrop, we assume that Congress will quickly enact a fiscal stimulus package aimed at priming the economic pump.  The total size at $150 billion-plus may be slightly smaller than we assumed a week ago (see “Upping the Ante on Stimulus,” Investment Perspectives, January 31, 2008).  But its essential features — tax rebates and business investment incentives — will add significant short-term stimulus to growth, amounting to more than 1% of GDP.  The IRS is expected to mail more than $100 billion in tax rebates to consumers, including many who paid no tax, no later than early summer.  Businesses will likely get about $47 billion in two investment tax breaks — an additional 50% “bonus” depreciation allowance for investments in capital assets and full expensing of $250,000 in both new and used tangible property in the year of purchase up to an overall investment limit of $750,000.  The package may also include funding for extended unemployment insurance, and some grants to state and local governments.

The result will be large swings in both income and spending that will obscure their underlying pattern.  We assume that consumers will spend 40 cents of each rebate dollar spread across the third and fourth quarters of 2008, adding roughly three percentage points to consumer spending in those quarters.  Our presumption that the structure of the rebates skews their impact toward lower-income recipients will give the plan temporary traction. 

However, four factors imply that the follow-on or “multiplier” effects from this stimulus on the overall economy will be small.  First, unlike in 2001, there is no permanent tax reduction, so there may be a bulge in spending in 2H08 followed by payback in 1H09.  In addition, imports and inventories will satisfy some of the pickup in demand, so it will not translate completely into output.  Third, firms aware of the transitory nature of the stimulus probably won’t step up hiring much to satisfy new demand.  Finally, proposed business investment tax incentives may bring forward some spending but will not permanently boost it.  Indeed, the “use-it-or-lose-it” nature of the business incentives increases their short-term influence, but leads to payback when they expire.  And firms that have no tax liability won’t benefit from either the bonus depreciation or expensing features of this provision.  Profits taxes probably will decline, as we expect that declining operating leverage and deteriorating credit quality will promote a contraction in earnings for both non-financial and financial companies. 

Although the Fed has eased aggressively and fiscal help is coming, risk management tactics suggest that officials will take out another 50 bp of recession insurance at their meetings in the spring, bringing the Federal funds rate to 2½%.  In our view, the uncertain outlook, economic slack, and easing inflation will give the Fed the latitude to keep rates low for much of the year.  Officials are unlikely to reverse course at the first sign of recovery, nor will they take back accommodation as forcefully as they provided it.  But the combination of improving fundamentals for growth and a gradual pickup in inflation in 2009 will warrant a proactive reversal in policy — one that should bring the funds rate back over 4% by midyear.  And while policymakers likely will look through much of the volatility in the pattern of growth, we can’t rule out a bumpy path to higher interest rates.

For their part, investors still face as many hurdles as the Fed, and the tension between current weakness and expectations for improvement may dominate market sentiment.  We expect fundamentals in housing and financials will atypically lag a recovery in the rest of the economy.  Despite a better economic outlook, earnings still seem likely to decline this year.  Credit quality is only beginning to deteriorate outside of mortgages.  All reasons to be cautious about risky assets.  But our strategists believe that there is a lot of bad news in the price of risky assets, and bear market rallies seem likely.  In fixed income, however, another bear lurks, namely the bear steepening trade that is the product of an aggressive policy mix.  Longer yields are likely to rise as investors price in recovery and a return of inflation.  More Treasury supply could add to the pressure; we expect that with the fiscal stimulus plan, the FY2008 Federal deficit will rise to $400 billion (see “Budget and Financing Outlook — The Check is in the Mail,” January 24, 2008).  If, contrary to our assumptions, the Fed keeps rates lower for longer, that trade will get increasing traction.

United States
Review and Preview
February 04, 2008

By Ted Wieseman/David Greenlaw | New York

The Treasury curve steepened to another new high since late 2004 over the past week on good front-end gains and modest back-end losses. It was another volatile week that resulted in these relatively muted net changes, as the Fed acquiesced to market demands for a more aggressive 50bp rate cut to 3.00% on top of the 75bp inter-meeting move just a week earlier, views on the financial stability of the bond insurers swung around quite a bit, and the key employment report was significantly weaker than expected, with payrolls posting their first decline in four-and-a-half years. A downside surprise in GDP growth in the fourth quarter left the economy already close to recession as 2007 ended, and even though a bigger-than-expected inventory correction in 4Q07 suggested some potential support for output in 1Q08, we continue to see first half growth on track for a modest contraction. Certainly the disappointing employment report suggested that the slowdown is intensifying early this year. With the aggressive front-loading of monetary policy stimulus, substantial fiscal stimulus on the way, and the recent moderation in energy prices, we continue to expect a good cyclical recovery starting later this year and continuing into 2009 after the first half recession, likely prompting a much quicker and more aggressive reversal by the Fed than the market currently anticipates. We had thought that the Fed might take advantage of the stability in markets since its 75bp inter-meeting move to slow the pace of easing and only cut 25bp the past week, but fears of disappointing market expectations in the current fragile environment probably played a role in it choosing the larger action. Fed officials tried to rein in expectations of similarly aggressive moves going forward in the policy statement, but failed. Indeed, at this point there appears to be simply no way for the FOMC to satisfy the market, and at some point policymakers will have to stop following market demands for ever more aggressive action. No sooner had they finished chopping the funds target 125bp in eight days than markets were moving to price in a risk of another inter-meeting cut this month, and if not inter-meeting then still the likelihood of another 50bp rate cut by the March FOMC meeting and then another 25bp to a 2.25% trough by the June meeting, with a decent chance of a further move to 2% seen beyond that. We continue to look for a 2.50% funds rate trough this spring, which would leave the real funds rate close to 0% versus core inflation — more than enough stimulus for the relatively mild recession we expect, particularly with big support from fiscal policy also on the way.

On the week, 2s-10s steepened another 14bp to 151.5bp and 2s-30s 15bp to 223bp, highs since the fall of 2004. These spreads have now steepened every week this year for cumulative moves of 55bp and 84bp, respectively, since the close on December 31. In the latest week, the 2-year yield fell 11bp to 2.085% and the 5-year 4bp to 2.75%, while the 10-year yield rose 2bp to 3.60% and the 30-year 4bp to 4.32%. TIPS had a strong week, with the benchmark 5-year and 10-year inflation breakevens each rising 5bp to 2.17% and 2.29%. While stock market investors were feeling renewed optimism, bond market investors, both in rates and credit, remained a lot more cautious. There was a huge disconnect between a 5% rally in the S&P 500 on the week and slight deterioration in credit, with the 5-year HiVol CDX index trading 4bp wider on the week at 247bp late Friday and the broader investment grade index flat at 106bp. The high yield index was also trading a bit worse on the week, and the leveraged loan LCDX index did particularly badly, widening 37bp on the week to a new high of 455bp. Certainly the Treasury market resilience that was more in line with the performance of credit in the face of the week’s major stock market strength was a big shift from recent patterns, and the nervousness in the Treasury market was even more apparent in the continued heavy demand for cash. The four-week bill’s bond equivalent yield fell another 26bp on the week to just 1.82%, and the overnight Treasury general collateral repo rate moved from an already low 2.63% average at the end of the prior week to as low as 1.50% Thursday before moderating to 2.05% Friday.

No sooner had the Fed met the market’s demands for yet another 50bp rate cut on top of its 75bp cut a week earlier, then investors were demanding another big cut at the next meeting, if not sooner. The February fed funds contract rallied 12.5bp on the week, not just fully incorporating the 50bp at the FOMC meeting to 3%, but building in a chance of another inter-meeting move. The April contract gained 22bp to 2.575%, pricing in a likelihood of a 50bp cut by the March FOMC meeting, while the July contract gained 17bp to 2.225%. The trough funds target is still seen at 2.25%, but it is now expected to come earlier and a decent chance is seen of another move to 2% later in the summer. There was some steepening in medium-term eurodollar futures curves, but with so much front-loaded monetary policy easing already having occurred, with a lot more expected and big fiscal stimulus coming mid-year, we continue to be surprised by how low the market expects rates to stay over the next couple of years. There is only a 51bp spread between the low-rate Sep 08 eurodollar futures contract at 2.475% and the Sep 09 contract at 2.985%.

With the Dec 09 contract ending the week at 3.155% and Dec 10 at 3.78%, the market sees the fed funds target reaching no higher than 3% at the end of 2009 and 3.75% at the end of 2010. We think that once recovery takes hold later this year and into next, the Fed will reverse its easing much quicker and more substantially than the market is anticipating.

Non-farm payrolls fell 18,000 in January, the first decline since September 2003. Weakness was widespread, with drops in construction, manufacturing, wholesale trade, transportation, information, finance, business services and government, though the last of these may have been a seasonal adjustment quirk. Other details of the report were more mixed. On the positive side, the unemployment rate dipped a tenth to 4.9% on a sharp rebound in the volatile household survey employment measure. Looked at over a longer period, however, the year-on-year growth in payrolls (+0.7%) and household employment adjusted for definitional differences with the establishment count (+0.6%) were very close.

Meanwhile, more in line with the weakness in payrolls in January, the average workweek fell a tenth to 33.7 hours, causing total hours worked to drop 0.3%. Combined with a sluggish 0.2% gain in average hourly earnings, this left aggregate payrolls, a proxy for total wage and salary income, unchanged on the month.

In contrast to the weak employment report, the manufacturing ISM was better than expected. The composite diffusion index rose 2.3 points in January to 50.7, just above the 50 breakeven. A 6.6-point jump in the production index to 55.2 explained most of the improvement. The orders index (49.5 versus 46.9) improved, but to a level still pointing to declining bookings. Employment (47.1 versus 48.7) continued to deteriorate.

Despite the improvement in the composite index, the industry breakdown remained weak, with only 8 of 18 sectors reporting growth. The export orders jumped to a robust 58.5, fully reversing a big drop last month.

We look for continued solid export performance to help keep the unfolding recession mild and also help the factory sector hold up much better in this recession than normal.

Rounding out the early January data, based on a nearly complete count, we estimate that motor vehicle sales tumbled to a 15.2 million unit annual rate, a more than two-year low and down from 16.2 million in December and November. We estimate that sales of domestically produced vehicles fell to 11.6 million from 12.5 million, a low since June 2005, and imports dipped to 3.6 million from 3.8 million. Real consumer spending was flat in December, and January is starting off looking weak as well, based on these results.

The overall soft start to 2008 portrayed by the employment, ISM and motor vehicle sales reports for January followed a surprisingly weak end to 2007. Real GDP growth slowed to +0.6% in 4Q, resulting for growth for all of 2007 of +2.5% on 4Q/4Q basis, a low since 2002. Downside relative to expectations in 4Q was a result of a much larger-than-expected drag from inventories (-1.25pp). Final sales gained 1.9%, boosted by another solid contribution from net exports (+0.4pp). Final domestic demand growth decelerated to +1.4%, as residential investment (-23.9%) remained a huge drag, and growth in consumption (+2.0%), business investment (+7.5%, with equipment and software up 3.8% and structures 15.8%) and government spending (+2.6%) all slowed. The overall GDP price index accelerated to +2.6% as energy prices jumped, while the core PCE price index rose 2.7%, a six-quarter high.

Subsequently released construction spending numbers for December were worse than the BEA assumed in preparing this advance estimate, pointing already to a downward revision to +0.5%. The BEA also made some very high assumptions for December inventories, so the inventory drag in 4Q could wind up being even larger. With these figures and a number of other missing numbers that the BEA had to plug in assumptions for to be released over the next month, a negative GDP print as early as 4Q is certainly a possibility. Looking to 1Q, while the much bigger-than-expected inventory drawdown in the fourth quarter will provide some support early this year, we continue to see the first quarter on track for a modest contraction. We look for a further sharp slowdown in consumer spending growth, little change in business investment, another plunge in residential investment and further moderation in government spending as state and local government budgets come under increasing pressure.

After the action-packed past week, the upcoming week has little in the way of significant economic news. The most important releases will be the monthly chain store reports for January from most major companies on Thursday. Our retail team is expecting generally lackluster results to go with the weak auto sales, which would point to another soft retail sales report and leave our forecast for minimal growth in 1Q consumer spending on track. Supply will be a focus mid-week, with the US$13 billion 10-year auction Wednesday and US$9 billion 30-year auction Thursday. In addition to chain store sales, other data releases due out include factory orders Monday and productivity Thursday:

* We forecast a 2.5% rise in December factory orders. The sharp jump in the durables component points to a solid gain in overall bookings, even after factoring in the expected impact of a flattening in energy prices on the non-durables category. Meanwhile, inventories are expected to post a sizeable gain (+1.0%) – with the non-durables component just about matching the advance seen in the durables sector.

* We look for a 0.4% rise in fourth quarter productivity and a 3.8% gain in unit labor costs. The sluggish rise in 4Q GDP points to a significant moderation in productivity growth following some very sharp gains in prior quarters. On a year-on-year basis, productivity is estimated at +2.4%. This is still above the long-run sustainable trend, but we expect to see a very sharp slowdown over the next couple of quarters. Finally, unit labor costs are expected to rebound in 4Q following some outright declines in each of the two prior quarters.

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