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The Economic Outlook: How Hard A Landing? David Wyss Chief Economist Standard & Poor’s NAHB Outlook Conference Washington October 18, 2006 CONFIDENTIAL AND PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Copyright (c) 2006 Standard & Poor’s, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved. The Recovery Is Slowing • After a strong 2004 and 2005 • Growth has slowed to below trend. • The economy is rotating from consumer- and housing-led growth to investment-led growth. • The Fed is through hiking interest rates, and will probably have to reverse next year. • The housing market peaked last summer, but is more stalling than plunging. Starts are expected to drop 25%. • Oil prices are coming down from record highs, restoring some purchasing power. • Katrina rebuilding has been slow. • Stronger European growth and a weaker dollar should mean less drag from the trade deficit. CONFIDENTIAL AND PROPRIETARY. 2. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Another Soft Landing Recession 1967q2 * 1970q4 1975q1 1980q3 1982q4 1987q1 * 1991q1 1995q4 * 2001q4 GDP Growth (4 qtrs to Unemployment trough) (trough) Change 2.4% 3.9% -0.2% 6.1% -2.3% 9.0% -1.6% 7.8% -1.4% 10.8% 2.5% 6.9% -1.0% 7.8% 2.0% 5.8% 0.2% 5.9% 0.3% 2.7% 4.4% 2.2% 3.6% 0.3% 2.6% 0.4% 2.1% Fed Funds Treasury (peak) Change yield (peak) Change 5.76% 4.59% 5.22% 1.07% 9.19% 5.40% 7.91% 1.74% 12.92% 9.63% 7.40% 1.12% 17.61% 13.00% 12.75% 5.88% 19.10% 10.07% 15.32% 1.85% 11.64% 3.13% 13.56% 3.18% 8.29% 2.38% 9.85% 3.27% 6.05% 3.09% 7.96% 2.63% 6.54% 1.91% 6.66% 2.13% * Soft Landing CONFIDENTIAL AND PROPRIETARY. 3. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Housing Starts (trough) Change 843 -461 1,085 -808 904 -1590 927 -1270 902 -645 1,271 329 798 -823 1,249 -315 1,540 -258 Oil Prices Hit New Highs ($/barrel, WTI and deflated by CPI; household energy purchases as percent of disposable income) 90 80 70 60 50 40 30 20 10 0 1980 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 1985 Oil price (WTI) 1990 1995 2005 dollars 2000 % of disp. income (right) Source: BEA CONFIDENTIAL AND PROPRIETARY. 4. 2005 Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. The World Is More Energy Efficient (Tonnes of oil equivalent per $1000 dollars (2000 dollars) of real GDP) 1 0.8 0.6 0.4 0.2 0 US France Germany UK 1971 1980 Japan China 1995 Source: OECD CONFIDENTIAL AND PROPRIETARY. 5. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. India World 2004 The Fed Is Moving Toward Neutral (Percent) 10 8 6 4 2 0 1995 1997 1999 2001 Federal Funds Rate 2003 2005 2007 10-Yr Bond Yield Source: Federal Reserve CONFIDENTIAL AND PROPRIETARY. 6. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 2009 Mortgage rate Interest Rates Had Converged (Long-term government bonds) 6 5 4 3 2 1 0 US Canada Japan Oct-04 Euro Dec-05 UK Oct-06 Source: Bloomberg CONFIDENTIAL AND PROPRIETARY. 7. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Australia Quality Spreads Grind Tighter (Spread over Treasury yields, basis points) 900 800 700 600 500 400 300 200 100 0 2003 2004 Investment grade 2005 2006 Speculative grade Source: S&P CONFIDENTIAL AND PROPRIETARY. 8. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Financial Risk Is Greater 100% 80% 60% 40% 20% 0% 1980 1985 AAA AA 1990 A 1995 BBB 2000 Junk Source: S&P CONFIDENTIAL AND PROPRIETARY. 9. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 2004 But Corporate Debt Has Dropped 6 0.6 5 4 0.5 3 2 1 0 0.4 1993 1996 1999 Cash flow/debt service 2002 Debt/net worth (right) Source: Federal Reserve Flow of Funds CONFIDENTIAL AND PROPRIETARY. 10. 2005 Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. World Growth Is Steady (Real GDP, % change) 8 6 4 2 0 US 2003 Canada Eurozone 2004 2005 Japan 2006 Other Asia 2007 Source: Global Insight and S&P CONFIDENTIAL AND PROPRIETARY. 11. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Latin America 2008 And Comes Mostly From Asia (IMF purchasing power weights, 2005) Other 19% Other 19% US 21% US 15% Eurozone 4% East Eur 7% Japan 4% East Eur 9% Other Adv 8% Eurozone 15% India 6% India 10% China 15% Japan 6% China 31% Other Adv 11% Percent of World GDP Percent of World Growth Source: IMF CONFIDENTIAL AND PROPRIETARY. 12. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Fiscal Deficits Almost Everywhere (Government balance as percent of GDP, 2004) 3 2 1 0 -1 -2 -3 -4 US Canada France Germ. Italy Source: IMF CONFIDENTIAL AND PROPRIETARY. 13. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. UK The Future Looks Bleak (Government debt as % of GDP) 600 530 500 350 400 300 200 100 113 173 101 49 223 182 38 62 57 86 220 59 71 0 US Japan 2005 UK France 2025 Source: S&P CONFIDENTIAL AND PROPRIETARY. 14. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Germany 2050 Aging Populations Will Boost Government Spending (Ratio of over 65 population to labor force) 60 50 40 30 20 10 0 US Canada France Germany Italy UK Japan AustraliaMexico OECD 2000 Source: OECD CONFIDENTIAL AND PROPRIETARY. 15. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 2020 US Trade Deficit Balances Surpluses Overseas (Trade balance as percent of GDP, 2005) 6 4 2 0 -2 -4 -6 -8 US Canada Germany France Italy UK Japan Source: Global Insight CONFIDENTIAL AND PROPRIETARY. 16. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. China India US Borrows From Abroad to Offset Weak Savings (Percent of GDP) 22% 20% 18% 16% 14% 12% 10% 8% 1970 1975 1980 Gross saving 1985 1990 1995 Private saving 2000 Private investment Source: BEA CONFIDENTIAL AND PROPRIETARY. 17. 2005 Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Can the Consumer Keep Spending? • Consumer spending has led the expansion • The tax cuts provided extra income • Lower mortgage rates freed up funds • Confidence is up • But the saving rate is negative • Tax cuts are over • Interest rates are up • Home prices are dropping • Net result will be a slowdown, not a retreat • Helped by lower energy prices • The saving rate will remain low CONFIDENTIAL AND PROPRIETARY. 18. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Household Debt Hits Record As Saving Goes Negative (Percent of after-tax income) 10 1.4 8 1.3 6 1.2 4 1.1 2 1 0 0.9 -2 0.8 1990 1993 1996 1999 Saving rate 2002 2005 2008 Debt/income (right) Source: BEA and Federal Reserve CONFIDENTIAL AND PROPRIETARY. 19. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. More Mortgages, Fewer Credit Cards And Other Loans (Percent of household debt, 2004) 2004 2001 1998 1995 50 60 Primary residence Credit Card 70 80 Other mortgage Other Source: Federal Reserve SCF CONFIDENTIAL AND PROPRIETARY. 20. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 90 100 Installment But Wealth Continues Strong, Helped By Housing Markets (Percent of after-tax income) 700% 600% 500% 400% 300% 200% 100% 0% 1990 1993 1996 1999 Net worth 2002 2005 2008 Financial assets Source; Federal Reserve CONFIDENTIAL AND PROPRIETARY. 21. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Higher Interest Rates Slow Car Sales And Housing Starts (Millions of units) 2.5 20 2 18 1.5 16 1 14 0.5 12 0 10 1993 1996 1999 2002 Housing starts 2005 2008 Car sales (right) Source: Census CONFIDENTIAL AND PROPRIETARY. 22. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Debt Service Now Above 1986 Record (Household obligations as percent of after-tax income) 22 20 18 16 14 12 10 8 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Financial Obligations Source: Federal Reserve CONFIDENTIAL AND PROPRIETARY. 23. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Debt Debt Repayments Are Evenly Distributed (Average debt repayment as percent of income by income percentile) 20 16 12 8 4 0 0-20 20-40 1995 40-60 60-80 80-90 2004 Source: SCF CONFIDENTIAL AND PROPRIETARY. 24. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 90-100 The Rich Have Mortgages, The Poor Have Credit Cards (Percentage of households with debt owed) 90 80 70 60 50 40 30 20 10 0 0-20 20-40 Mortgage 40-60 60-80 Installment 80-90 Credit card Source: SCF CONFIDENTIAL AND PROPRIETARY. 25. 90-100 Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. A Housing Bubble? • Housing remains affordable • Thanks to low mortgage rates • But what happens when rates go up? • Home prices have outpaced incomes • Ratio of home price to income is at a record high • There are big local bubbles – E.g., New York, California, Boston, Florida • And higher mortgage rates will cause starts and sales to drop • Housing looks less overvalued than other assets CONFIDENTIAL AND PROPRIETARY. 26. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. More Affordable Housing Allows Households To Own Homes 1.60 70 1.40 68 1.20 66 1.00 64 0.80 62 0.60 60 1980 1983 1986 1989 1992 1995 1998 2001 2004 Homeownership Rate (Right scale) Affordability (Left scale) Source: Census Bureau CONFIDENTIAL AND PROPRIETARY. 27. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Home Prices Are High Relative to Household Income (Ratio of average home price to average household disposable income) 4.5 4 3.5 3 2.5 2 1975 1979 1983 Existing 1987 1991 New 1995 1999 2007 Quality-adjusted Source: BEA CONFIDENTIAL AND PROPRIETARY. 28. 2003 Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Bubbles Are Everywhere (Percent increase in home prices, 1997-2005) US Canada Germany Switzerland Netherland Britain Ireland Italy Sweden France Spain Japan Australia China* NewZealan Hong Kong -100 -50 0 50 100 (* Based on 2 years’ of data) Source: The Economist CONFIDENTIAL AND PROPRIETARY. 29. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 150 200 250 The Most Expensive Cities Median Median House Household Price Income ($ thousand) San Diego-Carlsbad-San Marcos, CA Los Angeles-Long Beach-Santa Ana, CA San Francisco-OaklandFremont, CA San Jose-Sunnyvale-Santa Clara, CA Honolulu, HI Miami-Fort Lauderdale-Miami Beach, FL New York-Northern New JerseyLong Island, NY-NJ-PA Riverside-San BernardinoOntario, CA Reno-Sparks, NV Seattle-Tacoma-Bellevue, WA 604.3 43.3 14.0 691.9 51.8 13.4 715.7 56.3 12.7 744.5 590.0 65.4 60.5 11.4 9.8 371.1 43.1 8.6 446.5 56.1 8.0 374.2 349.9 316.8 50.8 49.0 44.5 7.4 7.1 7.1 Source: Census; 2005 data CONFIDENTIAL AND PROPRIETARY. 30. Price/Income Ratio Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. The Stock Market Will Recover, But Slowly • Market rose over 20%/year from 1995 -99 • But dropped from March 2000 through June 2003 • Biggest drop since 1929-32 • Double-digit earning gains for a record 17 quarters; profits are a record high relative to GDP • Earnings must slow • Share prices cannot continue to outpace earnings • As interest rates rise • Stocks will thus yield less in the future than in the recent past. • But the current rally is being spurred by strong earnings and dividend tax cuts CONFIDENTIAL AND PROPRIETARY. 31. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Most US Sectors Have Recovered From The Bear Market (Change in S&P 500 sectors since March 24, 2000 peak) Utilities Telecomm Materials Technology Industrials Health Care Financials Energy Cons Staples Cons Discr S&P 500 -100 -75 -50 Oct-02 -25 0 25 50 Sep-06 Source: S&P CONFIDENTIAL AND PROPRIETARY. 32. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. 75 100 Bottom Line: The Economy Recovers, But Slowly • Consumers are spending their max • Businesses are taking over the lead • But fiscal policy stimulus is over • Interest rates are up • Weak recovery for stock market • Risk of recession remains if: – Further terror attacks damage confidence, while oil prices soar – Problems in financing deficits push investment down and savings up • But could be better if productivity stays stronger CONFIDENTIAL AND PROPRIETARY. 33. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Risks to the Economy (Real GDP, percent change year ago) 6% 4% 2% 0% -2% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Baseline Pessim Source: BEA, S&P projections CONFIDENTIAL AND PROPRIETARY. 34. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Optim Economic Updates • Thank you for your attention • If you would like to receive our regular economic and credit market updates, please register at: • http://www.standardandpoors.com/gfir/register CONFIDENTIAL AND PROPRIETARY. 35. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s. Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received CONFIDENTIAL AND PROPRIETARY. during each analytic process. 36. Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s.