Economic Recovery Likely to be Subdued

The U.S. economic recovery is very important to the commercial real estate recovery. As the economy recovers, corporate revenues will grow and companies will make profits. These profits will allow hiring to resume and as unemployment shrinks, people who get good jobs will resume renting apartments, buying residences and the companies that expand, will need more office space. Our commercial real estate fundamentals will improve and we will all be in a happy place once again.

How is the economy doing?

Equity markets have rallied, credit spreads are much better than they were a year ago and U.S. employment is showing signs of easing. The banking industry is making profits and consumer spending in November was up 1.3%, substantially better than the 0.7% that was projected. In the third quarter of 2009, GDP grew by 2.8% (revised down from an initial announcement of 3.5%). The housing market has expressed some positive signs as inventory is decreasing and it is suspected that as manufacturer’s inventories shrink, factory output will increase to restock bare shelves. In fact, the Institute for Supply Management reports that manufacturing had expanded for three months in a row. This may all sound pretty good but let’s not get too excited.

With regard to GDP growth, following postwar recessions, real growth, in the four quarters after the recessions were declared over, averaged 6.6%. During the five years following those recessions, the average growth rate was 4.3%.  While growth was 2.8% in the third quarter and is expected to be about 3% in the fourth quarter, most economists project growth to range from 1.5% to 3% for all of 2010.  If growth is limited in this fashion, it will be a new event for our postwar economy. There has not been a single deep recession that has been followed by a moderate recovery.

This may no longer be the case. The recession we have just emerged from (many believe we are still in the recession) lasted a record seven quarters and experienced a near-record average GDP decline of 1.8% per quarter. Based upon this, and history, we should be witnessing the start of a powerful and sustained recovery. However, all signals and projections from economists are that the recovery will be subdued at best.

Why all of the pessimism? There are economic reasons that support this pessimism and there are some philosophical reasons.

There appears to be a growing fear that the federal government is retreating from the free-market economic principles of the last 50 years. We have seen tangible evidence of this in many ways, most notably the anti-business and anti-Wall Street sentiment in Washington.

Some argue that the $787 billion stimulus was successful in that things did not get worse than they did. Others argue that only $86.5 billion of the stimulus money was targeted towards encouraging broad-based private investment and thus failed to stimulate true economic growth. With interest, the stimulus will cost the taxpayers $1.1 trillion. While this spending succeeded in temporarily and marginally increasing disposable personal income, it left personal consumption spending virtually unchanged.

Given the massive deficits created by the printing and spending of money in Washington, taxes will be going up across the board. We will see this in marginal income tax rates, capital gains rates, dividend rates and death-tax rates. Almost everyone will pay more taxes – significantly more. Hardest hit by these increases will be the new and small businesses whose investment and hiring decisions either drive or starve recoveries.

Business investment may be curbed due to the uncertainty created by extraordinary events like the administration’s intervention in the GM and Chrysler reorganizations. The mechanisms used by the government upset decades of accepted bankrupcy law by placing unsecured and lower priority creditors, like the United Auto Workers, in front of secured and higher priority creditors. This intervention has arguably had the effect of stifling investment as wary investors watched political considerations cast the rule of law aside.

Corporate earnings have been positive causing the equity markets to rally. However, earnings have been created by cost cutting and the productivity gains which generally follow prior to real recovery in the form of growing revenues. Thus far, revenue growth has been disappointing. Therefore, growth in corporate output will be far lower than what would normally be expected in a solid economic recovery. A crucial reason for this is the fact that bad assets on institutional (as well as personal) balance sheets are like a ball and chain strapped to the economy.

Near-zero interest rates are also creating some potential problems for our market. More than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period. They are buying over $3 billion per day of expensive mortgage-backed securities as part of a $1.25 trillion purchase plan. With the system somewhat stabilized, the Fed hopes that artificially low interest rates and its purchases of MBS will stimulate growth. Instead, they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles.

Ironically, the near-zero rate policy, coupled with Washington’s preference for a weak dollar, has created a glut of American capital in Asia and other foreign markets as corporations and investors borrow in dollars and invest in other currencies and foreign assets. This creates a shortage of capital in the U.S.   For small businesses and new workers this capital rationing is devastating, advancing business failures and painful layoffs. Thousands of start-ups won’t launch due to credit shortages.

In a ninth consecutive decline, consumer lending shrank at an annual rate of 1.7% in October. This extended the dramatic evaporation of financing available to help fuel the economy. The $3.5 billion decline, calculated by the Fed, results in a 4% drop in consumer lending from its July 2008 peak. As our economy is 70% consumer based, curtailed lending to consumers could harm the chances for a strong recovery.

Moreover, it is not just consumers having trouble borrowing. Notwithstanding the perception that the economy and financial markets are recovering, many companies lack easy access to borrowing. All of the debt overhanging consumers and companies is the pivotal reason that we are seeing a free fall in bank lending. The nation’s lending markets have changed significantly as they adapt to post-crisis realities.

Markets where the U.S. government is either a big borrower or a defacto guarantor are ballooning. Simultaneously, corporate lending and consumer finance markets have shriveled. A Wall Street Journal report shows that these markets have shrunk by 7%, or $1.5 trillion, in the two years ending October 31st. The result of tighter lending is that consumers spend less and businesses are more reluctant to hire and invest.

Some of the decline in lending is due to lower demand as borrowers focus on paying down debt that they already have. In the past 25 years, household debt has exploded. It is now 122% of total disposable income, up from just over 60% 25 years ago. At the end of the third quarter of 2008, household debt began to decline as Americans started belt-tightening.

The most recent data shows that credit tightness peaked earlier this fall to the worst levels in 23 years. What we are all enduring, and what small businesses, workers and consumers continue to be pummeled by, is the dismantling of the great credit boom of the early 2000’s. This grueling, but necessary, deleveraging began last year and is now in full swing. We are seeing it in our investment sales market and expect that it will continue for 2 to 3 years as we face today’s problems and anticipate 2006 and 2007 vintage loans maturing.

In October of 2008, bank credit peaked at $7.3 trillion and is now down to $6.72 trillion. Banking sector debt, it is estimated, must fall by another $2 trillion or so and this should take over 2 years to complete. Since the peak, this 8% drop is enormous and it is accelerating. By comparison, the peak-to-trough drop during the Savings & Loan crisis in the early 1990’s was only 1.3%.

The last thing the central bank wants is a decline in the broad-based money supply. The Fed’s asset purchase program is not only about driving down mortgage rates. It is also about trying to prevent a collapse in the money supply. When the Fed buys assets, it creates deposits which, in turn, helps offset the reductions in available credit. If deleveraging and the credit contraction does last a couple of years, and if the Fed is interested in offsetting it, they will have to continue to buy assets through next year. Presently, they intend to stop the purchases well before that.

It appears clear that the economic recovery will not be as strong as history suggests it should be. We have a long way to go before we get back to above trend growth. The recovery in the commercial real estate market will come on the heals of the economic recovery as we generally lag behind the economy. As lenders put off dealing with the problems imbedded in their balance sheets,  the recovery simply slows down and credit markets remain soft. I certainly hope the recovery evolves more quickly and forcefully than it appears it will.  Our commercial real estate markets could use the help.

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8 Responses to “Economic Recovery Likely to be Subdued”


  1. 1 hummbumm December 14, 2009 at 9:42 am

    I always respect you analysis, but i think your political leanings color your views when you start talking of the macro picture. 50 years ago the marginal tax rate was 90% and banks were heavily regulated, as was trucking, transportation and other large swaths of the economy, and yet economic growth was robust and income disparities narrow. Even though i am in the financial sector, I would have to agree with Volcker that innovation in the financial industry does not really add value to the macro economy ex the ATM machine as he highlighted. As you know the projected deficit for this fiscal year was $1.2T before factoring the effect of the stimulus. this is a result of structural factors (running a large deficit in good times) and the cyclical impact of lower tax receipts and higher transfer payments. In addition, as an equity analyst i have read a large number of macro reports and all credit the stimulus for accelerating GDP growth. State and local governments would have had to drastically cut spending or raise taxes, both options curtailing growth without the stimulus. unemployment extension is money that is typically quickly recycled in the economy, and 1/3 of the stimulus was tax cuts (actually the part that had the lowest multiplier as that was most likely to be saved. There is no doubt that taxes will need to go up, but that is because as a % of GDP they are at record lows. With regard to economic growth, yes the consensus is for a slow recovery. Though i would not put the emphasis on fear of regulation etc.. but rather in the existing overcapacity in the economy, in particular in housing. Resi housing is typically the sector that pulls us out of recession. With still high inventory and a large shadow inventory, new home construction is likely to be subdued. the consumer as was highlighted is in balance sheet reparation mode (though thw WSJ article highlighting people walking away from their mortgages captures a means to more quickly repair consumers’ balance sheets) , and the only logical growth engine would be exports facilitated by a weak dollar. Unfortunately, our largest trading partner (ex canada) ie China is pegging their currency to ours and thus delaying the natural re-balancing that should take place.
    With all that said, my conversations with businesses point to people having cut to deep in Q4 and Q1 of 2008/2009 as they were panicking and concerned about lines of credit etc… Any uptick in demand may well lead to hiring which would trigger a virtuous cycle. It is hard to be an optimist but economist are anchoring their growth expectations. Just look back at 2008 and see who predicted how weak the economy would be?. Of course CRE is typically a late cycle story.

  2. 2 rknakal December 14, 2009 at 9:59 am

    Hi Hummbumm, thanks for your post. I am actually a registered independent, leaning right on fiscal issues and left on social issues. I try to look at macro issues only from the perspective of the real estate market ( a Realestatarian ). You make some very good points and it will be interesting to see how things play out. I certainly hope that a cycle of hiring occurs as it would benefit everyone. As you point out, over capacity and slack are clearly out there. Also, I have doubts about the residential market due to all of the government intervention propping things up which is not allowing for a natural bottom.

  3. 3 hummbumm December 14, 2009 at 11:10 am

    For a great take on the resi housing market, i strongly recommend the calculated risk blog. They provide great insight. All the options on the table are/were bad though encouraging short sales is probably the best thing the government can do at present. I was out of work between hedge fund gigs, and thankfully i had the means and liquidity to coast through that period, but a nice period of unemployment is an eye opener that more people should go through. Losing health insurance coverage for one, and gaining an appreciation for unemployment insurance. Extended unemployment or under employment destroys human capital, and is corrosive to our civic underpinnings (when you suffer, you withdraw from the public sphere). i would fall squarely on jobs over inflation/deficit as the #1 priority for the country as a whole. If i were king for a day i would go with the denmark model, a strong safety net coupled with a de-regulated labor market. you end up with labor mobility, and foster entrepreneurship.

  4. 4 r lobel December 14, 2009 at 11:22 am

    Hi Bob,
    Unfortunately I have to concur with you on a slow recovery…perhaps even slower than most are willing to admit. Banks are simply not lending and not only to real estate assets. Small business loans are enormously difficult to obtain.
    Bob, you certainly do not need to justify your political leanings: Hummbumm is absolutely incorrect that your political prism colors or clouds your good sense analysis: Specifically, politicians have an uncanny ability to read public sentiment and run with the crowds (lest they get crushed for standing still and firm on principal…all politicians have a separate and different set of principles and morals in their back pockets for the ‘just in case we need to get re-elected scenario’). Washington is not ‘anti-capitalism’. They are just doing their usual’ deflection’ of public anger until things cool down and they need re-election campaign contributions. keep in mind that politicians are in the primary business of ‘being re-elected’. Lets not forget that the roots of this current recession lie in Washington not in Wall Street (although once Washington put in place the disastrous policies, Wall Street saw the money making opportunities and jumped right in, adding fuel to the fire. I refer to such disastrous policies as ‘expanded home ownership’ for those who neither had the requisite equity nor the capacity to afford to carry the debt (Clinton), low interest rates for way to long (Clinton & Bush), ridiculous deficit spending on wars of choice (Bush)) etc etc. Additionally, the amount of lending by banks versus what they have taken in from the US Treasury is shamefully low….again, another mistake from Washington in not mandating certain minimums with our taxpayer dollars.
    I could go on and on, but will spare you the ‘sore eyes’ and instead wish you Happy Holidays and all best wishes for 2010.

  5. 5 rknakal December 14, 2009 at 12:01 pm

    Hummbumm, as they say, the three most important things to help the recovery are jobs, jobs, job!

  6. 6 rknakal December 14, 2009 at 12:04 pm

    Hi Robert, thanks for your post. Your points are well made and I agree. Trying to increase the homeownership rate in the U.S. and the things done to accomplish this were a major contributor to the mess we are currently going through. Best wishes for wonderful holidays to you and your family as well.

  7. 7 TL December 14, 2009 at 12:59 pm

    What F’ing recovery?

  8. 8 pubear December 18, 2009 at 4:59 pm

    Bob, your emergence as a commentator represents the best intentions. Thank you for devoting valuable time to share, and to the posts from many informed folks.

    At a recent well attended ULI “Brownbag” meeting, the presenter focused on what to expect for the 2010 economy and beyond. Pretty gloomy. He had a good sense of humor, though.

    A few highlights:

    A 30-yr. chart of U.S. unemployment vs. bellringer CA showed the current rate considerably higher then the 1989-94 R/E depression. Even the 2001 tech crash in CA failed to ding jobs like today’s situation.

    A prognostication – 50% chance the economy worse in 2010, 30% that it’s flat a few years, then improvement, and 20% chance of earlier improvement.

    Some of the Q&A something like this:
    Q: What’s “worse” as defined?
    A: More unemployment and inflation
    Q: But what’s the #1 goal of the FED’s policies after restoring liquidity in 2008/9? I offered it is preventing wholesale and rapid deflation.

    My discussion focused on deflation, or “depressed” asset pricing that’s emblematic of a depression. Why not use the dreaded “D-word” when addressing the truth?

    In an aviation metaphor, think of Mr. Bernanke as the FED’s Sully Sullenberger as he pilots the economy’s plane. It’s not Pres. Bush’s ’80’s “soft landing” vs. a hard one that he’s facing. It’s a heroic “controlled encounter {crash} with terrain” where the plane’s totalled but the passengers survive (we hope). Hey, we’re alive to rebuild the plane, are we not?

    It looks clear that in spite of all the efforts at the FED’s stimulus and market manipulation to date, the market speaks: asset pricing, starting with residential R/E, is in a multi-year reversal, including, of all things, consumer non-discretionary items; staples in grocery stores. Yes, comm’l. R/E is a year into its refersal with a way to go. Plus incomes as many ‘fully’ employed people are working less (30.2hrs/wk av)or part time, are more productive and taking salary cuts nonetheless. Shades of my grandfather in the mid-30’s: 25% salary cut at the PARRoad age 65 after 35 yrs, retiring late at 70 in ’42 after WWII ended the Depression. Looks to me like it’s not our fathers’ Recession, but our grandfathers’ Depression.

    We all realize there’s more to discuss…..at a future time as Bob keeps things going by blogging and communicating. One way or the other, as the dawn follows the night, we’ll get through this, thankfully less generationally scarred than our Depression-era relatives. After all, we’re wired into a global economy with the boats rising and falling pretty much in unison, so we’ll pay attn. to the global economy.

    I wager history will dub Mr. Bernanke as the “Great Reinflation” guru at the expense of the dollar and economists will debate whether it was his only option as a policymaker and scholar of the Great Depression. Just be sure where your personnal assets are invested when inflation eventually occurs; where the dollar lands and rates against glogal currencies, as it’s likely it’ll be worth less and less over time, by design.

    Suggest looking at the “Bretton Woods System” @ Wikipedia for perspective and to draw your own conclusions where and how the dollar will be valued globally and what this means. IMF’s SDRs as the new reserve currency, like offered up by China?

    …..and a Happy Holiday Season to all!!


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