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From a glass is half full perspective, the economic environment has shown some sign of improvement, although most of that improvement has been in a decline in the rate of deterioration. This reading is exemplified by the job market, where optimists take solace in the decline in the rate of job losses.
While there have been some glimmers of hope, economic conditions remain weak, with few prospects for a turnaround on the horizon. In this environment, survival remains the mantra for businesses, governmental agencies, and consumers. Since many have already cut the fat out of budgets to deal with declining income and dwindling reserves, the remaining options for staying afloat are painful and require even more difficult sacrifices than in the past.
On a positive note, the stock market has turned the corner from the meltdown earlier in the year, reversing some of the losses and raising hopes the market has begun to bottom out. Given the weak economic environment and the absence of an obvious economic leader, such improvement may not be sustainable. However, a flat-market outlook is better than many had predicted at this stage of the cycle.
The market has been helped in part by the stimulus packages and stabilization in the much-maligned housing market, as tax credits, low interest rates, and motivated sellers breathe some life into the sector. Despite this improvement, the industry remains on soft ground. There is additional downside risk as moratoria on foreclosures expire, and buyers struggle to gain the confidence and wherewithal to get off the fence.
The commercial real estate market continues to toil under the weight of weak fundamentals of supply and demand and tight credit markets. The sector also faces downside risk from with the built-up stock of distressed assets still off the market and a wave of refinancing coming due. This situation should continue over the near term, with a lagged recovery being the most optimistic scenario. The good news is that the erosion in market fundamentals may have peaked; however, net income levels will be under pressure as leases expire and market rents lag contract rents.
The Economic Environment
The economic environment remained very much on everyone's minds as we entered the summer of 2009. The U.S. economy continued to struggle, although there were some signs the recession might be playing out.
The banking industry survived the recent stress tests, suggesting that the industry may be able to avoid further deterioration. However, the results of the stress tests also revealed a number of problems that must be resolved before the industry can resume operations at the levels needed to restore stable credit markets. Interestingly, rather than focusing on credit flows, the major banks seem to be concentrating on getting out from under the Federal Reserve's hand. Indeed, of the ten banks that received financial injections under the Troubled Asset Relief Program (TARP) last fall, nine have announced that they have bought back the preferred shares issued as collateral for the bailout funds. While this could be taken as a positive sign, in a number of cases the underlying motivation was banks' desire to get out from under the onerous government regulations and executive compensation limits that had been imposed.
The banking industry received a major blow when Standard & Poor's downgraded ratings for eighteen U.S. banks, which pushed five bank's issues into junk-bond territory. This widespread downgrade had been rumored for some time, reflecting rising concerns over the risk profile of financial institutions and growing recognition that the industry would have to make significant changes. While banks try to shed balance-sheet risk, many continue to carry toxic assets that are likely to be problematic going forward, especially if the recovery stumbles. The Obama administration's extensive plan to revamp financial regulation will be closely watched as it extends efforts to return stability and regain confidence in the beleaguered sector.
The administration also seeks to extend its reach to the derivative and credit swap industries to help rein in the industry and avoid further financial meltdowns. While fraud prevention is one of the stated objectives of this initiative, the changes are also designed to restrict activities that pose an unacceptable risk to the financial system. The proposed changes are also designed to promote efficiency and transparency to protect unwary investors and the public at large from further scandals. Given the global nature of the problem, similar efforts are expected in other countries as evidenced by the announced regulatory crackdown on banks in the United Kingdom. The pressure on banks to improve governance and maintain adequate reserves in the United Kingdom has global implications and could reverse some of its draw for global banking activity.
The Obama administration also has turned its attention to the insurance industry and is proposing a new office to develop policies for the currently state-regulated industry. While federal oversight would signal a major change, it does not go as far as wanted by some large insurers. Large insurers have argued that federal oversight would lead to more standardized regulations than the state-based system. As might be expected, this proposal has triggered arguments among those with competing business interests. Given the stakes, the debate around insurance industry regulation is likely to be heated.
Other industries, business practices, or factors that have the potential to disrupt the economy or capital markets also are likely to come under increased federal scrutiny. This implicit pressure is liable to inhibit creativity and preempt the introduction of some potentially riskier private-sector initiatives that could help jump-start the recovery. The Administration will move carefully before taking on more battles, however, in the face of rising public concern over the growing deficit and the spate of economic interventions, some of which have met with limited success. This reluctance to enter new economic areas is especially true in light of the administration's aggressive agenda on such hot-potato issues as health care reform and energy regulation.
Although there are signs the economy is beginning to turn around, the recent decline in industrial production is a reminder that we are not out of the woods yet. Indeed, the near-term prospects for a significant recovery are cloudy, suggesting we are going into a long, hot summer with limited tailwinds to help propel us forward. Indeed, we can expect a period of economic volatility, much like the national weather patterns, vacillating from drought to flooding. The near-term economic environment should be characterized by a bouncy ride as we approach what appears to be the bottom of the cycle. As such, conditions will be more volatile than normal, with upside potential and downside risk taking turns peeking out from behind the curtains. Thus, the stage is set for even more interesting times that are a far cry from the summer doldrums of past years.
Economic Growth
During the first quarter of 2009, annualized real gross domestic product (GDP) growth declined around 6%, which reflected a modest improvement over the disappointing 2008 fourth-quarter figures. This represents the third consecutive quarter of losses, which started in mid-2008 with a very modest decline. For the trailing twelve months, GDP fell by 2.5%, the largest decline in over twenty-five years. The contraction in GDP growth was led by significant declines in fixed investment, imports, and exports. Government expenditures were off moderately. While consumption exhibited a moderate increase over the prior quarter, it was still down relative to the trailing eight-quarter averages.
Despite disappointing figures, there is a growing perception that the economy may start turning around toward the end of the year. Some of the factors behind this expectation include a drop in inventory levels and a modest increase in consumer spending in anticipation of spending under the federal government's stimulus program. Indeed, increased expenditures for infrastructure investment already have translated into a number of road and highway projects across the country. In addition to creating much-needed jobs in the construction sector, the increased expenditures on shovel-ready infrastructure projects will have a multiplier effect for related industries.
The dollar has remained mixed against major currencies, with the exception of the pound, which is being weighed down by concerns over the United Kingdom's economy. The current account deficit has improved, declining in absolute value and as a percent of GDP. This improvement was due in large part to a narrowing of the trade deficit to its lowest level in some ten years. This improvement bodes well for the economy and suggests economic output may be postured for some additional improvement.
On the global front, emerging markets continue to struggle, although the declines have moderated. Indeed, gains in emerging-market stock prices have outpaced those in developed countries. Similarly, spreads on emerging-market credit have narrowed, reflecting a moderate improvement in expectations.
Employment
The good news on the employment front has been the absence of major unexpected cutbacks as the pace of job losses has moderated. This slowdown in losses has been led by a number of industries, including leisure and hospitality, business services, construction, and trade/transportation. On the other hand, government employment experienced a reversal, with job losses supplanting gains in spite of the increase in temporary workers as the U.S. Census Bureau gears up for the 2010 census.
Despite the slowing of job losses, for the ranks of the unemployed there is little to cheer about with new hiring activity trending downward. Indeed, companies continue to pare back on employment as they tighten their belts. Some sectors and regions are being particularly hard hit by the ripple effects of the near collapse of the automobile industry and the continued weakness in consumer sales.
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