June 10, 2009
The deepest post-war recession likely will end by mid-to-late summer, a bit sooner than we've been expecting. The improvement in finan cial conditions and incoming data has outpaced expectations, and the backdrop for global growth is less daunting. Recessions are protracted declines in output, employment, incomes and sales, and all seem likely to stop declining within the next several months. Thus, for the second month in a row, we're slightly boosting our near-term economic outlook: We are raising 2Q-4Q09 estimates for the change in GDP by half a point, netting to a decline of 1.5% over the four quarters of 2009, compared with an expected 1.9% contraction a month ago. However, we strongly believe that the recovery will be gradual. Despite the ongoing benefits of monetary and fiscal stimulus, the economy faces several headwinds that seem likely to limit the growth pace through the end of 2010.
US Forecast at a Glance
(Year-over-year percent change)
| 2008A | 2009E | 2010E |
Real GDP | 1.1 | -2.8 | 2.2 |
Inflation (CPI) | 3.8 | -0.3 | 2.2 |
Core inflation (CPI) | 2.3 | 1.5 | 1.2 |
Unit labor costs | 0.9 | 2.0 | 0.5 |
After-tax ‘economic' profits | -6.9 | -19.1 | 2.4 |
After-tax ‘book' profits | -14.3 | -12.4 | 7.0 |
Source: Morgan Stanley Research
E= Morgan Stanley Research estimates
There's no mistaking the rapid improvement in financial conditions. Major financial institutions have been able to issue equity and non-government-guaranteed debt. Also, money and commercial paper markets are showing less need for support from the Fed's facilities. Unsecured interbank lending spreads (LIBOR-OIS) and commercial paper quality spreads have narrowed to pre-Lehman levels. The TALF continues to play an important backstop function, with the volume of TALF-eligible ABS securitizations picking up quite a bit over the past couple of months. Indeed, the new issuance run rate in consumer ABS in June was US$18.6 billion, or close to pre-crisis levels (US$18-21 billion). However, all-in spreads on typical deals still exceed pre-October 2008 levels, with new issuance limited to AAA tranches. While there has been a significant rally in the secondary markets in the last few weeks in securitized product markets - including CLOs, non-Agency MBS and CMBS - the new issuance market remains shut in these asset classes. Although retail mortgage rates have backed up recently, their prior decline has helped to stabilize housing demand. Both IG and HY credit market spreads have narrowed dramatically - in the case of HY, by half.
Incoming economic data have also improved faster, if only slightly beyond expectations. Notably, housing activity - both sales and new construction - appears to have stabilized in the past few months. Following a severe retrenchment in 2H08, we estimate that real consumer spending has edged higher in the first five months of 2009 to the tune of about a 1% annualized rate. The freefall in exports seems to be ending, and with imports still weak, net exports are contributing to growth. And business surveys, including our own canvass of business conditions, are showing significant improvement - albeit from extremely low bases. Purchasing managers' diffusion indices of orders in particular have begun to show growth as some companies are restocking. Accordingly, the collapse in payrolls has abated, with job losses slowing dramatically in May to 345,000 from an average decline of 645,000 in the first four months of the year. Labor inputs (hours worked) appear to have declined at a 6% annual rate in 2Q versus a 9% drop in 1Q. Correspondingly, we estimate that real GDP contracted by just 2% annualized in the current quarter, compared with the 5.7% decline seen in 1Q.
More important, however, we think that both the logic and evidence for a gradual recovery remain intact. Existing cyclical headwinds have lessened but have not disappeared: For consumers, labor income is still declining and home prices continue to fall. The decline in housing wealth is slowing from 2008's US$2.2 trillion pace, but any meaningful rebound is unlikely before 2H10 - or, more likely, 2011. Also, equity prices are still some 30% lower than a year ago. Thus, despite tax cuts, higher jobless benefits and other transfers, we estimate that real disposable income fell 1.6% in the year ended in May. In the business sector, record low operating rates and margin pressure are prompting firms to cut capital spending and continue liquidating top-heavy inventories (see Capex Bust and Capital Exit, April 20, 2009). And, despite federal assistance, state and local governments are responding to budget pressures by cutting spending and raising taxes.
New headwinds to recovery are surfacing: Consumers have only begun to embark on a long-run deleveraging process, and the combination of tighter risk controls and new regulations will probably keep credit availability below historical norms (see Deleveraging the American Consumer, May 27, 2009). Consumer credit declined at a 4.2% annual rate in the past six months, the fastest on record. Despite massive federal assistance to some firms, the auto finance companies have doubled required downpayments for cars and trucks, and most no longer offer leasing. While credit spreads are narrowing, the back-up in bond and mortgage rates is lifting the level of interest rates borrowers pay, and thus the cost of credit. And to the extent that the doubling of energy prices is driven by limited supply rather than growing demand, it will sap consumer discretionary spending power. If retail gasoline prices peak at about US$2.75/gallon, as we expect, the rise from the start of the year would sap about US$50 billion (on a seasonally adjusted annualized basis) from household cash flow, offsetting almost all of the impact associated with the latest round of tax cuts.
Sharply rising energy prices are fueling a pick-up in headline inflation, but slack in the US and global economy is exerting downward pressure on ‘core' inflation. Which force will win out? The verdict from markets is in: Deflation risks are old news, and inflation trades - rising breakevens, a steeper yield curve, a weaker dollar and financial sponsorship for commodities - are in. We like some of those trades too, but believe that markets may be surprised with just how tame the underlying inflation picture is in the coming months. Indeed, market participants seem to be ignoring the ongoing moderation in shelter costs, which account for more than 40% of the core CPI. We believe that this factor alone could trim core inflation by half a point or so over the next 6-9 months.
In this environment, the Fed faces a number of important challenges. While we believe that the recent jump in Treasury yields mainly reflects stepped-up supply, an improving appetite for risk and brightened recovery prospects, a bigger back-up in yields over the near term could pose a risk to the recovery. The Fed has been trying to lay the groundwork for economic recovery by holding mortgage rates - and other private borrowing rates - at artificially low levels. Policymakers now must decide how to react to market forces that have pushed yields higher. Originally, we believed that the Fed would respond by upping the ante and announcing at the June 23/24 FOMC meeting that it was raising the size of its purchase programs. However, recent market developments and the improved tone of incoming economic data have likely tilted the Fed away from such action. Looking further ahead, the time for a renormalization of monetary policy is drawing a bit closer, but the market seems to be way ahead of itself in pricing in rate hikes during 2009. A gradual exit from quantitative easing - on a passive basis - is likely to begin to unfold before the end of this year, but we don't look for the first hike in the fed funds target until mid-2010.
Against this backdrop, financial markets have priced out the adverse tail risk of prolonged recession and deflation. But we and our strategy teams think that the markets may well have swung too far in the other direction. High yield credit markets are pricing in a healthy cyclical recovery just as leverage is increasing and defaults are likely to rise significantly. Currency and commodity markets have priced in a bias to higher inflation. And equity markets are discounting a strong earnings rebound that seems unlikely to materialize quickly (see Corporate Profits: Stronger 2009, Slower Improvement Ahead, June 3, 2009). Even the Treasury bond market appears to be starting to anticipate a traditional V-shaped recovery and a return to normal inflation rates. We believe that supply/demand fundamentals will in fact lead to much higher real yields once the Fed exits from its buying programs (see Bear Market in Treasuries Begins, but Watch for Deflation Risks, May 11, 2009). However, we view this development as yet another potential headwind that is likely to help temper the pace of economic recovery over the next few years and challenge valuations of risky assets.
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