Euroland
Risk of Recession Rising
July 31, 2008

By Carlos E. Caceres & Eric Chaney | London

Surveys Painting a Bleak Outlook for 3Q, and Even 4Q

This month’s round of surveys showed once again a significant deterioration in business confidence in the euro area. First, all the principal components (current and expected output, and demand) recorded a fall in July. Second, the rather weak outcome from the survey headlines was shared by all the surveyed countries this month (at the time of writing, only the Spanish survey is lacking, but we do not count on this country to brighten the picture). Once more, manufacturers have spoken loud and clear: in this particular sector, which remains at the core of the overall business cycle, a recession remains the most likely scenario for the rest of the year. This gloomy assessment fits with our own analysis: we think that the macroeconomic headwinds faced by the euro area economies are more likely to intensify than to evaporate in the near term; hence, we believe that more bad news for the manufacturing sector in Euroland is already in the pipeline.

Current Production Experienced a Further Correction

Companies’ assessment on current production eased further this month. Current production in the euro area as a whole eased 0.2 standard deviations (s.d.) in July, and it is now at 0.3 s.d. below its long-term mean. Among the individual countries, Germany experienced the largest fall this month (0.4 s.d.), and it is now slightly below trend for the first time since mid-2005. The French survey showed that the intermediate goods sector keeps underperforming, likely due to this sector’s vulnerability to the high price of raw materials. In any case, two key points regarding current production are worth mentioning. First, it seems that the gap in production between the different euro area members is now closing, with all surveyed countries now below trend. Second, the divergence between current production and output plans is narrowing, with the former following the latter fairly closely in the last couple of months.  

Output Plans Plunged Significantly Below Trend

Output expectations eased around 0.4 s.d. this month and are now 0.7 s.d. below their long-term mean, after having hovered around zero as recently as May. In fact, all countries experienced a downward correction this month; notably the Dutch survey exhibited a stunning 1.8 s.d. fall in production plans. We find it interesting (and positive) that company managers have been anticipating the current slowdown fairly accurately, with production plans being cut by approximately 1.4 s.d. since the beginning of the year. Nevertheless, it is worth noting that company managers are now reporting their inventories as ‘excessive’, hence increasing the possibility of some inventory overhang, particularly in France and Italy.

Further Deterioration in the Assessment of Demand

Demand fell once again this month, although remaining slightly above trend at 0.2 s.d. in July, 0.2 s.d. below its June reading.  Note, however, that the assessment on demand is a lagging indicator and that, if companies’ production plans are consistent with the pipeline of orders, we would expect the demand indicator to fall significantly below its long-term average. Contrary to current production, the intra-European divide remains in place regarding demand, with Germany remaining one s.d. above the long-term mean, compared to Italy where demand is now 0.5 s.d. below trend. We think that demand for German manufactured products is still benefiting from strong overseas demand, in particular from Russia and the Middle East, but we are less optimistic for the future, given the global trade slowdown that we anticipate.

Our Compass Models Keep Sending a Warning

Despite the weak outcome observed in output expectations three months ago, current production came in weaker than the latter in July, pushing our Surprise Gap Index further down. Indeed, this indicator crossed the deceleration line – but not by much. This once again confirms how accurately companies have been anticipating the slowdown, minimizing the possibility of a large inventory overhang that could cause a hard landing in the euro area. Our Compass moved into the ‘Risk of Recession’ zone and looks slowly but surely attracted into the ‘Recession Deepening’ zone, a testimony of how serious the economic downturn is.

GDP Indicator Pointing at Zero Growth in 3Q and 4Q

Our Early GDP indicator is still close to zero growth in 3Q: 0.03%Q (0.1% annualised), even weaker than its estimate from one month ago.  In addition, its first attempt to gauge GDP growth in 4Q is disappointing: it is predicting a meager 0.08%Q growth (0.3% annualised) in the last quarter of the year. Indeed, this indicator is now slightly gloomier than – although very close to – our own forecasts for 3Q and 4Q (0.1%Q and 0.2%Q, respectively). Overall, we believe that these numbers would be consistent with a technical recession (i.e., two quarters of negative growth) in the manufacturing sector, together with a significant risk of overall recession. Our Manufacturing Production indicator is now predicting a contraction in manufacturing activity in both 3Q and 4Q, and this following an already negative growth number signaled for 2Q, suggesting that the manufacturing slump could be longer than we previously thought.

ECB Still Likely to Keep its Current Posture

Against this backdrop, we continue to think that the ECB will likely keep its hawkish tone in the very short term, despite the rather weak results in most manufacturing surveys observed in the last couple of months. The ECB is also anticipating an economic slowdown (in 2Q and 3Q). However, a further deterioration in the economic outlook in August and, more importantly, September business surveys, if coupled with a further easing in oil markets (i.e., inventory build-up), could change the balance between hawks and doves within the Governing Council, and reduce significantly the probability of another rate hike, or even raise the possibility of a rate cut. While money markets are now much less convinced that the ECB will hike again this year, the possibility of a change in the direction of monetary policy is not yet popular. Clearly, we are still far from there, but if, as we think, the global macro outlook continues to deteriorate, such developments should not be excluded. 

For more charts and tables, see Euroland Business Cycle Watch: Risk of Recession Rising, July 29, 2008.

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Global
Potential Growth Is Slowing, Too!
July 31, 2008

By Joachim Fels | London

Recoupling, at last. Earlier this year, hopes were high that the rest of the world could decouple from the US economic slowdown.  That was then.  Recent data suggest that economic conditions outside the US have deteriorated sharply, especially in other advanced economies.  This is not only true for countries such as the UK, Australia, New Zealand and Spain, which, like the US, are facing a slump in their housing markets.  In Germany – until recently Europe’s growth engine – business confidence plunged to a three-year low and consumer confidence to a five-year low.  In Japan, industrial output slumped and consumer spending probably fell in 2Q.  Thus, the recoupling of advanced economies to the US downturn that we have been expecting for a while has now become a reality (see “Recession, Recoupling and Reflation”, The Global Monetary Analyst, March 26, 2008)  In fact, our economists expect negative prints for 2Q GDP in the euro area and in Japan, and broad stagnation during 2H08.  The risk of a technical recession (defined as two consecutive quarters of falling GDP) is clearly on the rise.

EM slowing down, too. Growth still looks more solid in most emerging economies.  However, surging inflation and rising interest rates are likely to take their toll, and our EM economists have recently cut their growth forecasts for 2009. As a consequence, we see global GDP growth slowing to 3.6% next year, the lowest rate since 2003 (see “From Inflation Upside to Growth Downside”, The Global Monetary Analyst, July 23, 2008).  Commodity markets seem to agree as oil prices have dropped by some 15% from their early July peak back to levels last seen in May.

Markets looking for sharp disinflation. With evidence of a global slowdown accumulating and energy prices falling, markets have jumped to the conclusion that inflation pressures will ease sharply later this year and next.  Short-dated breakeven inflation rates – a measure of inflation expectations priced into the bond market – have collapsed over the past few weeks. For example, the two-year US breakeven rate plunged by almost a full percentage point to less than 2% over the past four weeks.  This compares with a current CPI inflation rate of 5%.  Short-dated breakevens in Europe have dropped by almost the same amount. 

Lower inflation yes, but in a higher range. While we agree that headline inflation in the US and Europe will likely peak within the next couple of months and ease during next year, we think that markets are too optimistic about the pace and extent of the decline.  We continue to believe that the very lax global monetary policy stance of the past several years has shifted the world into a higher inflation regime where inflation rates will oscillate in higher range (see “A New Inflation Regime”, The Global Monetary Analyst, March 5, 2008). 

Slowdown may not bring much inflation relief. Moreover, many market participants may well overestimate the disinflationary effects of the current and prospective economic slowdown.  The conventional view is that with demand slowing, the output gap – i.e., the difference between actual GDP and its potential level – will widen, which should exert downward pressure on inflation as capacity utilisation falls.  We take issue with this view for two reasons: 

•           We think we are currently experiencing not only a slowdown in actual output and demand, but also a downshift in potential output growth.  Hence, slower demand growth may not open up as much of an output gap and thus create less disinflationary pressures than many believe.

•           Our research indicates that the disinflationary impact of a wider output gap is actually minimal for economies such as the US and the euro area, and that the global inflation trend is a much more important determinant of national inflation rates.  We have written on this aspect repeatedly in the past (see for example “More Global. Less Local”, The Global Monetary Analyst, April 2, 2008, so we focus on the first point above in what follows.

Why potential growth may be downshifting. There are several reasons to believe that we may currently be seeing a slowdown in not only actual but also potential economic growth. 

•           First, as energy is an important input into the production process, the oil price rise of the past few years lowers the productive potential.  The way to think about this is that higher oil prices make part of the capital stock (the most oil-intensive one) obsolete and thus lower potential output. 

•           Second, the sustained increase in oil prices raises transportation costs, which works like a tax on the international division of labour and thus hampers economic growth.  Our colleague Stephen Jen has written about the negative consequences of higher transport costs for globalisation (see High Transport Costs to ‘Un-Flatten’ the World, June 26, 2008).

•           Third, the credit crisis has increased the cost of borrowing and therefore the cost of capital for households and many firms.  As for the energy price shock, this implies a lower potential output. 

•           Fourth, tougher regulation, partly in response to the financial crisis, may lower potential output growth, too. 

A sizeable hit to potential output... Unfortunately, the dampening impact of these factors on potential output and its growth rate, which are both not observable, is very difficult to quantify.  However, a recent study by the OECD, which tries to estimate the impact of the energy price shock (our first factor above) and of the financial crisis (our third factor above) on potential output, suggests that the hit could be quite sizeable (see OECD Economic Outlook, June 2008, Chapter 3).  The OECD estimates suggest that the hit to the level of potential output from both shocks combined could be around 4% for the US and 2% for the euro area.  The impact on the US is bigger because it has a larger share of oil and natural gas in production and because the falling dollar has led to a sharper increase in oil prices in the US than in the euro area. 

…and its growth rate. The impact of these shocks on the growth rate of potential output obviously depends on how quickly supply converges to the lower equilibrium level.  Using different assumptions about the average scrapping rate of the capital stock, the OECD study comes up with a reduction of potential output growth of 0.3-0.7% for the US and 0.3-0.5% for the euro area over the medium term. 

Of course, these kinds of estimates are highly uncertain and should be taken with more than the usual grain of salt.  However, taken at face value, they suggest a sizeable reduction in potential output growth both in the US and in the euro area of around half a percentage point per annum.  Moreover, the impact of higher transportation prices and tougher regulation on potential output growth are not even included in the OECD estimates.

Conclusion. The recent shocks have not only hit demand but also the supply side of our economies.  The demand slowdown may thus not create as much spare capacity as many seem to think.  As a consequence, while inflation looks likely to ease later this year and next year due to base effects and the recent decline in oil prices, the pace and the extent of the decline could well be disappointing.  Against this backdrop, the recent collapse in break-even inflation rates looks excessive to us. 

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United States
Has Housing Bottomed, and Is Recovery Ahead?
July 31, 2008

By Richard Berner | New York

It’s hardly surprising that investors battered by a year-long credit crisis and a much-longer housing downturn are looking for any sign of good news — especially if it might signal the beginning of the end.  Now, there are glimmers: New and existing home sales have stabilized over the past few months, and landmark housing legislation offers assistance for struggling homeowners and for the GSEs.  This seems like unalloyed good news, given the pivotal role of housing and mortgage finance in the current economic and credit slump.  Is the end now in sight? And what kind of recovery is likely?

In our view, these developments are good news, and probably mean that the housing downturn will be less intense in the future.  But three negatives mean it’s too soon to celebrate: Further declines in housing activity or supply still lie ahead, declining home prices will continue to reinforce lender caution, and the recent backup in mortgage rates threatens demand.  Looking ahead, we see several reasons why the coming housing recovery will be lackluster — especially by comparison with those of the past.  Details follow.

There are good reasons why demand might be stabilizing now.  Most important, declining home prices and still-rising incomes have boosted housing affordability.  An index of affordability complied by the National Association of Realtors has risen by 25% over the past two years to a level slightly above its average of the past two decades.  Moreover, even during the recent crisis this affordability measure remained far higher than in the late 1970s and early 1980s, when the Fed engineered double-digit interest rates and two deep recessions to bring down inflation.  To be sure, the index isn’t foolproof: It doesn’t include the impact of tight or easy credit except via conventional mortgage rates, and so it may overstate the recent improvement, just as it may have understated how affordable housing became in 2006-7 when credit bubbled.  But it probably gets the direction right. 

However, in our view the negatives still outweigh the positives.  First, even if demand stabilizes, we estimate that 1-family housing activity still must decline by 20% or more to realign supply and demand.  We base that assessment on the notion that housing starts must reduce inventories to or below 6 months’ supply at the current and expected future pace of demand.  Thus, although inventories of new 1-family homes plunged by 22% over the past year to the lowest level since December 2004, today that represents 10 months' supply compared with 4 months back then and is down only slightly from a peak of 11.2 months in March.  Broader inventory measures tell a similar story of excess: New homes stayed on the market a record median 8.4 months following completion in June.  And overall homeowner vacancy rates stayed close to a record 2.8% in the second quarter.  As a result, while single-family starts tumbled 43% in the year ended in June, we think that they must keep declining to reduce inventories sufficiently. 

Second, this lingering imbalance between supply and demand points to further declines in home prices, which will reinforce lender caution.  The several home-price metrics continue to emit different signals.  Investors shouldn’t take comfort from the recent increases in the median price of existing 1-family homes sold; they rose 8.4% over the past five months, but prices typically rise in the spring, and shifts in the mix of homes sold affect these data.  In contrast, the new monthly OFHEO index declined 2.4% (seasonally adjusted) in the five months ended in May, but it excludes homes financed with subprime or alt-A mortgages, which have declined by more in price.  Investors should watch the OFHEO, the S&P-Case-Shiller, and the RPX price gauges to get a sense of pricing trends.

Finally, the recent rise in mortgage rates threatens to undermine demand, although the implementation of landmark housing legislation may help to bring rates down again.  Reflecting in part investor concerns about the creditworthiness of the housing GSEs — Fannie Mae and Freddie Mac — 15- and 30-year conventional mortgage rates jumped by about 60 bp in the past eight weeks, while hybrid (5-year fixed, indexed to 1 year securities) ARM rates rose by 55 bp.  All are the highest since last August, when the credit crisis began, and before the Fed eased monetary policy by 325 bp.  The current rates won’t crush housing demand – they only add about $78 to monthly payments for a $200,000, 30-year mortgage – but at the margin they menace a still-fragile market. 

Housing legislation is no panacea. The omnibus housing bill Congress approved over the weekend may help to relieve the strain by assuring investors that the GSEs’ debt issues and the mortgages they guarantee will retain their credit quality and by giving an estimated 400,000 troubled borrowers the opportunity to refinance their mortgage into an FHA-guaranteed loan on attractive terms.  The hope is that the combination will promote market functioning, buoy demand, mitigate the escalation in foreclosures, and thus limit the slide in home prices.  But there is significant uncertainty about utilization of the program, and it’s unlikely to cure all housing ills.  The bill authorizes the FHA to insure up to $300 billion of mortgages under a "Hope for Homeowners” program (not to be confused with the HOPE NOW Alliance that has been in operation since last fall).  However, the program is voluntary, first- and second-lien holders’ interests may not be aligned, and lenders may balk at the need to write down the loan based on the current home price.  Thus, the Congressional Budget Office estimates that less than 40% of the approximately 1.1 million borrowers deemed to be eligible will participate, and thus only $70 billion of the authorized funds will ultimately be tapped over the next three years.

Subsequent recovery will be modest.  Even when housing bottoms — and we believe it will early next year — the recovery is likely to be tepid for five reasons: First, cautious lenders are unlikely to offer generous terms for new mortgage lending until their balance sheets and mortgage securitization markets improve.  The housing GSEs will still face rising losses and the need to raise more capital, and they have expressed reluctance to add to their portfolios.  While their ability to securitize and guarantee mortgages is far more important than the loans in their portfolios — their MBS amount to $4.4 trillion, or 44% of the single-family mortgages outstanding — that ability depends on their capital and access to credit. 

Second, the adverse feedback loop of rising foreclosures, higher housing supply, depressed prices, mortgage losses, and lender restraint seems likely to continue for a while even after the recovery in housing activity begins.  Just as the deterioration in credit quality and the rise in foreclosure activity occurred over time, the resulting credit cycle likely will last a year or two after the trough in activity. 

Third, a more restrictive regulatory environment will effectively limit the supply of mortgage credit.  The cheap, exotic and risky mortgages so prevalent in the past five years are unlikely to return any time soon.  New, more restrictive guidelines for lending are already in place.  Lenders, including the GSEs, probably will be subject to stricter oversight and higher capital requirements.  While the regulatory pendulum won’t swing hard until officials are confident that a recovery is underway, lenders and investors are already anticipating some of the changes.

In addition, the pent-up demand that has spurred past strong housing recoveries seems absent, as homeownership rates remain high, if down from their peaks.  The housing boom of the past decade pushed demand and activity well above a sustainable trend.  Homeownership rates are now back to levels last seen in 2002, when the credit boom got going, but they may overshoot to the downside to correct the lingering imbalance.  Finally, a tepid overall economy implies pressure on employment, income, and consumer balance sheets, making would-be home buyers more hesitant. 

For investors, hope springs eternal that the bad news in housing is fully in the price.  The recent uptick in good economic news and expectations that the housing legislation will help mortgage markets have lifted risky asset markets.  In addition to the housing news, consumers have maintained spending at a stronger-than-expected pace; energy prices have peaked for now; and bookings for capital goods have advanced.  But if the fundamentals sour as we expect, that support could prove fleeting.  Likewise, market pricing is again suggesting a slightly higher chance that the Fed will tighten as soon as October.  Circumstances clearly matter more than the calendar, but based on the fundamentals we expect, the market is again pricing too much Fed tightening too soon.

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