Mid-year outlook update
How we got here and the global balancing actthat must follow.
By Walter Kemmsies
Recent U.S. and major economy data indicates we are in the fourth phase of the global economic correction.
Outside of a few risks concerning inflation, it is reasonable to maintain a guardedly optimistic outlook for the U.S. and world economies. To understand that, it is worth reviewing the five phases of a crisis-driven recession and their particulars for the current cycle:
1. Unchecked, unsustainable and unbalanced growth. China's entry into the World Trade Organization in late 2001 heralded an era of double-digit export growth, which also resulted in double-digit growth of the U.S. trade deficit. Some of this excess growth was due to China's policy of maintaining its currency at an artificially low rate against the U.S. dollar. To do that China did not convert the dollars it received for exports into renminbi.
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Instead, China bought U.S. Treasury bonds. The extra demand for bonds, particularly long-dated bonds, pushed their prices up and yields down. This helped bring down interest rates in other markets such as mortgage rates. Cheap and easy credit allowed households to buy houses they couldn't otherwise afford and supported consumer spending. Consumers needed credit to buy things because during the last 10 years employment and wages grew exceptionally slowly, in part because the rate at which manufacturing jobs were being outsourced was accelerating. Eventually the debt bomb had to blow up, which it did starting in 2007.
2. Crisis. The financial sector bet heavily that consumers would be able to pay off their debt. The trigger for the crisis to begin was the resetting of interest rates on subprime mortgages.
In order to sustain the housing boom, lenders had begun extending credit to poorly qualified borrowers by offering what are called subprime mortgages. Subprime mortgages often involved below-market interest rates for a few years and then a compensating payment was required along with the mortgage interest rate being reset to a higher level. As the loan defaults increased, the financial system came under severe stress because it had overextended credit to this sector through the use of financial derivatives. The number of banks experiencing financial difficulties began increasing, which resulted in loans being called in and reductions in lines of credit. The decline in loans and lines of credit hit companies at a difficult time because a lot of their capital was tied up in inventories that had accumulated due to slowing sales.
In late 2008 and into the first quarter of 2009, the U.S. economy went into freefall. Many foreign banks have branches with operations in the United States and were also affected by this. The U.S. credit crunch impacted other countries as well, and world trade in particular because it became very difficult to obtain letters of credit needed to finance exports. As sales fell, companies in every industry began to lay off employees. Company bankruptcies increased dramatically.
3. Stabilization. The Federal Reserve and the U.S. Treasury reacted by pumping hundreds of billions of dollars into the banking system. Bank examiners began shuttering financial institutions that were failing and sold their assets to healthier banks. The federal government began increasing its spending by extending unemployment insurance benefits and spending more on public work projects to create jobs. Tax receipts were falling due to rising unemployment, which along with higher spending has resulted in a much higher government budget deficit. The rate of growth of new unemployment claims peaked in March 2009, which indicated the worst was over.
From then until the end of the year job losses continued at a slower and slower pace and since the beginning of 2010, non-farm payroll has increased by 573,000. Mortgage and credit card default rates continued to rise until the early part of 2010 when the percentage of loans in default peaked.
The rate at which banks were being declared insolvent has also slowed dramatically. Federal Reserve data on bank loans shows an increase in April 2009, the first increase since the fourth quarter of 2008.
4. Recovery. The downdraft is over, but even though economic activity has begun to pick up, it still remains well below 2008 levels. In order to keep stoking the recovery, the Federal Reserve has to maintain interest rates at low levels and the government deficit will continue to increase as it extends unemployment benefits and funds new public projects to increase employment. These measures have supported retail and home sales increases. Companies are finding that their inventories are too low to support the current level of sales and have thus begun to restock as credit has become less difficult to obtain.
Not only does data published by government agencies show these positive trends, but they are also reflected in port, rail and truck volume trends. Some industries are already beginning to hire. The recovery is clearly becoming self-sustaining, which will be confirmed after the fact by withdrawal of policy support. After it becomes self-sustaining the Fed will have to raise interest rates to quell inflationary pressures and the government deficit will begin to decline.
5. A new long-term trend: global rebalancing. Following crisis-driven recessions such as 1929 and the 1973-74 Oil Shock recessions, economic policymakers not only devised short-term stabilization policies but also introduced structural policies as well to reduce the probability of reoccurrence. Fortunately for Europe, North America and Japan, the emerging market countries' banks were not involved in U.S. and European real estate finance.
It is even more fortunate that emerging market countries had been reducing their foreign debt and building foreign reserves since the 1997 Emerging Market Debt Crisis. This allowed them to stimulate their economies and avoid severe declines. Strong demand growth in emerging markets has boosted U.S. export growth and helped the economic recovery. However many emerging market countries, China in particular, continue to deploy policies such as currency market interventions that generate foreign trade surpluses.
The United States is on the other side of that and has developed a substantial and unsustainable trade deficit. This is the main reason why the dollar weakened. Either the U.S. imports less and/or exports more to reduce its trade deficit, or else it will have to sell assets to pay its debt. It is unlikely imports will decrease because the proportion of the U.S. population that will be of retirement age is increasing, which will make the United States even more import-dependent.
Slightly more than half of the deficit is due to imported oil and gas. This can be reduced with an energy policy that increases self-sufficiency. However even without fuel imports, the U.S. would still run a large trade deficit.
Therefore it needs to increase its exports. That could prove difficult in the near term because of inadequate freight infrastructure. Even if that is remediated, China still needs to let the renminbi-dollar exchange rate to be set by market forces. That would accelerate U.S. export growth, which would help lower the trade deficit.
While outcome of policy actions is uncertain, the economic agenda seems to have prioritized these issues in the form of negotiating with China to reduce its foreign exchange market intervention and the National Export Initiative. If these efforts are successful then the U.S. and world trade will become more balanced and growth will be sustainable.
For now, the U.S. economy remains in the fourth phase ' the recovery is becoming self-sustaining. The risk at this point is inflation. The Fed has flooded the economy with money, which it needs to remove as economic activity picks up in order to avoid inflation rising because of too much money chasing too few goods. Right now inflation is not much of a risk despite the recent large increases in raw materials prices such as oil, copper, steel and grain, as well as freight rates.
However, since labor is 65 percent to 75 percent of a typical company's costs, once wages start to rise, inflation could increase because as household incomes rise, companies are more able to pass on cost increases. At that point the Federal Reserve may have to raise interest rates aggressively to halt inflation momentum. That could result in a mild contraction in economic activity. For now that remains a risk and not a certainty.
For the transportation industry the trend is towards increasing freight movement, particularly containers at U.S. ports where international volumes for the year are expected to be 10 percent to 15 percent higher than in 2009. There are also clear indications that U.S. exports are gaining momentum and that provides a ray of hope that the 'new normal' will be more balanced growth.
Walter Kemmsies is chief economist of Moffatt & Nichol, a marine infrastructure engineering firm. He can be reached at (212) 768-7454 or e-mail, [email protected].