Life Among the Ruins?: The U.S. Economy Post-9/11
By Scott B. MacDonald and Keith W. Rabin
The twilight of the Gods has arrived. Gone is the shining hope of the "new economy" and the alleged massive gains to productivity caused by IT. The words of Harry S. Dent, once proclaimed as one of "the world's most prescient forecasters", now appear to be so much intellectual flotsam: "The Roaring 2000s will come with the aging of the massive baby boom generation into its peak productivity, earning and spending years and the emergence of their radical information revolution into the mainstream of our economy. Tighten your seatbelts and prepare for the greatest boom in history: from 1998 to 2008!" We concur that you should tighten your seatbelts, but that the ride is going to be bumpy and there are going to be some big ups and downs. Any forecast is now greatly complicated by geopolitical variables, including the war on terrorism, the fate of governments in Pakistan and Central Asia and the ability of the global economy to proceed toward recovery.
So is it time to store up on food and ammunition and head for the bunker? What are implications of 9/11 on the US economy moving forward? Plunging consumer demand, a 0.4% contraction in Q3 real GDP, ongoing bad news on the corporate front, and rising unemployment reflect the U.S. economy slipping into its first recession in almost 10 years. In addition, expectations are that the 4th quarter of 2001 is going to be worse. While there is a lot of bad news, this must be seen in balance with other forces at work. The U.S. Government now has a $100 billion stimulus package aimed at reviving economic growth. Also the Fed and the Treasury Department are reportedly doing everything possible to turn the situation around. Even after the November 6th FOMC meeting cut 50 bps from the fed funds rate, many economists anticipate further cuts.
Last week also saw the end of the 30-year Treasury bond. Although this took many on Wall Street by surprise, it is a positive for the economy. The suspension of the long bond issuance was done to lower longer-term borrowing costs and stimulate the economy. The Treasury and Fed were worried that long-term interest rates were holding down the economy. The federal government is believed to be doing everything that it can to re-stimulate growth. We think these measures will help set the stage for a recovery in 2002, probably starting in the 2nd quarter (with 1% real GDP growth). At the same time, we emphasize that the recovery is not likely to be robust compared to the dynamic growth of the 1990s. Rather, we expect -1.5% in Q1, 0.5% in Q2, 2.0% in Q3 and 2.5% in Q4, providing a year-end real GDP growth rate of 0.9%. It is important to note that the process to restimulate the economy is going to take time and must contend with higher unemployment (heading toward 6%), reluctant consumers, falling housing starts and depleted personal savings.
The idea that the economy will eventually return to growth is evident in the strategy of the major U.S. automakers. Sales for Ford, GM and Daimler Chrysler were up recently due to their new zero financing programs. This tells us two things: the auto makers are fighting hard to maintain market share and that they are willing to offer such programs until the economy picks up again. Many companies continue to cut costs, reduce work forces, slash debt and sell assets with a view that when recovery sets in they will be well positioned. There is an acknowledgement that the recession is here, but that it is better to take the pain up front. This bodes well for a recovery during the scond half of 2002. .
The U.S. corporate bond market is still making a gradual recovery from what was a very difficult September. This has been partially due to the improved performance of the equity markets. The equity market is being nudged upwards by a lot of liquidity and cash being put to work by mutual funds and other large institutional investors. We expect that the equity rally will continue and that the corporate bond market will be linked to that trend. Additionally, corporate bonds continue to be cheap compared to historic levels and are drawing investor interest.
Another factor helping the corporate bond market is the now widely recognized perception that the U.S. economy is in recession. Large institutional investors are placing their money on companies and sectors such as:
1. Food/agriculture expected to do well during the recession such as Albertsons, Conagra, Kroger
2. Defense and security companies likely to benefit from the war on terrorism
3. Companies that are likely to emerge more rapidly than others from restructuring and debt reduction
Although equity markets are likely to remain volatile, the improved mood on the New York Stock Exchange and NASDAQ have been helpful in sustaining some degree of spread tightening in the corporate bond market. Over the past couple of weeks we have noted that liquidity is continuing to return and the new issue pipeline remains open. While we see trends moving in the right direction, we must add that there remains considerable sensitivity to the possibility of another terrorist attack in the United States. If another major attack occurs, it would certainly be taken negatively with spread widening and raise further concern about airline, travel and entertainment companies. Still, the absence of another attack the corporate bond rally will continue to make slow, yet gradual gains.
For equity markets the short term is likely to be one of volatility, but a gradual swing upward. There is a very real possibility that a new bubble is occurring with a view that stock market improvements will make Americans feel better and with that the consumer will return. We think that any sustainable recovery in the stock market is not likely and that the bears will return, probably in time for Q4 earnings season. Unfortnately there remains a lot more bad news to come. Heavy debt loads, tough competitive markets and a retreating consumer are still going to push many companies into restructuring and, in some cases, into insolvency. Look at the recent troubles of Goodyear Tire. Although Goodyear is not headed towards bankrupcy, it has serious problems in its ability to make a profit in tough markets and is floundering.
One last point we would like to make - U.S. banks are not about to head into a major crisis along the lines of 1989-91. During the last recession in the early 1990s, U.S. banks had a difficult time. There was concern that some of the largest banks were going to fail. Once again there are some analysts arguing that the U.S. banking system is heading into a big crisis. On October 5th the regulators released their annual report on shared national credit or syndicated loans (SNIC). Based on a detailed examination of the country's biggest banks, the data showed a worsening in creditworthiness. In 1998 some 2% of all bank loan commitments were "adversely rated". That rose to 5% in 2000. The October 2001 report shows a marked increase in adversely rated loans, which have risen to almost 10% of all commitments. The expectation is that the next SNIC will show a bigger increase. When the last cycle bottomed in 1991, the shared national credit study cited 16% of loans as having serious problems. The regulators expect that number to be reached in mid-2002.
Despite predictions of doom, the US recession has arrived without any major bank failures nor do we expect any. Indeed, average profitability improved among U.S. banks since Q2 despite increased provisioning and continued restructuring charges. It is often overlooked that the majority of major banks did not make loans to the dotcoms (as they usually lacked any collateral) and, unlike Japanese banks, few U.S. institutions own shares, which means their capital was not directly depleted by the fall in share prices. Moreover, consolidation and restructuring have resulted in a stronger banking industry. The average rate of return on assets is 1.2%, compared with 0.5% in 1989. Capital strength has also improved. In addition, banks that originate syndicated loans are better at placing them outside the U.S. banking system - foreign banks hold 41% of the syndicated loans and non-bank financial institutions hold around 10%. Furthermore, the bankers are benefiting from the lowering of interest rates, which means a lower wholesale cost for its main product, money.
Two last points to remember about U.S. banks. First, as the recession takes hold, the level of nonperforming loans will rise. That happens during recessions. Consequently, we expect to see further deterioration in the creditworthiness of bank loan portfolios going into 2002. Second, U.S. banks are well-positioned to ride through a recession. They do not carry the baggage of 10 years of bad loans like Japanese banks nor will they sink their equity prices. If growth resumes in the second half of 2002, as we suspect, U.S. banks will have weathered this recession in good shape.
The recession of 2001-02 is going to be sharp and will force a tough restructuring on corporate America. We hope that recovery will begin Q2, but caution that many variables exist - the threat of new terrorist attacks, a sharper-than-expected retreat of the U.S. consumer and a worst-than-forecast recession for Japan. There were considerable excesses during the 1990s. Now, the U.S. is watching gravity pull the high-flying economy back to earth. Let's just hope that the landing allows the economy to take off again in 2002.
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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, Keiichiro Kobayashi, Jonathan Lemco, Jonathan Hopfner, Darin Feldman, Uwe Bott