Although the Economy Shows Signs of Leveling Out, PNC’s Economist Says We’re Not Out of the Woods Just Yet

by Amanda L. Gutshall October 2009
They say so much can change in a year — and from the time we spoke with PNC Economist Robert Dye in the late summer of 2008 until now, in August 2009, we have seen a multitude of bad news stories, but we are weathering the continued after effects of the mid-2000s “economic party” attitude. With the after-party crash, came tumult in the financial and consumer sectors. As we continue to experience a very long, drawn out and somewhat painful hangover effect, we hope to sweep up the confetti, take some aspirin and head toward a better next few years.
Robert Dye VP/Senior Economist, The PNC Financial Services Group, Inc.

In the latter half of summer 2008, the economy was shrinking but no one could have foreseen what would occur within the next few weeks. We all now know the results of the shattered financial system that affected well-known names such as Lehman Brothers, Fannie Mae, Freddie Mac, AIG and IndyMac. The U.S. and the world trudged through the rest of the year, followed an election and watched as the government drafted plans to light a flame under the chilled economy.

In fact, when we spoke with Dye in 2008, he saw a brighter future for Fannie and Freddie, and no one could have predicted otherwise. However, he did note that like the end of 2007, he expected to see a “cool down again at the end of 2008 before the economy picks up steam in 2009.”

In 2009, we saw a shaky first half of the year followed by increasing signs of stability this summer. On August 27, the Commerce Department
reported that the U.S. economy shrank 1% in the second quarter, significantly less than the 6.4% rate of decline in the first quarter.

This was less than the 1.5% decline predicted by economists in a Bloomberg News survey posted the same day. The second quarter also saw a 5.7% surge in corporate profits, the department noted, the most since Q1/05.

The U.S. Census Bureau, the day before, announced that there was a rise in new orders for manufactured durable goods in July from $7.8 billion to $168.4 billion, or 4.9%. The growth was impacted, the report said, by increases in the transportation sector. This was the third such increase in three months, the bureau said, and the largest rise since two years before. June 2009 posted a 1.3% increase, with new orders — excluding defense — increasing 4.3%. New orders, excluding defense for July 2009 increased $4.6 billion to $57.5 billion, or 8.6%.

Are We Out of the Woods Yet?
That wasn’t the only good news. One week before, on August 13, after completing its two-day meeting, the Federal Reserve said information it has received since June suggests that economic activity may be leveling out. The Fed also noted that the financial markets had improved in the second half of the summer. “Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market focus will contribute to a gradual resumption of sustainable economic growth in a context of price stability,” the Fed said, in its formal announcement.

Dye agrees that the broader economic indicators are starting to level off as the Fed has indicated. “Clearly last year, conditions did deteriorate rapidly through the fall with the collapse of Lehman Brothers and the conservatorship of Fannie Mae and Freddie Mac, and the bailout of AIG, all hitting within a couple of weeks of each other and that really threw the economy into a tailspin,” he says. “We had a sharp slide, massive downdrafts through the fourth quarter of last year and the first quarter this year, and it looks like we’re starting to emerge from that pattern now.”

He adds that when you look at the data from July and August, “we’re going to see the economy start to level out, with indicators like home construction not sliding anymore, home sales not sliding anymore, job losses not getting worse but relatively better as they trend back toward zero,” he says.

As the economy starts to turn a corner, and we look ahead through this year into 2010, Dye calls it an economy with a hangover effect. Although there may be signs that things are turning positive and a technical end to the recession may come, the party has definitely not started up again. “We’re not going to call it a party, we’re going to call it the hangover economy — the after effects from this are going to be with us for some time.”

The first indicator Dye predicts we’ll see that things are turning positive will be a “moderate, positive number — something around plus 3% for the third-quarter GDP driven in large part by the resumption of auto production.” His concern, however, is that what will follow will be “less than stellar. I’m certainly not expecting anything that we would call a V-shaped recovery trajectory. What I would expect to see is that after a strong third quarter, we may see a little bit of a weaker fourth quarter this year, though still positive.”

Dye is also concerned about the first two quarters of 2010. “I think economic indicators still will be weakly positive, and then build from that point. But I don’t want to downplay the downside risks. Even though we could see a nice third-quarter GDP number, there are a lot of factors out there that could pull the economy back into negative growth for at least a quarter to give us a sort of W-shaped recovery trajectory. That’s not my baseline forecast, but I think it is an alternative scenario that must be considered.”

Another area that will continue to be affected in the longer term is unemployment, Dye notes. An August 27 Bloomberg.com article confirmed this view saying that the latest report showed that unemployment “may jeopardize the strength of the economic rebound.” In mid-August, the Labor Department reported that 570,000 workers filed claims for benefits, which was down from 580,000 the previous week.

“We have so many hangover effects from this recession — 
it is the unfortunate gift that keeps on giving… The unemployment rate will continue to increase. I’m expecting to see something just over 10% by January, followed by a decline, but not a sharp decline in unemployment. We could be down to 9% by the end of 2010. That still looks like a very high number compared to where we were two-and-a-half, three years ago. We’ve run up this mountain, but I think it’s going to be a slow decline off that very high unemployment rate.”

Other indicators will continue to lag as well, Dye says. “We’re looking at the delinquency rates on a variety of loans, types of loans that are probably not going to crest until late this year, early next year. These hangover effects, as well as a negative wealth effect from the loss of house prices, are going to be with us for quite some time.”

Has the Fed Done Enough?
The federal government has instituted a number of programs aimed at supporting ailing markets. According to Dye, if you look at the latest Fed numbers, “They are continuing programs already put in place and I’m fully supportive of that. I think they’ll need to continue to do that. But we’re seeing no new programs coming out of the Federal Reserve. I think they’ve done all they’re going to do at this point until they see conditions start to noticeably improve.”

With the lowering of short-term interest rates and what Dye calls the “alphabet soup of liquidity programs” that are starting to wind down as the markets heal, and the economy begins to level out, “it will tell the Fed that they have done enough and that the ball really goes back to Congress.”

Time will tell whether the programs the Fed has put into play were really effective, but Dye sees signs that they have been just that. Along with the $787 billion stimulus package approved in February is the Public-Private Investment Program (PPIP), announced in March, which is designed to provide liquidity to still-hurting markets for derivatives. Then hopefully some relief will come. “As that starts to generate some momentum here later this fall, I think that will add to [what’s already been done.] The combined federal government — 
between the Treasury and the Federal Reserve actions and what’s come out of Congress and the presidential side has really been a full-court press to address this very, very long and deep recession.

“I think we are starting to turn a corner,” Dye says. “As we do that though, we will need to shift our attention from dispensing more economic medicine to dealing with the side effects of this massive dose of medicine that we’ve already ingested.” Dye notes such corrective measures include “getting the federal budget under control, getting a handle on any regulatory reform and scrutinizing new programs and taxes. This will ensure that the economy has been positioned for long-term growth.”

With all of these programs and future expectations, is there anything more that can be done? According to Dye, once unemployment crests, and the Fed’s various programs reach their natural end as we outgrow their need, the last thing from the Federal Reserve will be the inevitable notching up of short-term interest rates. However, he does not expect these rates to rise until about “six months after the unemployment rate peaks, at the earliest. Maybe this time next year, if not later, we’ll start to see the Fed starting to inch up rates.”

What Comes First?
When looking at today’s economic conditions, Dye notes that business investment expenditures will be a stronger proponent in 2010, improving before consumer spending. “There are so many drags to consumer spending right now. Even though we have seen some gain in terms of the Cash-for-Clunkers program boosting car sales, it looks like that’s come at the expense of other retail sales. Consumers right now are still in healing mode and as long as the unemployment rate is increasing, they’re going to stay there. I’m not expecting this to be what I would call a consumer-led rebound.” Although he does expect the consumer to participate in the recovery, with positive consumption numbers as the economy picks up, this spending will not surpass GDP growth, Dye says.

However, business investment may be the push that’s needed for now. “Business investment, I think, is going to be a stronger propeller of the economy in 2010, but businesses have to gain confidence that the right programs are in place again for long-term growth. I think business confidence has been deeply wounded as has consumer confidence, and it’s going to take a while to repair that.”

With this lack of consumer confidence, it shouldn’t be a surprise to anyone that CAPEX spending for U.S. businesses has become quite conservative. Dye calls it “justifiably conservative,” but also sees positive signs, noting that, “we’re starting to see trends that a confidence may be coming back. We’re going to be getting PNC’s semi-annual survey of small business owners results back over the next couple of weeks, and we hope to see some indicators that business confidence is being restored slowly. But I would say, as of right now, businesses are justifiably conservative and no one right now wants to be in a position of overextending themselves and risking a double dip or a W-shaped recovery trajectory. I think what we need to see is strength going into early 2010 to really justify a commitment to capital expenditures.”

In last year’s interview with the Monitor, Dye noted that we were in a cycle where we would see a shakeout in the financial services industry, which also saw the same in the restructuring of the auto industry as well as in residential construction. He added that these shakeouts would be healthy overall to the economy as we go forward into the next expansion. Although at the time of the 2008 interview, Dye was optimistic, predicting the turnaround to be at the end of this year, the events of the past year indicated otherwise. Now, with a look ahead, Dye says that the restructuring, especially of the financial services industry, is ongoing.

“This fall when the PPIP gets off the ground, if that can start to prime the pump for some of these derivative markets that are still greatly impaired, that will be a positive for the economy.” Another major need for healing comes from what Dye calls a foundational issue — home prices. “The latest data shows that house prices are starting to level out but we cannot say with any certainty right now that they are going to be consistently increasing any time soon… With a high unemployment rate, it is very difficult to see home sales bouncing back even though they have stabilized.” Dye predicts that they will start to stabilize by the second half of next year, but until then there will be a “fundamental weakness in any of these home/residential mortgage type derivatives.”

Taking the good news with the bad and somewhat murky, Dye does say he sees a “technical” end to the recession.

“I don’t want to get overly excited at this point and say that we’re out of the woods yet because there is a reasonable chance that the following two-to-three quarters could be weaker than we expect at this point,” he explains. “As long as oil prices don’t get ahead of themselves, as long as the consumer savings rate doesn’t take another leg up, as long as the rest of the world GDP continues to heal and gain forward momentum, I think we’ll be in good shape. But those three things have to happen, and at this point, we’ve had so many surprises over the last year-and-a-half to two years that we really can’t rule any factors out.”

He continues, “We want to be positive, but we want to be conservative and keep our eyes open at the same time.”


Amanda L. Gutshall is an associate editor for the Monitor.

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