2010 U.S.

Economic Outlook

Dimitri Delis, Ph.D.

 An Economic Train-Wreck

“The following presentation

contains disturbing economic material.”

“Viewer Discretion is Advised.”

 Several Economic Indicators Have Rebounded Sharply…

Leading Economic Index

• Major equity indices have risen sharply
0.8

• Credit spreads have narrowed

substantially
0.3

• Housing, manufacturing, and

confidence have rebounded sharply -0.2

• Many market participants have -0.7

declared the beginning of a V-shaped
recovery
-1.2 Recessions
Oct-60 Oct-66 Oct-72 Oct-78 Oct-84 Oct-90 Oct-96 Oct-02 Oct-08

Source : Conference Board

 …But Other Economic Indicators Still Show Weakness

Non-Farm Payolls
1,000

• String of consistently better than -

expected data was broken in late (1,000)

September
(2,000)

(Thousands)
• Non-farm payrolls at -268,000 vs. (3,000)
Changes Cumulative
-175,000 (4,000)

(5,000)
• Participation ratio dropped 0.3% to
(6,000)
65.2% - a 20 year low
(7,000)

• Average duration of unemployment at (8,000)

26.2 weeks, largest since 1948 Dec-07 May-08 Oct-08 Mar-09 Aug-09

Source : Bureau of Labor Statistics

 The Stimulus Propped the Economy….. Temporarily

• The recovery is dependent on the

generosity of the government and the
US Auto Sales of Domestic Vehicles
Fed 14

12
• Once “Cash for Clunkers” ended so
did the growth in auto sales

Millions of Units
Sales dropped again

10

• Housing has benefited from $8,000 tax

credit for first time home buyers.
8

• Can spending be sustained in the

absence of government help? 6
Sep-05 Apr-06 Nov-06 Jun-07 Jan-08 Aug-08 Mar-09 Oct-09

• Tight credit, rising unemployment, and Source : Bloomberg

overburdened balance sheets pose
serious risks
 No Housing Bottom Yet…
4%

9%
3%
• Glut of unsold new and existing Deliquencies

homes. 7% Foreclosures
2%
• Vacant homes at a record level of
over 18MM units. 5%
1%

• Delinquencies and foreclosures have

soared to historically high levels. 3%
Jun-79 Jun-85 Jun-91 Jun-97 Jun-03 Jun-09
0%

Source: National Association of Realtors

14
M o nths of S up ply For N e w H ome s

10
• Sales of new and existing homes
have dropped precipitously.
6
• Months of sales supply almost at
twice their normal level. 2
• Inventory should be put pressure on Ja n -6 3 Ja n -7 0 Ja n -7 7 Ja n -8 4 Ja n -9 1 Ja n -9 8 Ja n -0 5
Source: National Association of Realtors
prices.
 …Means Lower Housing Prices…

• Prices are down 30% from their peak.

• Home prices may fall another 15% before
they bottom out to their average level of 190
the last 50 years. Home Price Index 30% drop
currently
• OFHEO Price Index also suggests a drop 170
of at least 15% from current levels.
150

130

Lower home prices should spur demand, but

110
it will be marginal. Why? 45% drop to
historical mean

• Credit Availability Remains Limited 90

• Expectations of Future Home Prices 1950 1960 1970 1980 1990 2000 2010
• Consumer Confidence is Shattered Source: S&P CaseShiller
 …And More Credit Losses

• Since 2Q 2007, financial institutions

y = 35.5 * x + 31.9
worldwide have lost $1.47 trillion. 200
R 2 = 96%

U.S. credit losses ($billions)

• U.S. institutions alone have lost -200
$970 billion.
-400

-600
• Financial institutions lost $35.9 billion
for every 1% drop in housing prices. -800

-1000

• A 15% drop would translate to an -1200

additional $538 billion. -35% -25% -15% -5% 5%
h o u sin g p rice d ro p

• A 10% drop would translate to an

additional $359 billion.
Source: Bloomberg,BMO
 U.S. Financial Institutions Balance Sheet

ASSETS LIABILITIES

Black Financial Claims

Hole

Equity

Result: Credit Crunch

 Household Liabilities have Increased as a % of Net Worth

• Household and financial institutions

have balance sheet problems

30%
• This is not a typical post WWII
recession; it is a “balance-sheet 25%
recession” Liabilities / Net Worth
20%
• Balance sheet problems linked to
asset bubble busts tend to last 15%

10%
• The government has stabilized the
banking system but has failed to
restart lending 5%
1951Q4 1958Q1 1964Q2 1970Q3 1976Q4 1983Q1 1989Q2 1995Q3 2001Q4 2008Q1

• Lending has been dropping as

Source : Federal Reserve
consumers have been repaying debt
 Consumers Have Been Saving More

• There will be a reverse of the 1990’s

boom, when rising asset prices
boosted the economy 16%

12%
Savings Rate
• Consumers have increased their
savings and reduced consumption
8%
• The savings rate is at the highest level
over the last 10 years
4%

• Debt will act as a permanent drag on

the economy 0%
Jan-59 Jan-67 Jan-75 Jan-83 Jan-91 Jan-99 Jan-07

Source : Federal Reserve

 Consumer Spending has entered a “New Normal”

• Over the last 25 years consumer Consumer Spending YoY

spending has grown at about 6%
2.9% growth
10500
• Since the beginning of this year
consumer spending has grown at
about 3%

Billions ($)
9500
6% growth
• What happens to consumer spending
when government supports expire?

8500
• Assume that we are able to maintain a
3% spending rate over the next 12
months in the absence of government
stimulus.
7500
Jan-03 Mar-04 May-05 Jul-06 Sep-07 Nov-08 Jan-10

Source : Federal Reserve

Changes in the Unemployment Rate Track Consumer Spending

14 Consumer spending -4
• Changes in the unemployment rate
exhibit a strong correlation with Unemployment rate changes average growth
consumer spending 10 -2

12-month change (%)

12-month change (%)

• If consumers maintain their spending 6 0
spree at 3%, unemployment will
increase by 1.5% over the next 12
months to about 11.3% 2 2

• Market expects unemployment to peak -2 4

at 10% over the next 6 months

-6 6
Nov-85 Apr-91 Oct-96 Apr-02 Sep-07

Source : Federal Reserve, BMO

The Unemployment Rate Remained Elevated for Several Years
Following the Financial Panic of 1929

• During the Great Depression, 30 Financial panics of Depression levels

unemployment peaked at 25%, four years 1929 and 2008 Current levels
after the financial panic of 1929 25

Unemployment rate (%)

20
• Studies have found that on average,
following a banking crisis, unemployment 15
keeps rising for almost 5 years and the
jobless rate goes up about 7% points 10
2009

(Reinhardt and Rogoff) 2008

2006 2007
5

• Thus we do not discount the possibility 0

that unemployment keeps on rising (to 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936
around 12%) and remain elevated for
several years

Source : Federal Reserve, BMO

 The Fed Hikes Rates……After Unemployment Peaks

• Over the past 25 years the Fed has

12 12
followed a consistent policy of raising Fed Funds Rate
Unemployment Rate
rates after unemployment peaks
10 Unem ploym ent Peaks 10

• In the1990s the Fed raised rates 18 8 8

months after unemployment peaked.
Subsequent to the 2000-01 recession the % 6 6 %
Fed raised rates 10 months after the
unemployment peaked
4 4

• The market expects unemployment to 2 2

peak at about 10% some time in the first
quarter of 2010. That would mean that the 0
Fed Hikes
0
Fed may not start raising rates until the Jul-85 Jul-91 Jul-97 Jul-03 Jul-09
Q1 2011.
Source : Federal Reserve
 Rates Remain Low For Long

U S 1 0 -ye a r ra te
5
• In the aftermath of the Long Depression U.S.
10-y rates remained below 3% for over 20 4
years
3
1873 1877 1881 1885 1889 1893

5
• In the aftermath of the Great Depression U.S. U S 1 0 -ye a r ra te
10-y rates remained below 3% for 22 years 4

• In Japan 10-y rates have remained below 2% 2

1925 1930 1935 1940 1945 1950
for the last 17 years
10
J a p e ne s e 1 0 -ye a r ra te
8

• Following a credit bubble burst rates usually 6

drop and remain at lower levels for a 4

prolonged period of time 2

0
Ja n -8 8 Ju n -9 3 D e c -9 8 Ju n -0 4 N o v-0 9

Source : Federal Reserve, BMO

 Has the Federal Reserve Gone Wild?

• The Fed’s Balance Sheet has exploded.

– On 08/08/2007, it was about $790
1000
Billion
– On 10/08/2009, it was over $2 800
Trillion
ExcessReserves
• Excess Reserves have ballooned to 600 ($billions)
over $800 billion.

• Friedman taught us that inflation is a 400

monetary phenomenon. If you increase
the money supply too fast, you risk
inflation. 200

• But there is more to inflation than just

money supply. Money supply is what 0
you see. How about what you don’t Jan-59 Jan-69 Jan-79 Jan-89 Jan-99 Jan-09
see?

Source: Federal Reserve

 Inflation or Deflation ?

• Velocity of Money is the average

frequency with which a unit of money V =GDP / M
is spent in a specific period of time

2.1
• Velocity = Nominal GDP / Money Velocity of Money
Supply
1.9

• Financial innovations spur growth in

velocity 1.7

• The lack of new innovation and the

1.5
elimination of old innovations (i.e. Jan-59 Jan-67 Jan-75 Jan-83 Jan-91 Jan-99 Jan-07
subprime related) are slowing the
economy down
Source : Federal Reserve, BMO
 Conclusion

• We remain skeptical that the recovery will be V-shaped as it is based on the

unprecedented generosity of the government.

• Many consumers are burdened with heavy loans taken out during more prosperous
times. The debt problem will act as a permanent drag on the hopes for recovery.

• Unemployment may remain stubbornly high for many years dampening consumption
prospects and thus subduing the governments’ efforts to boost the economy.

• The Fed may not raise rates until the first quarter of 2011.

• A large body of historical evidence suggests that it takes a long time for an economy
to recover following a recession caused by a financial crisis. This time may be no
different as consumer spending, which represents 70% of economic activity, will
remain anemic given the numerous headwinds the consumer is facing.