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By Uwe Bott It is no secret that economics is an imperfect science at best. However, since the events of 9/11 we have truly experienced a shift of paradigms. Many things that we ordinarily assumed to be constant are uncertain today. The universe of forward-looking scenarios, political as well as economic, has grown and is now nearly infinite. Anything we say or predict must be measured against that stark background. For example, a nuclear attack against a major population center in the United States, and especially against the site of our federal government, Washington DC, is unlikely but far from impossible. The consequences of such attack, i.e. the elimination of government as provided for under our constitution are unthinkable. Therefore, we have to reduce our new universe to something more manageable. This does not mean to assume normalcy. Normalcy as we knew it on 9/10 will not return for a long time, if ever. Yet, policy-makers, analysts and investors have to design a stable platform of assumptions to make decisions that will impact our outlook for the coming years. My base case in looking at the U.S. in 2002 is one, in which we might continue to fight a war in Afghanistan. At a minimum we will have large concentrations of our military forces committed to that region. We will also continue to pursue the terrorist networks responsible for the mass murder of 9/11. At the same time, we are unlikely to face an attack similar to or worse than that of last September. Obviously, our outlook is so much grimmer should I be wrong in my last assumption, but this is a truly unpredictable scenario as is the likely fallout from it. There is a 20% probability that the war might spread to Iraq, should we determine that Saddam Hussein was directly involved in 9/11 or in the anthrax attacks on our population. Such a scenario would likely have a negative impact on our outlook for the U.S. economy as well, but it is far from clear that it would sharply differentiate from our base case. Much would depend on the way in which such expansion of the war were undertaken and how able the administration would be in shoring up global support for it. Shrewd diplomatic management could considerably reduce costs to the U.S. economy. Yet, the state of the U.S. economy is weak and will be even weaker at the beginning of the New Year. Growth in the fourth quarter will contract by as much as 2.5% when compared to the fourth quarter of 2000. Interest rates were lowered once again on December 11 by a .25 bp point in recognition of this weakness. At the same time, the Federal Reserve is running out of maneuvering room. Further fiscal stimulus has been subject to partisan debate. The outcome is likely to have negative long-term effects on fiscal stability that far outweigh the short-term benefits. The Bush administration is a already preparing the population for a return to seemingly irreversible budget deficits. This was a very predictable and predicted consequence of a weakening economy and the first phase of the Bush tax cut. The return to years of deficits is partially responsible for the stubbornly rising interest rates in the bond market, a reaction that nullifies much of the Fed action. Unemployment has risen to 5.7% in November and may reach 6% by year end with further bloodletting to be expected. This is indeed a poor starting position for 2002. It is especially of concern, when one considers that there is considerable room for further softening. In spite of recent events, consumption has remained unreasonably strong with a lot of potential for a downward correction, as has the real estate sector. It has been much noted that our financial system has not experienced any fundamental weakness yet, because the real estate market has remained strong. Given the existing fundamentals as well as a diminishing appetite for mortgage refinancing once interest rates have leveled off, residential and commercial real estate are likely to suffer steep losses in the first two quarters of 2002. This, in turn, will negatively impact the balance sheets of our banks. At the same time it is important to note that the usual remedy to such a downturn in the real estate market, i.e. lower interest rates, will already have been used up by the Federal Reserve, as we approach a zero interest rate policy comparable to that of Japan. The financial system is not mortally wounded by any stretch of the imagination, but the Enron disaster has underlined the lack of transparency even in the sophisticated U.S. market. There are likely to be many skeletons in the closets of the financial system. Durable consumer goods, and especially cars, have also done extraordinarily well in October of 2001, when car sales reached a record high. This has boosted our monthly retail sales to an abnormally high 7.1% growth rate compared to October 2000. However, this record high was the result of give-away, zero percent financing offers by U.S. automobile manufacturers. This "subsidy" has had a detrimental impact on current earnings expectations for those companies. Moreover, it also reduces volume projections in the automobile sector for 2002, suggesting that the earnings trough for that industry may be a lengthy one. At the same time, this too underlines the danger that monetary and fiscal policy will continue to fail to stimulate the economy, because the most sensitive sectors to such policies have in fact experienced a growth bubble during the third quarter of 2001. Hence it is likely at this point that the economy will further and possibly more sharply contract in the first quarter of 2002, perhaps by as much as 3% compared to the first quarter of 2001. Unemployment may reach 6.8% in March of next year, which will have a contractionary impact on consumption. A major concern under this scenario is that the continued weakening of the U.S. economy will be exported to the rest of the world. A global recession will diminish prospects of an early and strong recovery in the U.S. A global reduction of trade is a lose-lose proposition. Thus, the economy may continue to contract even in the second quarter of 2002, albeit at a slower pace, maybe around 1.5%. In my base case scenario of a controlled military exercise with limited further casualties in the United States, we will be confronted by the end of the first semester of 2002 with a negative growth rate of over 2% when compared to the first six months of 2001. This will be characterized by a severely weakened financial sector, an environment of high unemployment (over 7% by June 2002), falling prices (deflation may reach 1-2% in the United States during the first six months of 2002), and a lagging global slowdown that will have peaked during the second quarter. At that point, opportunities should begin to emerge. A continuously low interest rate environment and accelerating consolidation in the corporate sector will lead to increased efficiencies, albeit to even higher unemployment, and accommodating fiscal policy will allow for a slow recovery in the third quarter of next year. The core of this recovery will likely come from the technology sector that will be considered as oversold at that point. Companies will start to invest again in updating their technologies. Consequently, there will be productivity gains during the second half of 2002 that might compete with those experienced in the late 1990s. The important real estate and automobile sector will be drags on the economy, however, because they were artificially inflated during the early period of the U.S. recession. Growth will be at 1% in the third quarter, rising to 1.5% during the fourth quarter of 2002 because of a recovery in foreign markets. All in all, 2002 will be a calendar of negative growth, high unemployment, falling or stable prices in an environment of low interest rates and loose fiscal policy likely to result in a significant budget deficit for that year. Towards the end of 2002, the Fed will be on its toes and begin to raise interest rates ever so slowly to prevent inflation in 2003 without choking off growth. This will indeed be a challenge. The Fed has radically driven down rates to levels not experienced for 40 years. At the same time, the Bush administration has put in place fiscal stimulus before and after 9/11. Much of the stimulus put in place before 9/11 will grow exponentially as the decade progresses. This may indeed result in an overheating of the economy in early 2003 accompanied by rapidly rising prices, which will be difficult to contain through interest rate policy alone. Therefore, we are likely to face much greater economic volatility and instability over the medium term in the United States than we did in the second half of the 1990s. Our fiscal position will worsen and it is indeed very likely that most of the gains of fiscal prudence accomplished during the 1990s will have been squandered by 2005. As the Chinese saying goes: We are living in interesting times.
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Editor: Dr. Scott B. MacDonald, Sr. Consultant Deputy Editor: Dr. Jonathan Lemco, Director and Sr. Consultant Associate Editors: Robert Windorf, Darin Feldman Publisher: Keith W. Rabin, President Web Design: Michael Feldman, Sr. Consultant Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Uwe Bott, Jonathan Lemco, Jim Johnson, Andrew Novo, Joe Moroney, Russell Smith, and Jon Hartzell
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The
U.S. Economy in 2002: Rebound or Unsound?