|President Barack Obama, standing before the US Constitution, delivers an address on national security, Thursday, May 21, 2009 at the National Archives, in Washington DC.
In an assessment of the US economy on Thursday, Morgan Stanley's Richard Berner asked what will the shape of the recovery be? Genuine improvement in financial conditions and a string of less-bad economic data have increased speculation that the recession is now ending and a healthy rebound might be at hand. He said business cycle lore and the law - - Zarnowitz's Law - - associate deep recessions with V-shaped recoveries, and thus it would be reasonable to expect a strong recovery following the deepest post-war recession. Berner said: "But we disagree. We concede that the near-term outlook is a bit less dire, but in our view the recession has further to go." He says a prolonged convalescence is likely.
Richard Berner, who is a Managing Director, Co-Head of Global Economics and Chief U.S. Economist at the US investment bank, said most important, however, MS strongly believes that four factors make a V-shaped rebound unlikely: First, financial conditions will stay relatively restrictive. Second, a still-large imbalance between housing supply and demand likely will remain a drag on home prices and housing activity into 2010. Third, consumers have only begun a long process of deleveraging and repairing their balance sheets and saving positions, so spending growth should be subdued. And finally, the breadth of the recession limits the cushion from any stronger sectors, including activity overseas.
However, a sub-par recovery seems to be the consensus view, so it's important to look at upside risks.
Finfacts article - - May 21, 2009: Global Economy: U, V, W – Alphabet soup spells out economic developments but be skeptical of the sunshine wafflers
Finfacts article - - May 22, 2009: Irish Economy: Cowen says his policies will bring “rapid growth” in 2010; Rejects “dead-end politics of the past”- - Ireland is more dependent on the US economy, than any other developed country.
In what follows, MS examines the logic and recent evidence for their position, and then consider the circumstances that could potentially promote a more vigorous rebound:
A strong case for a sub-par recovery. The history of financial crises is on our side; because they result in deep and prolonged declines in asset values, such crises not only promote deep recessions, but typically the aftermath involves prolonged convalescence.
More specifically, four factors underpin our case for a sub-par recovery. First, financial conditions will stay relatively restrictive. Losses are still rising at lenders, limiting risk appetite and balance sheet capacity, and thus restraining the availability and boosting the cost of credit. A slow cleaning up of lenders' balance sheets will keep lending capacity low and the cost of using it comparatively high, and increased regulatory oversight will reinforce that restraint. We think that such lingering restraint will affect all credit-sensitive areas of the economy, including housing, consumer durables, capital spending and working capital for businesses large and small. As evidence, the National Federation of Independent Businesses just reported that, in April, credit was harder to obtain by small businesses than at any time in the past 29 years. And while loan-to-value ratios at auto finance companies rose slightly in April - to 89% from 86% in January-February - required downpayments were still more than double what lenders wanted last year.
Moreover, the lags between the change in financial conditions and the economy will prevent rapid progress. To be sure, as Morgan Stanley interest rate strategist Laurence Mutkin argues, when more capital comes into the financial system, and securitization revives, competition will erode the high rates lenders are able to charge for the use of their balance sheets today. In our view, however, that time may be far off, and both the scars from the crisis and the regulatory response to it probably will keep those costs permanently higher than pre-crisis norms.
Second, the imbalance between supply and demand in housing is still significant and likely will remain a drag on home prices and housing activity into 2010. The single-family vacancy rate in existing homes is double the 1.2% historical average through 2004. Given the persistently tight financing backdrop, vacancies might undershoot that old 1.2% norm for a while to bring down the supply/demand imbalance quickly, especially as foreclosures rise again. Consequently, prospective buyers need to start occupying roughly 750,000 single-family vacant homes before the housing market and home prices stabilize. In turn, this implies that new and existing home sales must rise by roughly 20-25% from the current pace. Likewise, in commercial real estate, vacancy rates and cap rates are rising and rents are falling.
Third, consumers have only begun the process of deleveraging and repairing their balance sheets and saving positions, and we believe that the personal saving rate, currently at 4%, will rise to 7-10% in the next few years. This process will mean slower growth in US demand. Some argue that pent-up demand for vehicles and durables is strong following the recent retrenchment in sales. We disagree. It's true that to maintain the stock of vehicles on the road (245 million light vehicles) given normal scrappage would require about 13 million vehicles sold annually. But with financing constrained, we think that consumers can endure 3-4 years of sales below those levels, since we spent the last 13 above them, especially with 15% more light vehicles on the road than licensed drivers.
Finally, the breadth of the recession limits the cushion from any stronger sectors. For example, while growth appears to be improving in Asia, the global recession will limit US exports. Unlike the experience since the crisis began nearly two years ago, in which net exports contributed more than a full percentage point on average to real US growth, we expect that the cyclical contribution to US growth from overseas activity will be flat to down over the next 18 months.
We think that the evidence for near-term economic weakness still dominates. Home prices, pre-tax real incomes and profit margins are declining - by 18%, 0.3%, and 2 percentage points, respectively, over the past year. Retailing is softening again, despite tax cuts that kicked in on April 1. Pricing power is fading, notably for business semi-finished and capital goods, and especially as import prices for similar goods are falling. High inventory-to-sales ratios suggest further production cuts: In March, we estimate that the real I/S ratio in manufacturing and trade rose back to 1.43 months, equaling the cycle high. Finally, as more companies file for bankruptcy, we think they will liquidate stocks. Big production cuts in autos will trim roughly one percentage point from GDP. And, in contrast with the leveling off in initial claims for unemployment insurance, continuing jobless claims have risen sharply, to an all-time record and a 27-year high in relation to the workforce.
Yet that evidence may not fully refute the bull case for a more vigorous recovery. The bullish scenario relies primarily on turning the vicious circle of the ‘adverse feedback loop' between credit markets and the economy into a virtuous one. The story is straightforward; indeed, it is simply the basic recovery story without the headwinds: Aggressive policy actions are breaking the cycle of losses leading to a deeper credit crunch, adverse economic outcomes and thus more losses. Policy will get traction, first by eliminating systemic ‘tail' risk; for example, despite skepticism about how tough the ‘stress' tests for large bank holding companies were, the results reduced market uncertainty about the tail risk in the financial system. The rally in financial stocks enabled several institutions to raise equity capital and debt without a government guarantee.
In this optimistic scenario, improving financial conditions will thus increase the appetite for risk, reduce prospective credit losses, boost willingness to lend to creditworthy borrowers, and enable consumers and businesses to finance spending and working capital. Improving financial conditions will also enable fiscal stimulus to get traction. With the potential to satisfy pent-up demand built up during the recession, and inventory liquidation turning into accumulation, the time-honored cyclical dynamics of recovery can produce a strong, sustainable rebound.
If the logic for the rebound case is clear, what about supporting evidence? There is some financial and economic evidence to support the rebound case. First, financial conditions are becoming less restrictive. Notably, funding and money market conditions have improved to pre-Lehman levels, hinting that concern about counterparty and liquidity risk has almost evaporated and that the pressures on bank balance sheets from ‘reintermediation' may be ebbing more quickly than we had expected. Three-month LIBOR rates reached all-time lows last week, having declined for seven straight weeks, thanks to historically low policy rates and continued narrowing of LIBOR-OIS spreads - to 63bp. Forward LIBOR-OIS spreads now discount a return to levels not seen since the credit crunch began, with December at 53bp. And swap rates - a benchmark for bank loan pricing - may dip below Treasury yields soon. Moreover, credit spreads have narrowed significantly; since April 1, investment grade spreads measured by the CDX index have tightened by roughly 50bp, to 157bp, while spreads in terms of the high yield index have narrowed by nearly 400bp to 1,150bp. Surveys of credit availability - ranging from the Fed's Senior Loan Officer canvass, to the credit component of our own Business Conditions Index show important progress. Some of the Fed's facilities, like the PDCF and the TSLF, are falling into disuse - a sure sign that money markets are healing. And an improving economy would validate the new appetite for risk.
There is also encouraging evidence that the intense declines in US output of the last two quarters are over: Although spending is weakening again, consumers are no longer retrenching aggressively. Vehicle sales have stopped declining, and a ‘cash-for-clunkers' incentive may give them a modest boost. Housing demand and big-ticket durable goods orders seem to be stabilizing, and business surveys are improving (e.g., our MSBCI rose above 50% in early May for the first time in two years). Moreover, companies are aggressively liquidating inventories, I/S ratios have stopped rising, and jobless claims appear to have peaked.
Unfortunately, the evidence either supporting or refuting these two competing views is inconclusive. And upcoming data, as always at inflection points, could be especially volatile and confusing. For example, we cannot rule out a short-term inventory-led bounce in production if firms decide they have gone too far in destocking, only to give way to a relapse. For investors, therefore, it makes sense to stay balanced and look for opportunities. Risky assets, especially the higher-beta, lower-quality names and sectors, have discounted a good measure of the recovery story. But our FX strategy team believes that reduced risk-aversion should weaken the dollar.
And while our US equity strategy team has preferred US over global cyclical names, they believe that a weaker dollar makes global cyclicals attractive . For their part, our credit strategists believe that it makes sense to move up the quality scale, as markets likely will be more hospitable to higher-quality borrowers . Finally, we agree with our rates strategy team that significant increases in interest rates are eventually coming. But the near-term possibility of disappointment in the progress of recovery and the lingering risk of another deflation scare should cap 10-year US Treasury yields near 3.25% for now.