Recession Watch
Recession talk has picked up. In order for that to occur, consumer spending has to slow dramatically from its recent trend. This article looks at the GDP components and the outlook for consumer spending, and concludes that the key variable is payroll growth.
The GDP Components
Total nominal GDP in the third quarter was $13.927 trillion.
The components break down as follows:
**Consumer spending 70.3%
Business investment (including structures) 10.7%
Residential construction 4.5%
Government spending 19.5%
The totals do not add to 100% because net exports and inventories also impact GDP. In the third quarter, net exports added a whopping 0.93% to the annualized change in GDP, while the change in inventories added .35%.
Recessions and Component Trends
Recession is typically defined as two straight quarters of a decline in real GDP.
The component data show that, for a recession to develop, consumer spending has to decline.
Residential construction is not going to cause a recession. It comprises only 4.5% of GDP. It has already fallen about 25% from its peak over the past seven quarters, and has not yet caused anything close to a recession. The rate of decline may lessen in 2008.
Government spending, almost 20% of GDP, is also not going to cause a recession. Not much comment is necessary here other than to note that it has risen at about a 2.4% real annual rate in 2007 following about a 2.6% gain in 2006. It will rise in 2008.
The outlook for business investment is hard to assess but it also is not going to cause a recession by itself. It has risen at about a 7.0% annual rate in 2007 after rising at a 5.3% rate in 2006. Spending on nonresidential structures has been very strong and could soon decline. However, indications from most technology firms are that spending on equipment and software remains reasonably strong.
There are concerns that business investment might turn negative if business lending becomes restricted. There is no evidence yet, however, that a credit crunch is developing as a result of the write-down of assets by financial firms. Data on commercial and industrial (C&I) loans are released every Friday via the Fed's H.8 report. These loans have continued higher through last week and were up in October and September. Business investment will be sluggish next year but won't cause a recession.
Overall, growth in net exports and government spending could net out weakness in residential construction and business investment in 2008.
Which brings us back to consumer spending.
Consumer Spending Considerations
Over the past ten quarters consumer spending has risen at the following real annualized rates, from the second quarter of 2005 through the third quarter of 2007:
3.5%, 4.1%, 1.2%, 4.4%, 2.4%, 2.8%, 3.9%, 3.7%, 1.4%, and 3.0%.
That's pretty stable. Of course, there is a concern that consumer spending will slow in coming quarters due to weakness in home prices.
It is doubtful this will happen.
In a Big Picture column last year we noted that Fed Vice Chairman Ferguson cited studies that suggest a 10% decline in home prices over a period of two years will cut about 0.25% off GDP each year through the wealth impact on consumer spending. That sounds about right to us.
Existing home prices are down 4.2% over the past year and were down for a number of months before that. Yet, there has been little perceivable impact on consumer spending to date, as reflected in the numbers above.
There is a very good chance that home prices decline another 5% in the year ahead, and possibly continue lower into 2009. That would only serve to dampen consumer spending. In itself it won't lead to declines.
Far more important to the outlook for consumer spending is employment. If payrolls are rising, and wages are rising, consumer spending power increases. The American consumer spends almost 100% of income, and there is no reason to expect that to change.
The average monthly increase in nonfarm payrolls this year has been 125,000 a month. That is equivalent to a 1.1% annual rate of increase. The past three months the gains have averaged 118,000. The trend is steady.
Furthermore, there is no indication that businesses are about to engage in large scale layoffs or alter hiring trends. Past recessions have been preceded by large jumps in the number of new claims for unemployment benefits. This is shown in the chart below.
Just prior to the 1990/1991 recession, and prior to the 2001 recession, claims jumped to over 450,000 per week. Claims have been steady so far through the turmoil of 2007. This suggests that payrolls will continue to increase at about 100,000 per month or more.
If payrolls continue to rise at a 1% annual rate, and wages continue with their recent trend of 4% annualized gains, then total consumer spending power will rise at 5%. After adjusting for inflation, that is only about a 2% rate of increase (even taking into account higher gas prices), but it is positive nonetheless.
So long as payrolls are not declining, consumer spending will continue to increase.
Conclusions from the Data
Government spending at a 3% real annual rate, coupled with strong export growth, will boost annualized GDP by about 1% each quarter. Residential construction and business investment weakness may offset those gains.
For GDP growth to turn negative for two straight quarters, however, consumer spending has to go negative.
This won't happen because of weak home prices or foreclosures on low income subprime borrowers (who will continue to spend even if they lose their homes). It will only happen if payrolls decline. And before that happens, there will be indications from sharply rising claims for unemployment benefits.
It is therefore not surprising that a survey of top economists by the Wall Street Journal showed expectations of about 1.5% real annualized growth for GDP for the fourth quarter and about 2% for early 2008. It is also not surprising that the Fed has a similar forecast
That is the way the numbers add up.
What it All Means
Forecasts of recession are largely based on expectations that the severe housing slump will slam consumer spending or that the write-offs at financial firms will lead to a cutback in credit availability that will reduce business investment.
The first of those we discount because the two-year old housing slump hasn't slowed the consumer down yet, and won't. There is no sign of the second, but we will be watching C&I loans closely for signs of any credit crunch. Even if business investment does slow, however, it still represents less than 11% of GDP.
The key, as always, will be consumer spending. And as long as wages keep rising near a 4% annual rate, and payrolls keep rising, the consumer will keep spending.
The economic outlook is unquestionably poor. The Fed forecasts sluggish growth for quite some time. But the forecasts of recession still require assumptions of a large change in the current trends that are not yet evident.
The Credit Crisis: Chicken Little or a Game of Chicken?
By Rachel Barnard, Ph.D.
If the sky isn't falling on financial stocks, it certainly looks that way. Every day there are new reports of companies being exposed to losses in mortgages, subprime credit, or CDOs. Banks are taking charges that run into the billions of dollars. There is no doubt that market conditions are deteriorating rapidly and financials are taking it on the chin.
Fear now dominates the marketplace. Financial-services stocks have fallen by 15% over the past three months, as measured by the S&P Financial Services Index. Investors are running for the hills--or at least for safer havens including cash and gold.Yet at Morningstar, our analysts are recommending an unprecedented number of financial-services stocks, even names that have been badly beaten up such as Countrywide Financial (CFC), PMI Group (PMI), and Citigroup (C). What can we be thinking?
To sum things up, we base our recommendations on numbers and not emotion. We also model how much stress a company can bear before cracking.
To date, paper losses and non-cash charges abound, but the actual cash impact of the credit crisis has been fairly minimal. There is a lot of room yet before the financial industry reaches a breaking point. Could a catastrophic financial crisis be looming? It's always a possibility. But the data we've seen so far suggest that it's a remote one--and hence not something we'd want to base our recommendations on. Our approach has been to model in the worst mortgage-related losses in recorded history (a scenario that isn't even close to fruition yet) but stop short of predicting a financial collapse. We feel this represents the most likely scenario. And though we may have some very bearish assumptions built into our valuations, they are bullish compared with what prevails on Wall Street. So we have been advising investors, as Warren Buffett says, to be greedy when others are fearful.
But investing in times like these is not for the faint of heart. The decline in financial stocks could be nothing more than a Chicken Little rumor that the sky is falling when in fact, the financial markets are built to handle the stress of an occasional credit crisis. Or it could be a real game of chicken, with the health of the U.S. financial system riding on the hope that rational investors don't blink first.
Recession talk has picked up. In order for that to occur, consumer spending has to slow dramatically from its recent trend. This article looks at the GDP components and the outlook for consumer spending, and concludes that the key variable is payroll growth.
The GDP Components
Total nominal GDP in the third quarter was $13.927 trillion.
The components break down as follows:
**Consumer spending 70.3%
Business investment (including structures) 10.7%
Residential construction 4.5%
Government spending 19.5%
The totals do not add to 100% because net exports and inventories also impact GDP. In the third quarter, net exports added a whopping 0.93% to the annualized change in GDP, while the change in inventories added .35%.
Recessions and Component Trends
Recession is typically defined as two straight quarters of a decline in real GDP.
The component data show that, for a recession to develop, consumer spending has to decline.
Residential construction is not going to cause a recession. It comprises only 4.5% of GDP. It has already fallen about 25% from its peak over the past seven quarters, and has not yet caused anything close to a recession. The rate of decline may lessen in 2008.
Government spending, almost 20% of GDP, is also not going to cause a recession. Not much comment is necessary here other than to note that it has risen at about a 2.4% real annual rate in 2007 following about a 2.6% gain in 2006. It will rise in 2008.
The outlook for business investment is hard to assess but it also is not going to cause a recession by itself. It has risen at about a 7.0% annual rate in 2007 after rising at a 5.3% rate in 2006. Spending on nonresidential structures has been very strong and could soon decline. However, indications from most technology firms are that spending on equipment and software remains reasonably strong.
There are concerns that business investment might turn negative if business lending becomes restricted. There is no evidence yet, however, that a credit crunch is developing as a result of the write-down of assets by financial firms. Data on commercial and industrial (C&I) loans are released every Friday via the Fed's H.8 report. These loans have continued higher through last week and were up in October and September. Business investment will be sluggish next year but won't cause a recession.
Overall, growth in net exports and government spending could net out weakness in residential construction and business investment in 2008.
Which brings us back to consumer spending.
Consumer Spending Considerations
Over the past ten quarters consumer spending has risen at the following real annualized rates, from the second quarter of 2005 through the third quarter of 2007:
3.5%, 4.1%, 1.2%, 4.4%, 2.4%, 2.8%, 3.9%, 3.7%, 1.4%, and 3.0%.
That's pretty stable. Of course, there is a concern that consumer spending will slow in coming quarters due to weakness in home prices.
It is doubtful this will happen.
In a Big Picture column last year we noted that Fed Vice Chairman Ferguson cited studies that suggest a 10% decline in home prices over a period of two years will cut about 0.25% off GDP each year through the wealth impact on consumer spending. That sounds about right to us.
Existing home prices are down 4.2% over the past year and were down for a number of months before that. Yet, there has been little perceivable impact on consumer spending to date, as reflected in the numbers above.
There is a very good chance that home prices decline another 5% in the year ahead, and possibly continue lower into 2009. That would only serve to dampen consumer spending. In itself it won't lead to declines.
Far more important to the outlook for consumer spending is employment. If payrolls are rising, and wages are rising, consumer spending power increases. The American consumer spends almost 100% of income, and there is no reason to expect that to change.
The average monthly increase in nonfarm payrolls this year has been 125,000 a month. That is equivalent to a 1.1% annual rate of increase. The past three months the gains have averaged 118,000. The trend is steady.
Furthermore, there is no indication that businesses are about to engage in large scale layoffs or alter hiring trends. Past recessions have been preceded by large jumps in the number of new claims for unemployment benefits. This is shown in the chart below.
Just prior to the 1990/1991 recession, and prior to the 2001 recession, claims jumped to over 450,000 per week. Claims have been steady so far through the turmoil of 2007. This suggests that payrolls will continue to increase at about 100,000 per month or more.
If payrolls continue to rise at a 1% annual rate, and wages continue with their recent trend of 4% annualized gains, then total consumer spending power will rise at 5%. After adjusting for inflation, that is only about a 2% rate of increase (even taking into account higher gas prices), but it is positive nonetheless.
So long as payrolls are not declining, consumer spending will continue to increase.
Conclusions from the Data
Government spending at a 3% real annual rate, coupled with strong export growth, will boost annualized GDP by about 1% each quarter. Residential construction and business investment weakness may offset those gains.
For GDP growth to turn negative for two straight quarters, however, consumer spending has to go negative.
This won't happen because of weak home prices or foreclosures on low income subprime borrowers (who will continue to spend even if they lose their homes). It will only happen if payrolls decline. And before that happens, there will be indications from sharply rising claims for unemployment benefits.
It is therefore not surprising that a survey of top economists by the Wall Street Journal showed expectations of about 1.5% real annualized growth for GDP for the fourth quarter and about 2% for early 2008. It is also not surprising that the Fed has a similar forecast
That is the way the numbers add up.
What it All Means
Forecasts of recession are largely based on expectations that the severe housing slump will slam consumer spending or that the write-offs at financial firms will lead to a cutback in credit availability that will reduce business investment.
The first of those we discount because the two-year old housing slump hasn't slowed the consumer down yet, and won't. There is no sign of the second, but we will be watching C&I loans closely for signs of any credit crunch. Even if business investment does slow, however, it still represents less than 11% of GDP.
The key, as always, will be consumer spending. And as long as wages keep rising near a 4% annual rate, and payrolls keep rising, the consumer will keep spending.
The economic outlook is unquestionably poor. The Fed forecasts sluggish growth for quite some time. But the forecasts of recession still require assumptions of a large change in the current trends that are not yet evident.
The Credit Crisis: Chicken Little or a Game of Chicken?
By Rachel Barnard, Ph.D.
If the sky isn't falling on financial stocks, it certainly looks that way. Every day there are new reports of companies being exposed to losses in mortgages, subprime credit, or CDOs. Banks are taking charges that run into the billions of dollars. There is no doubt that market conditions are deteriorating rapidly and financials are taking it on the chin.
Fear now dominates the marketplace. Financial-services stocks have fallen by 15% over the past three months, as measured by the S&P Financial Services Index. Investors are running for the hills--or at least for safer havens including cash and gold.Yet at Morningstar, our analysts are recommending an unprecedented number of financial-services stocks, even names that have been badly beaten up such as Countrywide Financial (CFC), PMI Group (PMI), and Citigroup (C). What can we be thinking?
To sum things up, we base our recommendations on numbers and not emotion. We also model how much stress a company can bear before cracking.
To date, paper losses and non-cash charges abound, but the actual cash impact of the credit crisis has been fairly minimal. There is a lot of room yet before the financial industry reaches a breaking point. Could a catastrophic financial crisis be looming? It's always a possibility. But the data we've seen so far suggest that it's a remote one--and hence not something we'd want to base our recommendations on. Our approach has been to model in the worst mortgage-related losses in recorded history (a scenario that isn't even close to fruition yet) but stop short of predicting a financial collapse. We feel this represents the most likely scenario. And though we may have some very bearish assumptions built into our valuations, they are bullish compared with what prevails on Wall Street. So we have been advising investors, as Warren Buffett says, to be greedy when others are fearful.
But investing in times like these is not for the faint of heart. The decline in financial stocks could be nothing more than a Chicken Little rumor that the sky is falling when in fact, the financial markets are built to handle the stress of an occasional credit crisis. Or it could be a real game of chicken, with the health of the U.S. financial system riding on the hope that rational investors don't blink first.
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