What's the Economic Outlook for the U.S.?Published: November 15, 2007 in Knowledge@Emory
Will the combination of leaping oil prices, shrinking credit markets and plunging consumer confidence be the undoing of six years of economic expansion for the U.S.? Battered by a falling dollar, rising foreclosure rates and a stream of CEO resignations sparked by the sub-prime fallout, the U.S. economy may not look very rosy right now. But in some respects the economy is performing surprisingly well, say experts from Emory University and its Goizueta Business School. They warn however, that continued turmoil from the energy markets and other sectors could lead to a sharp downturn.
A bag of mixed signals from the economy
The current economic turmoil, during which the stock market has gone through dizzying swings on an almost-daily basis, differs from previous shakeups in some significant ways. For one thing, recent economic slowdowns have been sparked by high interest rates aimed at fighting inflation that quickly translated into high levels of unemployment and cutbacks in consumer spending. Yet this time around both interest rates and unemployment remain relatively low.
And although some developments—including sharp increases in the price of crude oil and other commodities, and a weakening U.S. dollar—have stoked some fears of inflation, Federal Reserve Chairman Ben Bernanke seems to discount that possibility. On November 8, for example, he reported that the “…overall and core inflation to be in a range consistent with price stability next year.”
A relatively tame projection like that could mean that Bernanke sees room for a third consecutive cut in interest rates. But although rate cuts are traditionally seen as a salve for an underperforming economy, current challenges like the sub-prime mortgage defaults and falling home sales may be traced, to some degree, to the low interest rates prompted by the Fed during recent periods, says T. Clifton Green, a professor of finance at Goizueta.
“The stock market keeps expecting the Fed to ride to the rescue with lower interest rates, but to some degree we’re in the current sub-prime and consumer debt crisis because of low interest rates,” he says. “The low rates spurred consumers to dig deep into debt to purchase homes, and then to get deeper into debt by leveraging their homes as an investment tool.”
With the current crisis of confidence, says Green, the Fed may actually have less maneuvering room than it previously did. “Whether or not Bernanke is concerned about inflationary pressures, the stock market’s pricing may already reflect expectations of a rate cut,” Green notes. “Previously, when the Fed targeted inflation [and signaled a need for higher interest rates] the market wouldn’t necessarily swoon. But that’s no longer the case, and market expectations may, in effect, have tried to take the Fed hostage. If the Fed ever does bow to the market, we could be in for a dangerous situation.”
Green, however, is quick to point out that U.S. hasn’t yet reached the tipping point where the economy may slip into a recession or depression.
A reservoir of fiscal strength?
“There’s still some resiliency in the economy,” he notes. “For example, although we’re in a housing crunch, it may not turn into a meltdown. Many people don’t have to move, so they may not be in a rush to unload their homes. But there is still a significant level of pain—among speculators and others who over-leveraged; and certainly among home builders and suppliers, and among financial institutions with a high degree of exposure to the sub-prime market.”
The economic fallout, he adds, has not been limited to the United States. European stock markets, for example, have been shaken in recent weeks.
“Today’s economies are connected on a global scale,” Green observes. “So the problems that start in one country can easily spread to others, as we’re seeing now.”
But the same issue that spread America’s economic troubles across borders—a lack of barriers—may also help the U.S. and other economies recover, adds Green.
“The positive factor is the relatively liquid way that capital can move between countries,” he says. “This makes it easier to raise the funds needed to get out of an economic downturn.”
In fact the market may hold the key to its own recovery, observes Roy T. Black, a Goizueta professor in the practice of finance who focuses on real estate.
“Right now we’re in a downturn, but the economy will rebound because sooner or later capital has to move,” he says. “There will be winners and losers, but there will be movement.”
Despite misgivings, this isn’t the first credit crunch
Black, a former real estate attorney, says this is the third real estate crunch he’s seen since the 1970s.
“In the early 1970s we saw a lot of institutional money chasing few deals, and prices got out of hand until the real estate market collapsed,” he recalls. “In the 1980s the drive was real estate deals that were driven by a favorable tax code instead of by fundamentals, but the 1986 Tax Reform Act [which increased the period over which real property could be depreciated, limited the deductibility of passive investment losses and made other changes] brought about another meltdown. Now we’re in a third meltdown, albeit a major one. And this one is largely due to real estate syndicates that bought mortgages, and packaged them into derivative securities while ratings agencies underplayed the downside risk. Wall Street simply didn’t price the mortgage risks correctly.”
Right now, he says, the real estate market is helping to drag down the broader economy because inherent risk in real estate-backed derivatives has not yet been quantified.
“The secondary mortgage market is in a slump right now and it will take some time to shake out,” says Black. “Right now, for example, mortgage derivatives are being offered at a significant spread above treasury notes and other securities, with not a lot of takers. But the demand is there—and sooner or later someone will buy the underlying properties and the risk that is currently unknown will be quantified.”
Not everyone however, is so sanguine about the economy’s prospects, especially with the range of economic opinions being touted.
“My sense is there is more pessimism than optimism, at least for the one- to two-year term,” says J.B. Kurish, a professor in the practice of finance at Emory’s Goizueta Business School. He notes, for example, that the sub-prime mortgage crisis, which has rippled out to affect otherwise credit-worthy borrowers too, has an immediate and continued impact on household purchasing decisions. The effect, he adds, is exacerbated by stubbornly high energy prices.
“The stocks market is also skittish,” he notes, which could explain the near-daily swings that have investors biting their nails. “One concern is that much of the market’s recent growth has been driven by the financial service sector, and many people question its ability to continue its record profitability. Another reason for the market swings is that in times of uncertainty, the market tends to grab onto any available snippet of information, and often over-magnifies its effect. So if Wal-Mart reports good results, it can lift the entire market. Of course the reverse also holds true.”
Although there are plenty of issues that could drag the economy down—including uncertainties in the Middle East, and the upcoming presidential elections—Kurish says that the traditional worries, interest rates, unemployment and inflation, are at relatively low points.
“By many measures, the economy is doing well,” he acknowledges. “But going forward, there are questions about the potential for shocks that could have a sharp, negative effect on unemployment, inflation and interest rates.”
As with other components of today’s economy, the distinction between problems and solutions is not always clearly defined.
“Consider interest rates,” says Kurish. “People have been worried about the thin pricing spread between low-risk and higher-risk corporate debt—which may have encouraged unnecessary risk—and [now] appear to welcome an increase in the spread to more accurately quantify risk. But if higher-risk activity carries a higher borrowing cost, we’re likely to see fewer deals and projects, which could put a damper on economic activity, and ultimately translate into higher levels of unemployment.”
We may be in for some long-term changes
“The big issue is the credit crunch,” according to Goizueta finance professor Jeffrey A. Busse. “It’s gotten tighter despite lower interest rates as the easy credit people expected to see appears to be drying up.”
Busse thinks a tight-money environment may be here for a relatively long period.
“In the short run we’re seeing finance-industry CEOs [like Stan O’Neal of Merrill Lynch and Citigroup Inc.’s Charles Prince] lose their positions due to their companies’ exposure to problem mortgages, but in the longer run I believe we’ll see tougher lending criteria,” says Busse. “I think the days of the three-year adjustable-rate mortgages (ARMs) with an ultra-low teaser are gone.”
In addition, the housing market, and by extension, the broader economy, may still have a distance to go before bottoming out, he adds.
“We’ve only seen the first wave of foreclosures triggered by ARMs that are now resetting,” says Busse. “Soon, other overleveraged homeowners will face significantly higher carrying costs, and they’re also likely to be in a tight credit market—unable to refinance—when the higher rates kick in.”He adds that given the number and variety of risk factors that are currently operating—including spiraling oil prices, a tightening credit market, and massive toy recalls that could threaten manufacturers—“it’s surprising that the economy and the stock market have done as well as they have. I would have expected a sustained correction by now,” Busse says, but cautions “The market has held up reasonably well, given the numerous risk factors that have appeared over the past few months. If some other significant negative piece of news materializes, then that might be the impetus for a significant correction.”