PNC Economist Discusses the Economy, Industry Into 2009

by Darryl Seland October 2008
With the barrage of negative economic indicators over recent months, the Monitor took the opportunity to sit down with Robert Dye, senior economist of The PNC Financial Services Group, Inc., to get some perspective on the state of the economy and where the industry is headed as we enter the last months of 2008 and the start of the new year.
Robert Dye VP, Senior Economist, The PNC Financia; Services Group, Inc.

It shouldn’t surprise anyone to say that the U.S. has been in an economic slump since the end of 2007 with the problems created by the subprime mortgage market and the tightening of lending practices, but the question may be, how far along in the down cycle is the economy?

“We have to separate it into a couple of components, one of which is the cycle in financial markets and the other being the real economy,” says Dye. “And as the subprime flu spreads through financial markets we are starting to see, I think, a bottom in that cycle.”

At the time of this interview, there were reports of ongoing losses at Fannie Mae and Freddie Mac, as well as talk of an intervention at the Treasury Department to prop up these government-sponsored agencies. Dye calls this a sign representing the bottom of the cycle. “I do not expect to see a significant deterioration in financial markets after the problems of Fannie and Freddie are resolved,” says Dye. “There is a lot of repair that has to be done to balance sheets, but I am not expecting to see another big shoe drop after this.”

According to Dye, we will continue to see write-offs and some stress, particularly at some regional banks that need to raise capital. “But, I think the overall level of fear and anxiety within these credit markets, in my impression, has peaked,” he says. “If you look at the spreads in interest rates between a market-based euro-dollar rate and an equivalent treasury rate, that spread has been easing over time.

“I would say that if we were in a nine-inning ball game, we are probably in inning six. We are over the halfway point, not out of the woods yet. But I am not expecting to see any more major surprises,” he says.

Along those same lines, on August 5, the Fed elected to hold off on making any changes to short-term rates, to the surprise of no one, including Dye. “The Fed is reconfirming a more balanced risk assessment right now, saying that there are downside risks to growth ahead, as well as some upside risk to inflation. I think that with housing markets in disarray, and with ongoing job losses that look like they are going to continue through the rest of this year, the Fed is not in a position to be raising rates.”

Retail Sector, Others Hit Hard
Dye also mentioned that job losses, including in the retail sector, are influencing the Fed’s actions on interest rates. “We are seeing ongoing job losses in the retail sector,” he explains. “That unfortunately does put the squeeze on lower income households, who may have had employment in that sector. One aspect of the slowdown that does not get enough airtime is how difficult it is for low-income households right now who are taking the brunt of the job losses and feeling the brunt of the price of inflation right now. There is definitely a price squeeze on those households.”

The domino effect of the slowdown in retail is hurting commercial construction. “We have had a good amount of inertia keeping office and other commercial construction numbers fairly healthy so far this year, but lower job growth means less demand for office space, and consolidation in the retail industry means less demand for store space. We are also starting to see some consolidation, or at least slower growth, in leisure and hospitality industries as well,” Dye says. “That says that overall commercial construction numbers are likely to get softer before they get better.”

However, with all things economic, current negatives can lead to future positives. “The Fed is in a place where it simply has to let the low interest rates work to stimulate the economy and wait for some signs of fundamental [GDP] growth in early 2009 before they will start to increase rates,” he adds.

“If GDP numbers are plotted on a graph, beginning with the third quarter of 2007, we would see a ‘W’ on the graph when we slowed down significantly at the end of 2007. While we are currently enjoying a boost from the fiscal stimulus, we expect to cool down again at the end of 2008 before the economy picks up steam in 2009,” says Dye.

As he points out, the ongoing stress to consumers in the form of very weak consumer confidence, job losses and declining house prices, means a continuing drag on consumer spending for the rest of this year and an expectation of very weak economic growth in the second half of the year, before things firm up again in 2009.

“We did get a boost from the fiscal stimulus package, nearly $100 billion distributed to low- to middle-income households,” Dye says. “Now that the program is finished, we should expect to see some lingering positive effects. Unfortunately those stimulus checks were delivered right when oil prices were at their peak, so a lot of it was spent filling gas tanks and paying for higher food prices.”

From another point of view, those checks hit taxpayers right when consumer confidence was bottoming out, and auto sales were falling rapidly. So the fiscal stimulus checks did not go to durable good purchases, which would have had a stronger multiplier effect on the economy.

“The drag from auto sales right now is overwhelming the boost from the fiscal stimulus, so we are expecting to see consumer expenditures soft in the third quarter and perhaps even softer in the fourth quarter,” he notes. “It’s not to say that the stimulus package was a failure. I think we would be in far worse shape, in the second half of this year without it,” he explains.

So, if the obvious benefits of the stimulus package were dampened by economic conditions and consumer confidence remains low, what does that mean for business investment and the potential for GDP growth in the future? In other words, are businesses sitting on cash in anticipation of tough times ahead?

“There is a profit squeeze going on right now with high energy prices, even though we have had some recent relief,” says Dye. “And $120 a barrel oil only looks good compared to $145 per barrel for oil. It doesn’t look good compared to $80 or $90 a barrel from last year.”

It’s pretty simple — input prices are high and demand is weak and producers are caught in the middle. This is going to be a drag on business investment. At the same time, however, there is an incentive from the fiscal stimulus. “The tax incentives were designed to promote investment, and there may be a use-it-or-lose-it mentality that leads to more business investment toward the end of this year, before that tax incentive goes away,” he says.

According to Dye, there are two factors at play. “It is my feeling that the profit squeeze is going to overwhelm the tax incentive, but again, it’s a question of what would things look like without the tax relief,” he notes. “It put a floor under things and I think the way we need to look at the stimulus package is both in terms of the impact on consumer spending and the impact on business investment. It does help to firm up the floor. Unfortunately, because of economic conditions, it is looking like it is not going to result in rosy top-line numbers for the second half of the year.”

On top of the complex economic situation, we have a Presidential election, which adds uncertainty to business planning for 2009 and beyond. According to Dye, the two biggest factors governing the election are the state of the economy and how long the incumbent has been in office. “Based on political modeling, those factors point to a change in party,” he says.

Where We Are Headed
As we look beyond the election into 2009, what can we expect for the business investment as well as the general economy? “Falling oil prices are a positive for the economy right now, which affects everything from consumer spending to food prices to producer prices,” says Dye.

Fully aware of potentially overusing his allotment of metaphors, he adds, “blowing the froth off the oil market is a major relief for the economy.”

And, not unheard of in the financial or political worlds, much of a potential turnaround in the economy has to do with consumer confidence. “Consumers are going to be feeling better about $3.50 gasoline than they were about $4.25 gasoline,” says Dye. “That does improve consumers’ mood and allows them to spend on other things.”

Looking ahead, other positives for the economy, according to Dye, are some factors that are currently negatives, including housing and consumer confidence. “Housing starts are getting to that point where they typically turn around,” he notes. “We are close to the turnaround rate of 800,000-900,000 housing units per year. Even if residential construction continues to slide a little bit, the drag from construction is getting smaller. This will allow other positive parts of the economy to give top line GDP a boost.”

Currently, the low value of the dollar and still-expanding global GDP is very good for export-oriented manufacturing. “Both components of that — the low value of the dollar and the fact that global demand has been high — look like they are starting to turn,” Dye says. “The dollar is bottoming out and will tend to gain value through the rest of the year as global GDP falters. The good news for international trade is that these markets don’t turn on a dime — there is quite a lot of lag time in the process, so I do expect trade numbers to continue to add to real GDP growth, but to a lesser extent by the second half of 2009. If we continue to see softening in Europe and possibly a post-Olympic let down in China, I would expect to see less benefit from trade in 2009.”

Another source of energy in the economy to watch for is improving business confidence and a return of those “animal spirits,” which Dye defines as an improved appetite for risk-taking behavior. “We look for capital to start flowing into areas where it can be best put to use and that is part of the creative destruction that is an important part of the business cycle.”

He continues, “We are in a cycle now where we are seeing a shakeout in the financial services industry, we are seeing a restructuring in the automotive industry, we are seeing a massive shakeout in residential construction and all of these are ultimately going to be healthy things for the economy as we reposition ourselves for the next expansion. The difficult thing is looking around and seeing exactly where the energy is going to come from. It’s very hard to see that when you are in the bottom part of the cycle, but I do have faith that it will come and we will be on track by the second half of next year and things are going to look much better.”

Darryl Seland worked as an editor and writer for a number of trade publications and industries, including software, heavy equipment, home building, insurance and the automotive aftermarket. Previously, he was an associate editor at Construction Equipment Guide. He also is currently earning his M.B.A. in finance. Seland can be contacted via 
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