In a downturn of this magnitude, before things start to look ‘good’ we first look for them to be ‘less bad’ than they have been over a broad number of indicators. Although not necessarily over a broad range of indicators, the ‘less bad’ theme is becoming more evident as we move into the second quarter of 2009.
Below are a few summary points including a couple of references to the ‘less bad’ concept.
Real estate, which has been at the root of the credit crisis, needs to stabilize before a sustainable recovery can happen. Here are some things to consider with respect to the current situation:
- Housing to Income ratio: At its peak, the ratio of house prices to household incomes in the U.S. was 27% above its long-term average. It is now down 30% from that peak. While seemingly ‘ugly’, this has brought housing prices back to their equilibrium level. That in itself doesn’t generate new buying, but it does create “capacity” – something that’s important for recovery. With housing affordability at its best level in a generation, once household balance sheets are restored and confidence returns, people will then take advantage of this more ‘normal’ house price to income relationship and go back to buying houses.
- Housing Sales: Although existing housing sales are still falling – they are falling at a much slower rate compared with last year, which suggests that the situation is getting ‘less bad’.
Corporate Balance Sheets
One of the bright spots in the decline of the economy until now has been the health of corporate balance sheets – things like corporate debt to equity ratios and ability to cover interest payments on outstanding debt. With continued contraction in the economy, we are now starting to see meaningful erosion in corporate balance sheets as business profits continue to come under pressure. However, despite this erosion, corporate balance sheets are still relatively healthy.
The U.S. manufacturing index (ISM) tends to respond favorably six months after interest rate cuts. This is because manufacturing orders are dependent on consumer demand, which is stimulated by low interest rates. Although possibly a long way off, there’s some evidence that we may be seeing a positive response to historically low interest rates.
Earlier this year, the manufacturing index in the U.S. (the ISM) was moving sideways instead of falling and yesterday, data showed that the ISM improved modestly in March. While the ISM data was still weak, recent trends suggest that the health of manufacturing is not getting any worse (i.e. the situation is ‘less bad’ than has been previously been the case).
Although inflation may likely have to be dealt with longer-term, it’s not a near-term issue for policymakers. There is risk of “transitory/temporary deflation” (the opposite of inflation and a situation where prices of goods are declining over time) but we believe it is unlikely to develop into a sustained period of falling producer/consumer prices. As the credit crunch and deepening recession continue to dominate policy, rates are expected to hold at rock bottom levels.