2009 Outlook

By Walter Kemmsies, Chief Economist for Moffat & Nichol

This column is being penned on December 1, 2008, as the National Bureau of Economic Research has declared that the U.S. economy has been in recession as of December 2007. As recent events have shown, extremely large changes can occur on a worldwide basis over a very brief period. By the time this column is published, a lot of issues that matter to the 2009 outlook may be resolved, in particular, the level and focus of fiscal policy.

Given our expectations for coordinated monetary and potential fiscal policies to effectively stabilize the financial and housing sectors, and assuming oil prices aren’t driven back to the bubble levels of 2008, we expect the U.S. economy and foreign trade to begin to recover in the first half of 2009.

Looking Back

To understand how things will unfold, it is important to understand how the world economy got to its current state. The U.S. and Global economy suffered negative shocks in 2008:

• Oil prices spiked to $147 per barrel of West Texas Intermediate even as the global economy slowed. Drivers reacted by driving less for the first time since 1979, and car sales declined to levels not seen since the 1991 recession. Less driving correlated with declining retail sales and fewer imported goods. Unemployment, which had been rising modestly since March 2007, jumped higher in the summer.
• Residential investment declined at a double-digit rate since the third quarter of 2007 and this trend continued in 2008 while policymakers debated what to do.
• GDP and employment growth in the five years following the 2001 recession were the slowest compared to similar post-recession periods since World War II. For the first time, manufacturing employment fell during a prolonged non-recessionary period. Total employment rose (at a below-historical-average rate), thanks to growth in the service sector, which compensated for the loss of manufacturing jobs.
• Failing banks, accompanied by inconsistent treatment of faltering financial institutions, created additional uncertainty that helped freeze credit markets. This affected large corporations, like automakers, that depend on access to credit markets. These corporations became unable to provide credit to their customers, further aggravating the slowdown in consumer and company spending. The Troubled Assets Relief Program (TARP, informally referred to as the Bailout Plan) was hastily crafted in response to collapsing financial markets, but by the end of November had not been put into effect.
• After maintai ning its policy interest rates at historically low levels for several years during this decade, the Fed kept its policy interest rate at a high level even as problems in the financial sector began to emerge, and the economy began sliding into recession.

Recession Began May 2008

The decline in housing, topped by spiking oil prices, was too much for the economy to bear. The tax rebate checks, offered as a stimulus plan in the second quarter, were too little, too late in that they only postponed the contraction in GDP by a few months.

We estimate the U.S. economy entered into recession around May of 2008. The recession would have begun sooner if exports hadn’t grown strongly in the last few years and companies hadn’t been investing in infrastructure. U.S. inflation-adjusted GDP contracted in the third quarter, and given poor consumer spending trends and weakening export growth in the last few months, we expect the fourth quarter data to show continued recession in economic activity.

U.S. economic weakness has impacted other regions of the world. However, it was the collapse in U.S. financial markets that unsurprisingly precipitated the collapse of global markets, which spilled over into other countries’ economies that were already suffering from inflated commodity and energy prices. Real GDP began declining in European economies in the second quarter.

A Gloomy Start to 2009

The outlook for the beginning of the year is bleak, with consumer credit restricted when it is most needed, companies undoing failed investments under the guise of economic malaise, and state and local governments running deficits while they struggle to issue debt to finance their spending.

Even more worrying is the recent decline in the general level of prices in the U.S., Canada, and the UK. Deflation is a serious problem for policymakers — as the U.S. experience in the 1930s and Japan’s 1990s experience demonstrated.
The current situation is the worst-case scenario we had projected over a year ago. The sequence of events leading to this began with declining house prices leading to declining financial asset prices as homeowners sold their financial investments to make mortgage payments. Falling asset prices lower wealth and reduce consumer spending. Lower consumer spending drives export-dependent countries to engage in policies to stimulate exports and investment. Export subsidies effectively lower the price of goods to consumers in the importing countries.

In 2008, China increased its export subsidies twice and has cut its central bank policy interest rate three times. Economic weakness in China has also had the predictable effect of the yuan depreciating against the U.S. dollar. Between the depreciating yuan and export subsidies, prices of imported goods are prone to decline.
The last piece of the puzzle was falling energy and commodity prices, due to slowing growth in export-dependent emerging markets. Thus generalized deflation has occurred. Falling prices means lower company profits and layoffs. Higher unemployment means less consumer spending and further declines in prices.

Battling Deflation

The occurrence of deflation means that lowering interest rates and adding liquidity to the economy are insufficient to staunch the decline in economic activity. To accomplish that, spending must increase. However, consumers are unwilling and/or unable to do so, and companies are unwilling to do so. Therefore, the government must kick start the economy by increasing its spending, preferably on things that employ people.

For this reason, President Elect Obama’s advisers are recommending a second government stimulus to the economy to take place within less than a year of the modest $150 billion tax rebate in the second quarter of 2008. Furthermore, the Federal Reserve will have to keep interest rates low and supply ample liquidity to financial markets at least until the end of 2009.

According to the Federal Reserve’s Survey of Professional Forecasters, the federal government is expected to pass a $211 billion package of increased spending and tax reductions. However, the survey was taken on November 10. Since then, the economic news has worsened with General Motors considering a bankruptcy filing.
We estimate that, excluding the TARP handouts to financial institutions, the government will pass a fiscal spending package of $300 billion to be activated before the end of the first quarter. Some of this package will include tax cuts and spending on activities that will create jobs. Some of this money should find its way to transportation infrastructure. However, given the substantial delays between planning/permitting and commencement of construction, transportation infrastructure spending would not have the immediate effect of avoiding a prolonged recession characterized by deflation.

Improvements in Early 2009

Given our expectations for continued monetary policy support and fiscal policy, in the U.S. and in other major economies, we expect recession to end in the first half of the year.

The European Union is attempting to pass a EUR 200 billion program (about $250 billion) for early 2009. Japan, China, and India are doing the same. Currency effects aside, this should support U.S. exports growth and, thus, the economy. Therefore, the second half of the year is forecast to see sustained expansion. The amount of policy stimulus should see strong growth in the second half, but the weak first half means that the overall real GDP growth rate is unlikely to exceed 1.5 percent.

However, it should be noted that the forecast is policy action-dependent. If the government doesn’t pass a substantial policy package, and the Fed doesn’t keep its supportive policies in place until not only the economy begins to recover, but also until home prices stabilize, then the U.S. economy would struggle well into 2010. Given what President Elect Obama has been saying about taking immediate action, this downside scenario is unlikely to unfold. In our view, policymakers now feel that they have carte blanche to do whatever it takes to stabilize the economy.

With all the policy stimulus that countries around the globe are enacting, we expect to see a surge in global economic growth in the second half of the year. Provided oil prices do not spike up on another speculative frenzy, growth in 2009 could recover strongly just as it did in 1999 after an anemic performance in 1998.

Implications for Container Trade

The early signs of recovery will primarily feature inventory building as retailers re-stock, correlating with rising imports. Even earlier than that, we expect to see empty containers being returned to Asia with a commensurate reduction in empty containers stowed at Asian ports’ container yards.

By the third quarter of 2009, we expect to see strong container volume growth and ocean carriers re-deploying laid up ships. Although unemployment has tended, in past recoveries, to continue to rise even after the economy begins expanding, growth in unemployment insurance claims tends to peak at the end of the recession. Therefore a slowdown in the rate of growth of unemployment claims will also provide confirmation of recovery.

We remain concerned that the effort to revive global growth and avoid deflation could see inflation rise significantly late in 2009 and force policymakers to slow the economy within a short period of time after that. We expect below average growth for the next several years. Next month we will lay out our medium term (five year) outlook in more detail.