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Financial Pacific: Investment Research (third party), July 26,2010

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Financial Pacific: Investment Research (third party), July 26,2010

  1. 1. MORGAN STANLEY RESEARCH NORTH AMERICA US Economics Team Morgan Stanley & Co. Incorporated Richard Berner Richard.Berner@morganstanley.com David Greenlaw David.Greenlaw@morganstanley.com Ted Wieseman July 15, 2010 Ted.Wieseman@morganstanley.com David Cho US Economics David.Cho@morganstanley.com Double Dip Is Not a Dance No dip in the second half. The incoming US economic data have been disappointing of late, but we continue to see evidence that the economy will achieve moderate, sustainable growth during the second half of 2010. Double dips are unusual. If we define double dip as a recession that begins less than two years after the prior recession has ended, then the US has experienced only one double dip since the Great Depression. That occurred in the early 1980s, and the catalyst for the dip was clear-cut: Short-term interest rates rose more than 1000 basis points and long-term yields jumped by more than 400 bp between the end of the 1980 recession and the beginning of the 1982 recession. Labor market is still the key. Most observers agree that the key to sustaining recovery in the US is the labor market, and we still see signs of a handoff from an export- and productivity-led recovery to a more mature expansion that is sustained by job and income growth. Fading stimulus fears are overblown. After-tax income is finally on the rise, infrastructure spending has only just begun to increase during the past few months, and more support for state & local governments is probably on the way. Meanwhile, the homebuyer tax credit helped to clear out the inventory of unsold new homes. Two-sided fiscal policy risk in 2011. If tax rates rise across the board next year, there would be some downside risk to our current economic forecast. Conversely, if tax rates remain at current levels for everyone, there is upside risk. For important disclosures, refer to the Disclosures Section, located at the end of this report.
  2. 2. MORGAN STANLEY RESEARCH July 15, 2010 US Economics Double Dip Is Not a Dance lost during the Great Recession of 2008-09. The recent David Greenlaw (New York) divergence between output growth and labor input reflects robust gains in productivity. History tells us that an economy is The incoming US economic data have been disappointing of capable of registering extremely strong growth in productivity late, but we continue to see evidence that the US economy will during the early stages of economic recovery. But history also achieve moderate, sustainable growth during the second half suggests that this sort of performance is not sustainable of 2010. We made the case for a sustainable economic indefinitely. If output is going to continue to grow, then recovery in a note that was published a couple of weeks ago companies are going to have to add labor. We still see signs of (see “Growth Scare,” July 2, 2010). Here, we expand on some such a handoff from an export- and productivity-led recovery to of the key themes. a more mature expansion that is sustained by job and income growth. For example, layoff announcements are running at the Double dips in the US are rare. During the 19th and early part slowest pace in a decade, temporary workers continue to be th of the 20 century, double dips in the US were fairly common added at a rapid rate, and (despite a bit of a blip in June) the because economic cycles were closely tied to agricultural length of the workweek still appears to be gradually conditions. But it’s important to keep in mind that double dips lengthening. Most importantly (as highlighted in our previous are quite rare for an industrialized economy like the US. If we “Growth Scare” note), there has been a steady underlying define double dip as a recession that begins less than two improvement in Federal government withheld taxes over the years after the prior recession has ended, then the US has course of the past few months. Historically, such a experienced only one double dip since the Great Depression. development has linked up quite well with movements in job That occurred in the early 1980s, and the catalyst for the dip and income growth. was clear-cut: Short-term interest rates rose more than 1000 basis points and long-term yields jumped by more than 400 bp Fading stimulus fears are overblown. Many observers cite between the end of the 1980 recession and the beginning of the withdrawal of fiscal stimulus as a potential catalyst for a the 1982 recession. Obviously, there is no such easily second half slowdown – or even an outright double dip. There identifiable catalyst at this point. have been numerous fiscal stimulus initiatives enacted in recent years, but the one that justifiably attracts the most Exhibit 1 interest is the American Recovery and Reinvestment Tax Act of Employment and GDP 2009 (ARRA) adopted in February 2009. ARRA contained 120 14.0 three key components – tax cuts, infrastructure spending and 13.5 aid to state & local governments. Original estimates claimed 115 13.0 $787 billion of so-called “stimulus” over a 10-year period, while Employment (Millions of more recent official estimates put the figure at $862 billion (see Employees, left scale) 12.5 CBO’s latest “Budget and Economic Outlook”). However, 110 12.0 much of the feared fading of stimulus is highly misleading July 2003 11.5 because ARRA included items such as an extension of the 105 11.0 alternative minimum tax (AMT) fix, which is routinely adopted GDP (Trillions of Dollars, right scale) 10.5 every year. In fact, the AMT fix accounts for nearly $100 billion of “stimulus” in FY 2010 in the ARRA budget scorekeeping. 100 10.0 Also, the withholding changes related to the “Making Work 9.5 Pay” component of ARRA went into effect in the spring of 2009, 95 9.0 resulting in a temporary boost to after-tax income. Shortly after 97 98 99 00 01 02 03 04 05 06 07 08 09 10 the withholding changes were implemented, after-tax income Source: Bureau of Labor Statistics, Bureau of Economic Analysis resumed its decline, reflecting the severe job loss that was occurring at that point. More recently, spurred by the relative Most agree that the key to sustaining recovery in the US is improvement in the labor market over the course of 2010, the labor market. Even with the modest uptick in employment after-tax income has begun to grow (see Exhibit 2). So the seen over the past several months, the level of private sector boost to after-tax income – the goal when implementing a tax jobs is below the mid-2003 trough (see Exhibit 1). Yet the cut – is now underway. economy has recovered just about all of the output that was 2
  3. 3. MORGAN STANLEY RESEARCH July 15, 2010 US Economics Exhibit 2 There are some fears tied to the loss of other types of fiscal After-tax Income Now on the Rise stimulus. In particular, the recent plunge in new home sales in 10400 the wake of the expiration of the homebuyer tax credit appears Real Disposable Personal Income 10300 (Billions of Chained 2005$, SAAR) to be the source of the latest round of stimulus-related angst. The homebuyer tax credit did pull forward some sales, and thus 10200 a payback is to be expected. But the homebuyer tax credit also 10100 helped drive inventories of unsold homes to near-record lows, 10000 which helps alleviate some of the stress for homebuilders (see 9900 Exhibit 4). 9800 Exhibit 4 9700 Homebuyer Tax Credit Helped to Clear Excess 9600 Inventory 9500 700 New Homes Available For Sale 9400 (SA, thousands) 2006 2007 2008 2009 2010 600 Source: Bureau of Economic Analysis 500 Meanwhile, infrastructure spending has finally started to show 400 signs of life in recent months. In fact, public expenditures on construction projects plummeted through most of 2009 and 300 early 2010 following passage of ARRA, and it is only in the last few months that we have started to see signs of a turnaround 200 (see Exhibit 3). This is likely tied to the stimulus funding finally beginning to kick in (although it doesn’t really matter whether it 100 is tied to stimulus or not – the important new development is the 0 rise in public construction activity). 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 Source: Census Bureau Exhibit 3 Infrastructure Spending Starting to Rebound The situation is analogous to the cash-for-clunkers program, 330 which provided a big boost for car sales in the summer and fall Public Construction Spending (Billions of $, SAAR) of 2009. The follow-on production effects of cash-for-clunkers ARRA 320 Enacted have lingered to today. For example, some automakers announced last month that they would forgo the plant 310 shutdowns that typically occur around the July 4 holiday. Instead, factories remained up and running to help bolster lean 300 inventories. Based on assembly schedules published by the automakers, we estimate that vehicle production, on a 290 seasonally adjusted basis, will jump about 15% in July (see Exhibit 5). This situation has helped drive jobless claims much 280 lower over the last couple of weeks, and the boost to July vehicle assemblies should also help to bolster industrial 270 production, payroll employment, and Q3 GDP. Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Source: Census Bureau Admittedly, the sizable chunk of financial support for state & local governments that was included in ARRA is slated to phase out later this year. But we (and many Washington observers) suspect that there will be additional Federal funding – primarily tied to Medicaid relief – in the pipeline. 3
  4. 4. MORGAN STANLEY RESEARCH July 15, 2010 US Economics Exhibit 5 Exhibit 6 Vehicle Production Poised for Big Jump in July Housing Construction Expected to Remain Subdued 15 2500 Total US Motor Vehicle Production Housing Starts 14 (Millions of Units, SAAR) (SAAR, thousands) 13 12 2000 11 10 9 1500 8 7 6 1000 5 4 3 500 2 1 0 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10 Note: June and July 2010 represent Morgan Stanley Research estimates Note: 2Q10 to 4Q11 represent Morgan Stanley Research Estimates Source: Federal Reserve Board, Morgan Stanley Research Source: Census Bureau, Morgan Stanley Research In the case of the auto sector, reigning in excess inventories Finally, we would note that there is justifiable concern with some short-term demand stimulus helped to lay the regarding potential fiscal drag going forward. But that is a story groundwork for a prolonged recovery in vehicle production. In for 2011 – not 2010. Indeed, as addressed in a recent note, our view, residential construction is unlikely to show the same there is probably too much emphasis on the economic spillover degree of upside going forward, but the lack of an overhang of effects of the fiscal pressures confronting state and local unsold new homes should – at the very least – help to limit the governments (see “State & Local Fiscal Problems: How Big a downside in homebuilding going forward. Headwind?” June 25, 2010). It’s the Federal government that really matters. Our current baseline assumption is that Moreover, the housing sector is not a critical part of our Congress will extend expiring income and capital gains tax cuts sustained recovery story for the US. Residential investment for all but the highest-income individuals (i.e., households with directly accounts for less than 2.5% of GDP at this point – down more than $250,000 annual income). But there are a wide from a recent peak of 6% in 2005. Also, among participants in range of possible outcomes, and the situation may not be the Blue Chip survey of forecasters, our estimate of an 11% resolved until after the November elections. If tax rates were to rise in housing starts in 2010, moderating to a 5% increase in rise across the board in 2011, there would certainly be some 2011, is among the most pessimistic (see Exhibit 6). downside risk relative to our current economic forecast. Conversely, if tax rates remain at current levels for everyone, there is upside risk. 4
  5. 5. MORGAN STANLEY RESEARCH July 15, 2010 US Economics Disclosure Section The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. As used in this disclosure section, "Morgan Stanley" includes Morgan Stanley & Co. Incorporated, Morgan Stanley C.T.V.M. S.A. and their affiliates as necessary. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA. Global Research Conflict Management Policy Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies. 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