No Turnaround Likely Soon

David Wyss, Standard & Poor's chief economist, says unemployment will rise, economic activity will remain weak, and the housing market won't bottom for several months.

We remain optimistic that the economy will find a bottom in the next six months, boosted by the $787-billion stimulus package finally agreed on by Congress.

The major problem remains the credit markets. Although there have been some encouraging signs, quality spreads remain wide and lending activity light. Federal Reserve intervention has opened up the conventional mortgage and commercial paper markets, and highly rated bond issuance has picked up. However, speculative-grade bond issuance and securitization remain dormant.

The housing market continues to decline, with prices and starts both down sharply in the latest reports. The only good news is a recovery in existing-home sales and a drop in inventories of unsold homes, perhaps an indication that bargain hunters are trying to take advantage of lower prices and near-record low mortgage rates. Housing affordability is rising to its highest level in history.

[Yet] the new-home market remains depressed, as new home sales and housing starts both dropped to record lows. The drop in existing homes has made it highly unprofitable to build new ones. Builders have cut back to only 550,000 (annual rate) new starts in December, down from 2.1 million in 2005.

Although we believe sales and starts are bottoming out, little recovery is likely in 2009. The still-high inventory of unsold homes will likely keep downward pressure on home prices.

Consumer confidence hit a record low in January on falling wealth and rising unemployment. The economy lost 3.6 million jobs since the cyclical peak in December 2007, and we expect it to lose another 3.0 million this year. The unemployment rate rose to 7.6% from 4.4% less than two years ago. We expect the rate to exceed 9.3% by early 2010, which would be the largest increase in any postwar recession.

When consumers are scared, they stop spending. Although the caution is certainly prudent for the individual household, it is creating major problems for the US economy, which has been dominated by consumer spending (71% of GDP in 2007).

Investment is not likely to accelerate in the near future, even with tax incentives likely to be included in the stimulus bill. If businesses are laying people off and shutting down factories, why would we expect them to spend money on adding capacity? Last year's investment incentives, which accounted for one-third of the tax cuts in the 2008 stimulus package, had no apparent impact on business equipment spending, which plunged 27.8% in the fourth quarter.

But the main requirement for revitalizing the economy is reviving the financial system. The new plan for the remaining $350 billion in TARP funds continues the emphasis on providing banks with capital. There are more strings attached, which should encourage the repayment of these funds but could also restrict credit by making banks less likely to take them. Treasury Secretary Timothy Geithner has resisted calls for bank nationalization, which we think should be a last resort.