Businomics Blog

Is Your Management Team Prepared for Recession?

A business manager with 25 years of experience today has worked through two recessions.

Compare that to a generation ago:  in 1983, a manager with 25 years of experience would have worked through FIVE recessions.

Whether the current economy is going into recession, or merely a "recessionette," your senior company's management team needs to get its head above the day-to-day issues and think about what it will do if the economy turns really ugly.  Put aside for a while the question of how bad the slowdown will be.  You will gain more from contingency planning than from trying to figure out which of us economic gurus has the best forecast.

My simple four step process for economic contingency planning is described here, but you really should go to the book on how to adjust your business decisions to the changing economy.

Housing Vacancy Still Waaaaaay Too High

• We built more housing than we needed. 
• We still have too much housing. 
• We're not working off the excess very fast. 

(Underlying data released today here.)

Current vacancy of non-rental  housing units is 2.8 percent.  To my eye, a generous estimate of "normal" vacancy is 1.7 percent.  That difference, on a base of 78 million housing units, translates to 0.86 million too many non-rental housing units.  (On the chart, changes from thick to thin lines show changes in definition by the Census Bureau.)

Current vacancy is 9.6 percent; normal is 8.0 percent, on a base of 40 million units, for an excess of 0.64 units.

Total excess housing units in the United States:  1.5 million units.  (That's not a high precision estimate, but the true number, if it could be determined, is at least 1.3 million units, I think.)

Annual demand for new housing from population growth, change in family size, and second homes: about 1.4 million units (my estimate).  Average number of "losses," which includes tear-downs:  0.3 million units.  The losses are very volatile, but let's be generous and say that we need 0.3 million just to replace deteriorated housing stock.  Annual new demand for housing is 1.7 million units.

If homebuilders took 10 1/2 months off, we'd have supply-demand balance nationally.

I know, it's not a national market but rather a bunch of local markets, and you cannot move housing from areas of excess to areas of demand.  However, we obviously have too much housing in total, and that means that much of the country must also have too much housing.  The recent declines in new housing construction are not enough.  Look for another year of falling new construction and falling prices.

Now, would you like to hear some good news?  . . . .  I'm still thinking.  . . . . nothing yet . . . . well, how about this: the rest of the economy will not necessarily go into the tank along with residential construction.  Sorry, that's the best I could do.

New Home Sales Could Be Better Than They Look

New home sales plunged again, according to Census Bureau statistics:

However, at some point sales will be better than the official statistics, and that point might well be now.

The Census Bureau data misses canceled sales, which ran around 40 percent of total sales for some major homebuilders last year.  The bureau looks at particular houses; when one is reported sold, that house is removed from the statistical database.  If the sale falls through--like, if the buyer gets cold feet or does not qualify for a mortgage--Census never goes back to adjust the data.  So when cancellations are on the rise, sales are lower than official statistics.  What happens to those houses whose first sale was canceled?  When they get sold a second time (or a third), in a sale that finally closes, they are not counted as new home sales.  They are not counted because those houses were outside the Census Bureau database.

Are new home sales higher than official statistics?  I don't know.  At some time, though, true sales have to be higher than official data.  If it's not happening now, it will certainly be the case by later this year.

China Economy and Inflation: Strong and Weird

China's economy had another rip-roaring year, growing 11.4 percent for the year average.  (More details here.)  Experts on China had been saying that their long-run sustainable growth rate was about nine percent.  You have to take all of their numbers with a grain of salt; maybe GDP growth was over 11 percent, or maybe it was actually 9.  We don't know for sure, but we do know it was strong and higher than a non-inflationary growth rate.  We know this last point because inflation is surging.

That's the strong, now here's the weird, courtesy of the Financial Times:

Under the new measures, retailers of food products such as milk, pork and eggs will need to seek permission from local price bureaux, institutions that have long ago ceased to have any effective controls over produce markets.

Economists who say the measures will not work point to an announcement last year freezing prices for government-controlled commodities such as oil and natural gas.

Only weeks after this announcement, the government was forced to allow an increase in petrol prices to defray fuel shortages caused by escalating global oil prices.

That is followed by this worthy line (which may have been given to them by Richard Nixon):

“Our pricing law clearly states that the government wants to have a market-based pricing system.”

(Hat tip to China Law Blog for the FT article.)

Global Stock Markets: Some Perspective

Let's get some perspective on the stock markets around the world:

thanks to Dae Beck of the Oregon Office of Economic Analysis for passing these to me.

Major Banks Profitable in 2007--Who Woulda Thunk It?

The largest banks in the country were profitable last year.  Capital impaired?  It's hard to be capital impaired when you're hitting record earnings.  How does this square with all the bad news?  The losses were largely in the fourth quarter and were smaller than the profits recorded earlier in the year.  John Berry explains this quite well on Bloomberg (hat tip to Economist's View).  Berry was writing before Bank of America (BAC) announced its earnings, which were plus $15 billion.  OK, maybe I have a small town mentality, but it's hard for me to fathom how a company with $15 billion of profit could be hurting.

Economic impact: the banks have missed their targets, they are set back from where they were in the summer, but they are not so weak as to be unable to meet the credit demands of credit-worthy borrowers, whether companies or consumers.

Stock Market and the Economy: Not the Same Thing

When two things have different names, they are usually different things.  Take a look at stock prices and the economy:

The first thing you see is that changes in stock prices are far, far greater than changes in the economy.  There are two good reasons for this.  First, corporate earnings are more volatile than the economy.  If sales drop 10 percent, many companies will see profits fall 100 percent.  Their variable costs usually don't fall in proportion to the sales drop, and their fixed costs don't fall at all.  So fully rational investors should change their valuations of stock prices more than proportionately to changes in their expectations for the economy.  Second, not all investors are rational.  (Surprise!  You didn't know that?)  They often overreact to current news, causing stock market movements to swing much wider than economic trends.  There's also a herd effect that's at work.  You are getting nervous; not sure what to do; then you see everyone else selling like mad.  You sell.  It may not be rational, but it's more comfortable to follow the crowd.  This might be a good time to reread Keynes's General Theory.

What is the economic outlook, given the huge sell-off?  Here's a summary of the key points from Chapter 11 of Businomics:

• The economy impacts the stock market
• The stock market tends to be a leading indicator of the economy, but not consistently or with great precision
• The stock market can affect the economy, but only to a small extent

There's also a discussion for corporate CFOs about how to react to swings in your company's stock price.

For those of you involved in business planning, my 2008 economic forecast has slow growth this year, but no recession.  It's certainly time to do some contingency planning, as I discussed here.  You might also want to check out Chapter 7 of Businomics, which has a checklist for managing in a downturn.

Europe's Economy Decoupled from the U.S.?

Will the United States economic slowdown pull Europe down enough that we in the states will have an additional problem from them?  Or from a European perspective, has their economy decoupled from the U.S. to the extent that they'll be immune from our problems?

In theory, the knee bone is connected to the thigh bone.  However, the magnitude of the connection can vary from country to country, and from time to time.  The Euro area's GDP in 2007 will be about $11.9 trillion this year (according to IMF estimates).  U.S. imports from the Euro area have totaled $245 billion in 2007 through November; let's say $267 billion for the full year.  So Euro area's exports to the U.S. account for just two and a quarter percent of its GDP.

How much of a drop in our imports (Europe's exports) might we have in a U.S. recession?  Last recession our imports fell by 5.5 percent.  Let's say that with the fall of the dollar, our imports really drop, by say ten percent.  That would cut 0.2 percent off of Europe's growth rate, plus multiplier effects if any.  That does not send Europe into recession.  As for the echo effect, U.S. exports to Euro area amount to about 1.3 percent of our GDP.  You take 1.3 percent of a 0.2 percent drop and you get a trivially small number, less than three thousandths of one percent.  So forget an echo recession, unless . . .

The direct effect of a U.S. slowdown on Europe will be small, but it's possible that the same factors which are weakening our economy are also at work over there.  In that case, Europe could sink into recession for the same reasons we do, but not because we do.

But it turns out that the housing cycle is much milder in Europe than in the U.S. Take a look at the OECD's chart, which includes their estimates for 2007 and a forecast for 2008:

The bottom line is that I do not export Europe's economy to slow down very much, certainly not enough to slow down the U.S. economy.

Nonresidential Construction to Slow, Say the Architects

Nonresidential construction will slow this year and next, according to the American Institute of Architects.  (Details here.) Here are growth rates they are projecting:

Commercial / industrial	2008	2009
• Hotels	5.1%	-3.1%
• Office buildings	1.7%	-3.7%
• Industrial facilities	-3.8%	0.4%
• Retail	-5.7%	-3.6%
Institutional
• Health care facilities	5.6%	3.6%
• Education	5.5%	-0.1%
• Public safety	3.5%	0.4%
• Amusement / recreation	1.4%	-2.6%
• Religious	-1.0%	4.0%

Their forecast is in line with mine (though I don't go into as much detail).  Non-res has been a strong part of the economy over the past two and a half years, with no slow-down in activity yet.  That's probably because of the long lead times for many buildings.  The doom-and-gloom of 2007 and 2008 will show up in the construction figures this year and next.

But look at their forecast of 2009 religious facilities.  Maybe the downturn will help some folks return to spirituality.  Or maybe developers have found a way to get financing for spec churches.

Retail Sales: Proof of Recession?

December's bad retail sales report (details here) lead us to wonder if we now have proof of a recession.  I think not, though the report is certainly bad news.  Let's walk through the data:

Observe that the month-to-month data are naturally jittery.  The bad December report does not automatically mean we are in recession.  The third quarter (July, August and September) showed strong GDP growth despite coming on the heels of June's very bad retail sales figure.  Now let's look at the role of gas station sales:

Note that both of these charts are in dollars of change, not percentage change.  The second chart shows that almost half of the dollar drop in retail sales was due to gasoline.  You may recall the gasoline prices rose in November, then retreated in December.  The retail sales report is NOT adjusted for inflation, so gas prices push gasoline sales volumes up or down a lot.  What the gas data tell us is it's bad, but not quite as bad as the overall number shows.

Now let's smooth out the data by looking at 12-month changes:

Consumers are clearly increasing their spending measured over a longer time period, but they have slowed the growth rate of spending substantially.  Now, let's look at the actual level of the data:

The December decline in sales looks like just another little wiggle. and we routinely have such wiggles.

Economic Forecast for Business Planning:  The retail sales data do NOT confirm that we are in recession, but it's still possible that we are either in a recession now, or headed that way.  Business leaders should have in place their contingency plans for a worsening of this slowdown.  If consumer spending continues to decline for a couple of more months, then there's no avoiding a recession.  However, there's still a good chance that we are looking at a one-month blip, and the economy will grow--albeit slowly--this year.