Deck 2010 Annual Outlook

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Deck 2010 Annual Outlook

  1. 1. December 09, 2009 Economics Group Special Commentary Annual Economic Outlook 2010 Rebalancing the U.S. Economy for a New Course Dear Valued Clients, We hope your ship has found a safe harbor in which to weather the gale of what was the worst recession in a half century. While the recession may be behind us, 2010 will not be all fair winds and following seas. The coming year may provide some opportunities in which to venture out from port. However, we would urge you to stay close to shore as the coming year has many risks lurking just over the horizon for those who choose to head far out to sea. Please read on as we explore the challenges and opportunities that will face your business, and the U.S. and global economies in the year ahead. -Wells Fargo Economics Group This report is available on wellsfargo.com/research and on Bloomberg WFEC
  2. 2. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP This Page Intentionally Left Blank 2
  3. 3. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Executive Summary: Charting the New Course Trading was fundamentally transformed by the European Age of Discovery, which was pioneered by Portuguese navigators, such as Bartolomeu Dias and Vasco da Gama, who set sail down the West African coast, eventually making it to India by the end of the 16th century. The new course broke the stranglehold that the Ottoman Turks had on the overland spice trade and the considerable wealth that it provided. Ferdinand Magellan and Juan Elcano further altered world navigation by 1522 when their expedition circumnavigated the globe. In the 21st century, financial trading has been permanently altered by the global crisis associated with subprime mortgages, structured products and credit default swaps. Yet, there still exists an imperative need to finance economic activity. Our economic ship has been thrown off course and is still listing. We face three problems. First, Our economic ship how can we right our ship with new and traditional policy tools to regain a sense of stability in the has been thrown economy? Second, what is our new course and at what speed can our ship move forward? Finally, off course and is how has our destination changed in terms of growth, inflation, employment and the dollar? still listing. Figure 1 Figure 2 Real GDP Real Personal Consumption Expenditures Bars = CAGR Line = Yr/Yr Percent Change Bars = CAGR Line = Yr/Yr Percent Change 10.0% 10.0% 8.0% 8.0% GDPR - CAGR: Q3 @ 2.8% 8.0% GDPR - Yr/Yr Percent Change: Q3 @ -2.5% 8.0% 6.0% 6.0% Forecast 6.0% 6.0% Forecast 4.0% 4.0% 4.0% 4.0% 2.0% 2.0% 2.0% 2.0% 0.0% 0.0% 0.0% 0.0% -2.0% -2.0% -2.0% -2.0% -4.0% -4.0% -4.0% -4.0% -6.0% -6.0% PCE - CAGR: Q3 @ 2.9% PCE - Yr/Yr Percent Change: Q3 @ -0.1% -8.0% -8.0% -6.0% -6.0% 2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010 Source: U.S. Department of Commerce and Wells Fargo Securities, LLC Economic forecasting, like sailing, requires constant adjustment to changing winds, currents and the occasional hazard. While the worst of the storm has passed, our ship is still struggling against fierce winds. We are far from an equilibrium point in the economy. We continue to anticipate subpar growth in 2010, with both the pace and composition of the expansion being very different than what we are used to or what we may wish. The pace of the expansion is characterized by real growth of 2.2 percent in 2010 with inflation at just 1.8 percent. Positive contributions to growth will likely come from rising consumer spending, business investment—particularly equipment and software, housing and of course, federal spending. Improved consumer spending will reflect the upturn in real personal income due to eventual job creation, a longer work week and rising wages. We expect real incomes to benefit from continued low consumer inflation. Business investment should improve as financing costs remain low and business expectations of final sales improve. Corporate profits will likely grow, which would improve cash flow and provide liquidity for business investment. We expect housing to continue its recovery as income and consumer confidence improve demand and housing finance continues to be supported by low interest rates. Our forecast shows federal spending stimulus will continue to be applied in the first half of next year and will only gradually begin to slow in the second half as election-year imperatives take over. As for trade, global growth and the weak dollar will stimulate exports but rising domestic consumption and increased energy prices will temper some of the positive effects. Also putting a damper on hopes for a swift recovery are both the disappointing outlook for housing and the slow growth in consumer spending. For our society, the modest pace of expansion implies only slow improvement in the labor market with the unemployment rate 3
  4. 4. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP remaining high. We expect sustained positive monthly payroll numbers will start to appear in the late spring of 2010. Our complete forecast can be found beginning on page 26. Figure 3 Figure 4 Nonfarm Employment Change Real Nonresidential Construction Change in Employment, In Thousands Bars = CAGR Line = Yr/Yr Percent Change 600 600 30.0% 30.0% 20.0% 20.0% 400 400 Forecast 10.0% 10.0% 200 200 0.0% 0.0% 0 0 -10.0% -10.0% -200 -200 -20.0% -20.0% -30.0% -30.0% -400 -400 -40.0% -40.0% -600 -600 -50.0% Non-res Construction - CAGR: Q3 @ -15.2% -50.0% Nonfarm Employment Change: Nov @ -11,000 Non-res Construction - Yr/Yr Percent Change: Q3 @ -22.1% -800 -800 -60.0% -60.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2002 2004 2006 2008 2010 Source: U.S. Dept. of Commerce, U.S. Dept. of Labor and Wells Fargo Securities, LLC Already, we sense that the convergence process to a new economic equilibrium has been more difficult than policymakers estimate. Job growth has been non-existent. Credit growth has been restrained and the recovery in housing far less significant than expected. Still, inflation remains subdued as unemployment limits the acceleration in wages and unit labor costs. Our central tendency for inflation, as measured by the Consumer Price Index (CPI), is 1.5 to 2.0 percent. Slow real growth will run into political pressures in the year ahead as economic realities fall short of political rhetoric. Finally, concerns remain about the long-run pace of growth in the economy as well as the ability of the recovery to sustain itself at a pace that meets the expectations of consumers and workers especially as an election nears. It is not clear how much of the recent economic upturn can be sustained without government support. Recent improvements in business surveys and capital goods orders may have peaked, at least near term. The remaining downside risks reflect weakness in the labor market, with implications for income growth and consumer confidence. How long can When the tempest in financial markets made the seas wild and hazardous in autumn of last year, expansionary most market-watchers were grateful the government stepped in to provide emergency financing economic policy to shore up the banks and provide liquidity to the frozen credit markets. The threat of a complete persist? collapse of the financial system made otherwise free market capitalists willing to accept government help—any port in a storm. But how long can expansionary economic policy persist before the negative feedback effects from excess support begin to show? This is the crucial question for decision-makers in the coming year. A general willingness to spend by government is facing a populace less willing and less able to fund that spending. The nation adds to its debt load each year and depends upon foreign savers to supply the financing. As we move into 2010, the Federal Reserve will face a difficult economic environment. While an exit strategy represents our base case estimate for the path of monetary policy, considerable risks exist to both the expected path as well as execution of an “exit strategy.” We discuss how policy-makers could right the ship in our policy outlook section which begins on page 6. Just as the Federal Reserve and the Treasury took measures to calm the U.S. financial system, their counterparts in foreign countries took action as well. Indeed, governments of the world’s major countries averted catastrophe last year by taking steps to recapitalize, provide loan guarantees and increase deposit insurance while at the same time engaging in stimulative economic policies. As the storm clears, another unique aspect of this recovery is that the U.S. is not the primary catalyst for global economic growth. Quite the contrary, the speed and character of the U.S. recovery reflects the influences of global capital flows and the allocation of production to serve global needs. There will be a new growth model for global economies going forward. Which countries will be the catalysts for growth? Will growth be export-driven or will internal 4
  5. 5. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP economic growth take the lead? We consider the new course and speed for the global recovery in our international outlook section on page 12. We also consider whether the dollar will continue to play the role of the world’s most important reserve currency. Real estate markets around the country have seen some modest improvement in recent months, The recovery in but much of that improvement can be attributed to tax rebates that effectively subsidize the cost residential real of housing. The residential real estate market is not actually making way. The recovery in this estate seems to sector seems to have more to do with government subsidies than it does with a resurgent private have more to do demand for real estate. Federal government support, with massive purchases of mortgage-backed with government securities by the Federal Reserve is helping drive down mortgage rates even as a tax-credit for subsidies than with first-time homebuyers lifts demand. This has created a sense of stability; but what happens when resurgent demand. that support is withdrawn? Is the housing recovery self-sustaining in any way? Meanwhile, commercial real estate remains in the midst of the storm. Nonresidential construction has pulled back significantly as many commercial projects have been delayed or canceled outright as financing has become much harder to secure. The ongoing correction in both residential and commercial real estate continues to hang over the economy as the rising tide of defaults and foreclosures of residential and commercial properties continue to put stress on the financial system. Supply and demand fundamentals are still deteriorating. In our real estate section on page 16, we discuss our view that residential construction may grow modestly through continued support from the government, while the commercial real estate sector will continue to deteriorate. California and Florida were two of the hardest hit states during the recession, as both were key participants in the housing boom and bust. Overbuilding in residential and commercial construction will continue to weigh on both states over the next few years but signs of growth are beginning to emerge, particularly in northern California and parts of central Florida. Find out if fairer winds are headed for California and Florida in our regional spotlight section on page 21. Just as the Portuguese explorers found a new route to wealth in East Asia, so too must the U.S. economy chart a new course to prosperity in today’s changing global financial markets. In this outlook, we explore how that new course is likely to take shape in the coming year and we describe some of the hazards that might be encountered along the way. 5
  6. 6. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Economic Policy: Implications of Massive Government Spending A willingness to When the ship is heading into uncharted waters, it is no time to raise sails and pick up speed. spend by the How long can expansionary economic policy persist before the negative feedback effects from government is excess support begin to show? This is the crucial question for decision-makers in the coming year. facing a populace What are the real and financial implications—both short- and long-term—of our current path of increasingly less spending and taxes? A general willingness to spend by government is facing a populace willing and able to increasingly less willing and able to fund that spending. Unable or unwilling to reconcile the fund that spending. spending/revenue imbalance, the nation adds to its debt load each year and depends on foreign savers to supply the financing. Fiscal Policy: Party Is Over, Bills Coming Due Fiscal year 2009 for the United States government ended this past September with the closing bell sounding to the sour tune of a $1.438 trillion deficit. Some perspective: $ 1.4 trillion is equal to more than $4,500 for every person living in the United States. Many measures of debt have never been as high during peacetime—wartime spikes in debt levels were temporary, however, and therefore did not permanently damage economic growth prospects. In contrast, the current path of indebtedness shows a permanent venture into economically unfavorable territory. While the United States is certainly not in the worst position compared to other developed economies, its fiscal situation does not leave room for complacency or free spending, especially given our dependence on foreign capital inflows. This presents a real challenge to policymakers who would like a fresh start, but cannot disinherit past spending. Elevated spending and diminished revenues, always a dangerous duo, are byproducts of the financial crisis and economic downturn as well as the fiscal policy response. During any recession, government spending tends to increase in the short run to help fill the gap left by private spending. Concomitantly, receipts fall off because personal income and corporate profits decline, reflecting shrinking payrolls and declining business sales, respectively. However, the severity of the recent economic malaise, compounded by the increasing entitlement imbalance, has driven the deficit to new heights. In parsing the deficit, stimulus spending through TARP and the American Recovery and Reinvestment Act constituted only 24 percent of the 2009 budget deficit—substantial, but not the whole story. 1 Unusually large increases in healthcare and income security spending also contributed. With more than 7 million jobs lost, unemployment claims skyrocketed; in addition, more individuals began to meet eligibility requirements for entitlement programs, such as food stamps and Medicaid, and these programs felt the pressure. More than just the economic cycle, the demographic, secular pressures on government spending will become increasingly evident. End in Sight? Economic Recovery Alone Will not Restore a Balanced Budget Cyclical recovery indicates that the nation’s debt will accumulate more slowly in the years immediately following the recession simply due to a reduction in emergency spending and stimulus as well as a recovery in tax revenue. Yet, the more meaningful long-run factor of entitlements will serve to accelerate the severity and immediacy of the deficit problem. Indeed, fiscal 2010 has already begun, and its fiscal deficit will exceed $1 trillion, barring major near-term changes. Despite the diminishing effects of short-term deficit drivers, the recession and the financial crisis, a quick return to fiscal sustainability is off the table. Federal entitlement programs, Medicare and Social Security, already pose serious threats to fiscal sustainability. A new national healthcare program will raise additional concerns about long-term funding of more entitlements. Our election cycle provides an incentive for policymakers to concern themselves with only short-run benefits rather than the long-run costs of policy initiatives—a classic time inconsistency problem. 2 1 Joint Statement of Tim Geithner and Peter Orszag on Budget Results for Fiscal Year 2009. Oct. 16, 2009. 2 In economics, time inconsistency refers to the observation that policymakers today can and often do change policy over time although economic agents commit today to policies that they expect are permanent. See Kydland, Fynn E., and Edward Prescott (1977): “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, 85 (3): 473-491. 6
  7. 7. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Knowing the areas that will only become more problematic, it would seem that the solution would already be close at hand. However, balancing the budget and addressing the fundamental issues has eluded political decision-makers for generations. Through the next decade, the national debt is expected to relentlessly increase. The decisions that are made over that time horizon, however, will have important implications for the sustainability of federal budget deficits in the global context. From our viewpoint, current fiscal policy, if continued at its present pace, is inconsistent with the direction of interest rates, inflation and exchange rates. As we view current policy as unsustainable, then so are the market prices associated with that policy. Righting the Ship: Some Unpleasant Monetarist Arithmetic “You cannot escape the responsibility of tomorrow by evading it today." Abraham Lincoln With the ship of state listing badly due to fiscal deficits, even small steps toward averting fiscal While federal disaster would be most welcome. The longer the nation delays addressing its unsustainable fiscal spending has path, the worse the day of reckoning. While federal spending has helped fill the gap left by the helped fill the gap private sector over the past year, stimulus-induced growth is not self-sustaining; growth left by the private artificially pulled forward merely takes away from future growth. Take, for example, a (relatively sector over the past small) program such as “cash-for-clunkers”—this spurred sales and production in the auto sector year, stimulus- at the expense of sales and production down the road. Clearly, a long history of deficits cannot be induced growth is overcome in a year or even a presidential term, but this is not an excuse to turn a blind eye to the not self-sustaining. ever-expanding problem. Since the 1960s, the average deficit to gross domestic product (GDP) ratio has been about 2 percent. Moving closer to that long-run average would show considerable improvement from the current level of 10 percent. Figure 5 Figure 6 Federal Budget Balance Federal Gov't Financing and Debt Forecast Percentage of GDP Office of Management & Budget, Trillions of Dollars 4.0% 4.0% $25 $25 2.0% Forecast 2.0% $20 $20 0.0% 0.0% -2.0% -2.0% $15 $15 -4.0% -4.0% $10 $10 -6.0% -6.0% -8.0% -8.0% $5 $5 -10.0% -10.0% Budget Balance: Q3 @ -10.0% -12.0% -12.0% $0 $0 2000 2002 2004 2006 2008 2010 2009 2011 2013 2015 2017 2019 Source: U.S. Treasury, Office of Mgmt. and Budget, Dept. of Commerce and Wells Fargo Securities, LLC For decision-makers, the ratio of the deficit to GDP or alternatively the real stock of government bonds relative to the economy will become unsustainable if the growth of the real economy falls short of the real interest rate on the debt. 3 This is the talisman of long-run fiscal sustainability. Unfortunately, the recent rapid growth of debt/GDP gives rise to an unsustainable debt burden, given the current mix of interest rates, inflation and the dollar exchange rate. Yet, over the long term, under current CBO projections, revenues shrink as a percent of GDP, while spending trends are growing strongly and will likely not turn around without making difficult choices (Figure 6). Outlays, and specifically the trend of higher spending related to the major entitlement programs—Medicare, Medicaid and Social Security—will become the crux of 3 Sargent, Thomas J. and Neil Wallace (Fall 1981): “Some Unpleasant Monetarist Arithmetic,” Quarterly Review, Federal Reserve Bank of Minneapolis. 7
  8. 8. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP future budgetary challenges. The retirement of the Baby Boom generation will exert pressure on both Social Security and Medicare as they begin drawing on benefits. Healthcare cost increases, which significantly outpace inflation, reinforce the upward pressure on spending. It is widely recognized that these programs are at the heart of the problem due to their unsustainable growth. 4 Deficits, Dollar and Dependence: Does the Government Have a Teaser Rate Loan? While U.S. indebtedness has risen this year to one of the most inauspicious levels in history, the confounding reliance on global capital flows for deficit financing makes the debt/growth imbalance truly ominous. The deficit is financed through public borrowing, and thus far, the nation has been able to borrow from both the domestic and the foreign public at relatively low interest rates, making debt servicing (interest expense) a manageable budget item. Fortunately, high global saving rates and the demand for virtually default-risk free investments, such as Treasury notes, have produced low borrowing rates for the United States. In addition, countries with large current account surpluses have stored a large share of their wealth in dollar denominated assets, further supporting demand for U.S. debt. The Federal Reserve and U.S. households hold meaningful quantities of Treasury securities; however, the lion’s share of U.S. Treasuries are owned by foreign investors, public and private, with nearly 50 percent of Treasury securities outstanding in the second quarter of this year. Global saving rates Global saving rates and Treasury demand are both liable to change sharply if perceptions of U.S. and Treasury fiscal and monetary policy discipline slip. For example, in recent months, the role of the dollar as demand are both the world’s reserve currency has already been called into question. Given our outsized current liable to change account deficit, this heightens the exchange rate risk for foreign investors and a likely move sharply when upward in global rates. 5 perceptions of U.S. fiscal and Figure 7 Figure 8 monetary policy Net Foreign Purchases of Marketable US Treasury Securities Bonds and Notes, 12-Month Moving Sum, Billions USD U.S. Purchases of Foreign Securities Billions of Dollars discipline slip. $500 $500 $60 $60 $400 $400 $45 $45 $300 $300 $30 $30 $200 $200 $15 $15 $100 $100 $0 $0 $0 $0 -$15 -$15 -$100 -$100 -$30 -$30 Purchases of Foreign Securities: Sep @ $15B 12-Month Moving Sum: Sep @ $333.3B 3-Month Moving Average: Sep @ $16B -$200 -$200 -$45 -$45 98 99 00 01 02 03 04 05 06 07 08 09 2004 2005 2006 2007 2008 2009 Source: Federal Reserve, U.S. Department of the Treasury and Wells Fargo Securities, LLC Higher rates and slow growth further imbalance the monetarist arithmetic. As this imbalance grows, or is even just expected to grow, the market adjustments for interest rates, the dollar and even economic growth deliver a dynamic that further influences market pricing. If the debt load is perceived as irresponsible or unmanageable by investors, demand for Treasury bonds will fall off, and the Treasury will have to pay higher interest rates to meet its financing needs. We appear as if on a knife’s edge between weak and strong economic growth that will have significantly different implications for debt finance, the dollar and capital flows. 4 Current economic and financial conditions and the federal budget. Ben S. Bernanke, Federal Reserve Chairman. Testimony in Washington, D.C. June 3, 2009. 5 The implications of outsized current account adjustments on an economy are detailed in Carline L. Freund’s essay “Current Account Adjustments in Industrialized Countries,” International Finance Discussion Paper No. 692, Board of Governors of the Federal Reserve System, December 2000. 8
  9. 9. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Political Risk for Economic Decision-Makers: Time Inconsistency on a Global Scale Whether the fiscal outlook improves or worsens from its current abysmal state lies predominantly in the hands of politicians, and indirectly in the hands of voters. The political climate is an ever-shifting landscape of priorities and agendas, making it nearly impossible to forecast future legislation. However, we know that there is a two-year political cycle and that political decisions today, and their future changes, carry economic risks. Politicians have the luxury of frequently changing their minds. Individuals and firms must deal with the consequences of these changes. Within the United States, both sides of the political aisle have addressed this issue, particularly fiscal conservatives and the coalition of “Blue Dogs” citing fiscal responsibility as an important legislative consideration. As large spending bills go through, such as emergency stimulus packages and bail-out programs, each future spending bill, such as healthcare and cap and trade, becomes more difficult to support to the fiscally astute. Yet, the urge for politicians to show results in terms of jobs is overwhelming. What makes today’s fiscal policy context so different is that the economic agents responding to policy changes are global—not just domestic. U.S. domestic fiscal policy carries global economic implications, and those implications are likely to fall back on the U.S. economy with significant risks of inflation, higher interest rates and dollar depreciation. Monetary Policy: Where Are We and Where Are We Going? In 1788, France faced daunting fiscal deficits due to royal extravagance and military spending, “Paper money which combined with ineffective taxation, rendered the government essentially bankrupt. Less eventually returns than a year later, the chaos of the French Revolution began in earnest. In an attempt to prime the to its intrinsic pump of the economy, the government issued government debt secured by expropriated church value.” property. Easy money became addictive, and several more debt issues were arranged. The -Voltaire excessive reissuance of these notes caused the money supply to skyrocket and hyperinflation to ensue, exacerbating the violence of the Revolution. By the end of the 18th century, all the issued government debt was repudiated and became worthless. The years of fiscal turmoil were finally put to rest by Napoleon Bonaparte, who adopted the franc, and never went back to paper money. Voltaire predicted such an outcome, saying, “Paper money eventually returns to its intrinsic value.” Both the Federal Reserve and the Federal Open Markets Committee (FOMC) have chalked up Considerable risks quite a list of unprecedented actions over the past year and a half as they moved the traditional exist to both the target rate to virtually zero and the balance sheet ballooned to more than twice its pre-crisis size. expected path and As we move into 2010, the Federal Reserve will face a difficult economic environment. While an the execution of an exit strategy represents our base case estimate for the path of monetary policy, considerable risks exit strategy. exist to both the expected path as well as execution of that plan. A simple exit strategy represents a claire idée fausse—a convincing but wrong idea. We will have more on that in a moment. First, let’s take a step back and look at the entire cycle of monetary policy, something important to consider as we move through the cycle. Is it currently tight, neutral or accommodative? Second, in which direction is monetary policy moving—easing, tightening or holding relatively steady? In mid-2007, the FOMC was holding the target rate, and monetary policy in general, steady at a level that would general be considered “tight” monetary policy. As economic conditions began to weaken late in 2007, the FOMC responded by easing monetary policy with a reduction in the federal funds target rate. However, despite being in easing mode, policy was still considered “tight” until about the turn of the year. By then, with the Fed in full on “easing” mode, policy moved through neutral to a moderately accommodative stance before pausing in mid 2008. “Easing” continued until the funds rate reached zero after evidence of further economic weakness came forth. While the Federal Funds target rate has been the key policy metric for some time, this cycle brought forward “quantitative easing” as a major policy tool for the first time since the Fed was established. So with a new tool in its kit, the Fed continued to ease monetary policy until the end of 2008 with quantitative tools, such as lending to nontraditional Fed borrowers or providing 9
  10. 10. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP loans through an auction process. In the last few months of 2008, the Federal Reserve System’s balance sheet ballooned. 6 After a long period After a long period of actively easing monetary policy, the Fed has largely held policy relatively of actively easing constant with the funds rate target at 0–0.25 percent and the balance sheet hovering near monetary policy, $2 trillion throughout 2009. Clearly, policy remains at an extremely accommodative level—but the Fed has largely for how long and at what consequences? While the balance sheet has held roughly level in held policy aggregate size over the past three quarters, the composition of assets has evolved substantially. relatively constant. Initially, the Fed grew its balance sheet through a hastily cobbled together system of emergency programs, which while essential to the functioning of the financial system at a time of great stress, were not carefully planned preannounced actions. As the financial markets have thawed and these programs have wound down naturally in 2009, they were largely replaced with preplanned and announced purchase programs for Treasury securities, Agency debt and mortgage-backed securities (MBS). Backing Away from Accommodation—Very Slowly The treasury debt purchase program that began in the spring ended in October with roughly $300 billion in debt having been acquired. The Fed has also announced a tentative end to its purchases of Agency debt and Agency MBS at the end of the first quarter of 2010 with an aggregate purchase target of about $1.425 trillion. After these programs finish, the Fed’s balance sheet should start to slowly shrink as many of the remaining emergency programs naturally run off or are closed down. This will be the subtle beginning of a long “tightening” process. We do not expect that the Fed will be actively working to tighten policy for most of 2010 and will be content to let policy slowly tighten from its unprecedentedly accommodative level. However, policy will still be very accommodative by historical standards for the early part of 2010. As we get closer to the end of the year, the Fed will need to begin considering how to tighten monetary policy more rapidly, by either raising the Federal Funds target, shrinking its balance sheet or a combination of both. If the 2002-2004 experience taught us anything, it was that “too low for too long” can be just as damaging as tightening policy too soon. Figure 9 Figure 10 Federal Funds Target Rate Federal Reserve Balance Sheet Rate Trillions 7.00% 7.00% $2.5 $2.5 Other Foreign Swaps PDCF & TAF 6.00% Forecast 6.00% Commercial Paper & Money Mkt. $2.0 Repos & Discount Window $2.0 Agencies & MBS 5.00% 5.00% Treasuries $1.5 $1.5 4.00% 4.00% 3.00% 3.00% $1.0 $1.0 2.00% 2.00% $0.5 $0.5 1.00% 1.00% Federal Funds: Q3 @ 0.25% 0.00% 0.00% $0.0 $0.0 2000 2002 2004 2006 2008 2010 2007 2008 2009 Source: Federal Reserve Board and Wells Fargo Securities, LLC When it does become time to raise the Federal Funds target rate in late 2010 or early 2011, it will again be important to have more control over the size and composition of the balance sheet. However, there will be two important considerations to keep in mind at that point. First, in influencing interest rates and controlling money supply growth, it is not necessarily the size of the Fed’s balance sheet that matters but rather the direction and magnitude of growth. The Fed does not necessarily have to shrink its balance sheet back below $1 trillion to raise interest rates. In fact, it is likely that the balance sheet will persist above its previous average indefinitely. Second, a 6 Reserve bank credit averaged $870 billion over the first half of 2008 before the Fed began its policy of quantitative easing. The balance sheet eventually peaked at $2.25 trillion in December 2008. 10
  11. 11. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP key change will give the Fed some extra flexibility in removing quantitative easing while pushing up short-term interest rates—the ability to pay interest on banks’ reserve balances held at the Fed. In mid-2008 as the FOMC was reducing the target rate, but still trying to maintain a target, the Fed did not yet have the authority to pay interest on its reserves. 7 With this authority, the FOMC has another way to influence short-term interest rates without altering the money supply and its balance sheet. Once begun, tightening may be quicker than many market participants expect with the Fed raising the target rate and shrinking the size of its balance sheet at the same time. This will likely be the major story for 2011 and even into 2012. An Easy Exit Strategy? Once begun, While an exit strategy represents our base case estimate for the path of monetary policy, tightening may considerable risks exist to both the expected path as well as execution. A simple exit strategy be quicker than represents a claire idée fausse—a convincing but wrong idea. First and foremost, the economy many market remains extremely fragile and any unexpected hiccups could necessitate an easing of policy or an participants extension of the accommodative period. Next, in the coming year, Chairman Bernanke and the expect. rest of the board will likely face a torrent of political scrutiny. Much will be directed toward the Fed's role as a supervisor of bank holding companies, but this scrutiny could easily creep into Congressional scrutiny of monetary policy if the Fed's independence is not diligently protected. Adding to these issues will be the reconfirmation hearing for Chairman Bernanke to another four-year term as chairman, which has just begun. By midyear, Vice Chairman Kohn will also be up for reappointment. The amount of time that both men will potentially spend on Capital Hill answering questions about past and future Fed policy could be considerable. Finally, the massive deficit that the federal government continues to run could eventual prove problematic for the independence of monetary policy. If fiscal policy remains as loose as it currently is into 2011, the Fed may have to tighten more aggressively than would otherwise be necessary to offset outsized fiscal deficits. The interaction of expansive fiscal and tighter monetary policy will generate greater volatility for rates, the dollar and the economy. 7 Emergency Economic Stabilization Act of 2008 authorized interest payments as of Oct. 1, 2008. 11
  12. 12. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Global Catastrophe Averted: But How Do We Set Sail Going Forward? Major central Last autumn, the global economy plunged into its deepest recession in decades as financial banks slashed markets seized up in the wake of Lehman Brothers’ failure. By early 2009, industrial production policy rates, and in the 30 countries that comprise the Organisation for Economic Cooperation and Development governments in (OECD) was down more than 15 percent from year-earlier levels (Figure 11). It could have been most major far worse, however. The governments of the world’s major countries averted catastrophe last year countries opened by taking steps to prevent a wholesale collapse of their financial systems via recapitalization, loan the fiscal taps. guarantees and increased deposit insurance. In addition, governments responded to the crisis with stimulative economic policies. Major central banks slashed policy rates to unprecedented levels, and governments in most major countries opened the fiscal taps. But what is the growth model for global economies going forward, and which country(ies) will be the locomotive? Will growth be export-driven or will internal economic growth take the lead? Figure 11 Figure 12 OECD Industrial Production China Real GDP Year-over-Year Percent Change Year-over-Year Percent Change 10% 10% 14.0% 14.0% 12.0% 12.0% 5% 5% 10.0% 10.0% 0% 0% 8.0% 8.0% -5% -5% 6.0% 6.0% -10% -10% 4.0% 4.0% -15% -15% 2.0% 2.0% OECD Industrial Production: Aug @ -11.3% Year-over-Year Percent Change: Q3 @ 8.9% -20% -20% 0.0% 0.0% 76 80 84 88 92 96 00 04 08 2000 2002 2004 2006 2008 Source: OECD, IHS Global Insight and Wells Fargo Securities, LLC So far, the stimulus medicine appears to be working, because most foreign economies are starting to grow again. Let’s start with the developed world. Real GDP in the Euro-zone rose 1.5 percent (annualized rate) on a sequential basis in the third quarter, and the Japanese economy, which contracted sharply late last year and earlier this year, has managed to post positive growth rates over the past two quarters. Real GDP in the United Kingdom fell further in the third quarter, but the rate of contraction has slowed significantly from the beginning of 2009. Even in the developed economies that are growing again, however, recoveries are not yet truly self-sustaining. Unfortunately labor markets generally remain very weak, restraining growth in consumer spending. If there are bona- If there are bona-fide self-sustaining recoveries under way, they are occurring in some developing fide self-sustaining countries. For example, real GDP growth in China has picked up significantly over the past few recoveries under quarters due, at least in part, to aggressive monetary and fiscal stimulus (Figure 12). Stronger way, they are economic growth in China is helping to lift GDP growth rates across Asia. The South Korean occurring in some economy has expanded at a double-digit pace in the past two quarters, and real GDP in India rose developing 7.9 percent, year over year, in the third quarter. That said, there is more behind Asian economic countries. growth than simply China. Most countries in the region opened the fiscal taps, which helped to stimulate economic activity. Moreover, many Asian countries did not become overly levered during the last expansion. Therefore, banking systems in the region did not collapse, which allowed credit growth to remain buoyant. Latin America is picking up where it left off before the world financial markets collapsed last year, and most of the help, again, is coming from the region’s export sector and particularly from the strong recovery in commodity prices. Domestic demand in some Latin countries is starting to recover—real consumer spending in Brazil rose 2 percent in the second quarter of this year relative to the same period of 2008—yet it would be premature to claim that most economies in the region have entered the realm of self-sustaining recoveries. For example, Chilean final 12
  13. 13. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP domestic demand in the third quarter was still down 4 percent on a year-earlier basis, and Mexico lags even further behind the rest of the Latin region due, at least in part, to its extensive trade links with the U.S. economy and its dependence on the U.S. consumer and auto demand. Clear Sailing for Strong Global Recovery in 2010? Probably Not Looking into 2010, we project that the major economies of the world will remain in expansion The pace of mode, but we believe that the pace of recovery will remain frustratingly slow. As with the United recovery for major States, consumers in some large foreign economies—the United Kingdom and Spain spring to economies will mind—went on a borrowing binge earlier this decade. We project that growth in consumer remain spending will remain restrained in these economies as consumers delever and repair balance frustratingly slow. sheets that have been battered by falling house prices and financial asset losses. Our forecast calls for real GDP to grow a bit more than 2 percent in the advanced economies of the world next year. If realized, our forecast would be a welcome relief from the 3 percent contraction that was suffered in 2009. However, 2 percent growth would feel sluggish compared to the 3 percent annual growth rate that the advanced economies of the world averaged during the 2004-2007 period. Turning to the developing world, most Asian economies should achieve solid growth rates next year as momentum from the self-sustaining recoveries that have already taken hold in the region should carry over into next year. Although most governments should remove some policy stimulus in 2010, governments do not need to slam on the brakes thanks to benign inflation. Growth in Latin America should also strengthen next year, but not to the same extent as in developing Asia. If growth in the rest of the world should falter, which we do not anticipate, Latin economies would also suffer a relapse in growth that would manifest itself through downward pressure on commodity prices. Mexico will likely continue to lag the rest of Latin America, because the sluggish recovery we project for the United States should restrain growth south of the border. Medium Term: High Saving Rates Mean Strong Growth in the Developing World A decade ago, rates of economic growth in the advanced economies and in the developing world were approximately equal (Figure 13). During that decade, growth in the developing world was pulled down by the effects of frequent financial crises that were concentrated in emerging markets (e.g., China in the early 1990s, the “Tequila” crisis in 1995, the Asian financial crisis in 1997-98). Figure 13 Figure 14 Gross Domestic Product Gross National Savings Annual Percent Change Percent of GDP 10.0% 10.0% 40.0% 40.0% 8.0% 8.0% 35.0% 35.0% 6.0% 6.0% 30.0% 30.0% 4.0% 4.0% 25.0% 25.0% 2.0% 2.0% 20.0% 20.0% 0.0% 0.0% 15.0% 15.0% -2.0% -2.0% 10.0% 10.0% -4.0% Emerging Economies: 2009 @ 1.7% -4.0% 5.0% Developing Economies: 2009 @ 32.7% 5.0% Advanced Economies: 2009 @ -3.4% Advanced economies: 2009 @ 16.9% -6.0% -6.0% 0.0% 0.0% 1990 1993 1996 1999 2002 2005 2008 1990 1993 1996 1999 2002 2005 2008 Source: International Monetary Fund and Wells Fargo Securities, LLC In the current decade, however, developing economies have generally grown faster than their advanced counterparts. The underlying fundamental driving the acceleration in developing country growth is the significant rise in national saving rates in those economies (Figure 14). 8 For example, the gross national saving rate in India has risen from about 25 percent of GDP a decade 8 National saving rates aggregate the saving rates of the consumer, business and public sectors. 13
  14. 14. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP ago to more than 35 percent today. The national saving rate in China has shot up to nearly 50 percent. High saving rates are important, because they finance rapid rates of capital accumulation that drive long-run economic growth. 9 On a secular basis, we believe that the developing world will continue to grow faster than advanced economies for a number of years, because we do not expect to see a significant decline in national saving rates in most developing economies. Indeed, we would not argue with the forecast of the International Monetary Fund that developing Asia will grow more than 8 percent per annum in the medium term (i.e., three to five years from now). 10 In the IMF’s view, Latin America will achieve 4 percent growth in the medium term, significantly less than the projection for developing Asia, but stronger than the 3 percent per annum rate that the region averaged between 1980 and 2008. Unless national saving rates in Latin America rise significantly—they have been stable around 20 percent of GDP over the past few decades—the region will grow slower on a trend basis than developing Asia. The IMF projects that the advanced economies should grow about 2.5 percent per annum in the medium term. Although personal saving rates likely will rise in many advanced economies over the next few years, gaping budget deficits mean that it will be difficult for national saving rates to rise significantly. Figure 15 Figure 16 Composition of Foreign Reserve Holdings U.S. Trade Weighted Dollar Major Index Trillions of U.S. Dollars March 1973=100 $7.0 $7.0 115 115 Other Japanese Yen 110 110 $6.0 Euro $6.0 U.S. Dollar 105 105 $5.0 $5.0 100 100 95 95 $4.0 $4.0 90 90 $3.0 $3.0 85 85 $2.0 $2.0 80 80 75 75 $1.0 $1.0 70 70 Major Currency Index: Dec @ 73.2 $0.0 $0.0 65 65 2000 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: International Monetary Fund, Federal Reserve Board and Wells Fargo Securities, LLC Is the Dollar Doomed as a Reserve Currency? Not only are high saving rates helping to drive robust growth rates in some developing countries, but they also help to explain large current account surpluses over the past few years in those countries. 11 These surpluses have led to a sharp rise in the foreign exchange holdings of the world’s central banks from about $2 trillion at the beginning of the decade to more than $7 trillion at present (Figure 15). Although the percentage of total reserves held in dollars has trended a bit lower over the past decade, the greenback still accounts for the lion’s share of total reserve holdings. However, large holdings of dollar assets in conjunction with the trend decline in the value of the greenback are making some countries nervous (Figure 16). Indeed, China and Russia, which together own about $2.7 trillion worth of foreign currency reserves, have called for an alternative currency to replace the dollar as the world’s most important reserve currency. Is the dollar in danger of losing its reserve currency status? Although the importance of the dollar will surely erode over time, we are not overly concerned about the world’s central banks dumping their holdings of dollar assets in favor of something else. The primary investment objectives of central banks are safety and liquidity, and the $7 trillion 9 For a discussion of saving, investment and long-run growth in East Asia see Alwyn Young, “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience”, Quarterly Journal of Economics 110(3), 1995, 641-680. 10 See IMF World Economic Outlook, October 2009. 11 A country incurs a current account surplus when its national saving rate exceeds its gross investment rate. That is, the country produces more than it consumes, which equates to its current account surplus. 14
  15. 15. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP worth of marketable Treasury securities outstanding, all of which are AAA rated, offers central banks the largest, safest and most liquid financial market in the world. Could the euro supplant the dollar as the world’s principal reserve currency? Figure 15 implies Could the euro or that holdings of the euro have risen steadily from less than 20 percent 10 years ago to more than another foreign 25 percent today. That said, we do not expect the euro to replace the dollar as the world’s currency supplant principal reserve currency anytime soon. There is no central European government per se, so the dollar as the foreign central banks need to buy the securities of individual European governments. The world’s principal German, French and Italian governments have the largest amounts of government securities reserve currency? outstanding among individual countries in the euro area, but each of those markets is only about one-quarter the size of the U.S. government bond market. 12 Moreover, there are some concerns about the long-term viability of European Monetary Union, which reduces the attractiveness of holding some long-term securities that are denominated in euro. What about other currencies? The share of reserves held in Japanese yen has declined from about 6 percent a decade ago to only 3 percent at present (Figure 15). Given the long-term concerns about the Japanese economy, it does not seem likely that the yen will become a meaningful reserve currency asset. The Chinese renminbi could eventually play a role as a reserve currency, but until China opens its capital markets, which would allow central banks and private investors to freely buy and sell Chinese securities, the attractiveness of the renminbi will remain very limited. In that regard, we do not expect the Chinese government to eliminate its capital controls anytime soon. What about some new “international currency,” such as the basket currency that some important developing countries have proposed? Until a critical mass of securities are issued in this currency, which likely will not be realized until many years in the future, this new currency would not likely play a significant role as a reserve currency asset. Although the dollar certainly has its share of blemishes, other currencies are even less attractive as reserve currencies. In our view, the dollar will continue to play the role of the world’s most important reserve currency for years to come. After all, beauty contests are won on a relative, not absolute, basis. 12As of this writing, the outstanding debt of the U.S. government totals more than $12 trillion. Outstanding debt levels of the French, German and Italian governments range between $2.0 trillion and $2.5 trillion. 15
  16. 16. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Residential Real Estate: Fair Seas or the Calm before Another Storm? Residential construction finally found its way to fairer winds this year. Is this merely a short-lived improvement or the calm before a second storm? Federal government support has created a sense of stability in housing. Massive purchases of mortgage-backed securities by the Federal Reserve are helping drive down mortgage rates and an $8,000 tax-credit for first-time homebuyers helped lift demand. But what happens when that support is withdrawn? Is the housing recovery self-sustaining? A possible warning sign is that sales and new construction, which both improved during the spring and summer, faltered more recently as the tax credit was set to expire. The fundamentals While the tax credit was eventually extended and expanded, we expect this program to have of supply and diminishing returns. 13 Our forecast looks for a weak rebound in residential construction demand for the compared to prior economic recoveries. The current plan calls for the tax incentives to end in housing sector June. Housing starts should get at least a modest boost through April, which is just when the peak remain extremely home-buying season tends to ramp up. Sales and new construction will likely be pulled forward challenging. into the early part of 2010 and will then fall back a bit in the spring. The fundamentals of supply and demand for the housing sector remain extremely challenging. On the supply side, excess supply remains close to 2 million units. As for demand, potential buyers are being held back by concerns about employment and income prospects on real disposable income. Meanwhile, credit remains more difficult to qualify for and appraisals are much more conservative today. Temporary band-aid programs helped limit the housing downdraft but come at the cost of larger federal deficits. If these programs do not lead to a sustained improvement in underlying demand, there will be little follow through. We do not see the extension and expansion of the first-time homebuyer tax credit as influencing the ultimate timing of a sustainable recovery in the housing market. The demand for new and existing homes will not pick up on a sustainable basis until employment and income conditions improve. While this may technically begin to happen as soon as the middle of next year, employment conditions will not likely improve enough to generate a strong and sustainable recovery in home sales until spring 2011. There are simply too many households experiencing extreme financial stress to allow the conditions necessary for a stronger recovery to take hold. Figure 17 Figure 18 Existing Home Resales Housing Starts Seasonally Adjusted Annual Rate - In Millions Millions of Units 7.5 7.5 2.4 2.4 7.0 7.0 2.1 2.1 Forecast 1.8 1.8 6.5 6.5 1.5 1.5 6.0 6.0 1.2 1.2 5.5 5.5 0.9 0.9 5.0 5.0 0.6 0.6 4.5 4.5 0.3 0.3 Existing Home Sales: Oct @ 6.10 Million 4.0 4.0 0.0 0.0 1999 2001 2003 2005 2007 2009 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Source: U.S. Department of Commerce, National Association of Realtors and Wells Fargo Securities, LLC 13The economic concept of diminishing returns is that at a certain point, each additional input applied to a process will generate less additional output than the prior unit. 16
  17. 17. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP Remodeling Older Homes: Get a Lemon, Make Lemonade When you can’t afford to move then you remodel or upgrade your existing home. Spending for residential additions and alterations has been one notable bright spot. Spending is being driven by the high volume of foreclosure sales, many of which are being bought by investors. Foreclosed homes are then repaired and remodeled. Many homes are being divided into duplexes and triplexes and being put up for rent, which is one reason why the number of vacant homes for rent spiked upward in recent months. In addition, spending to weatherize homes has increased, thanks in part to tax incentives. The volatility in home sales and new construction during the first half of 2010 will likely to give Improvement in way to a modest improvement in underlying demand during the second half of the year. For all of sales and new 2010, we expect sales of new homes to rise 15 percent and sales of existing homes (Figure 17) to construction rise around 6 percent. Our forecast also shows new home construction picking up next year, with should take place starts of single-family homes (Figure 18) rising close to 20 percent and marginal gains for in 2011, but we do construction of multifamily properties. We look for more improvement in sales and new not look for a construction to take place in 2011 but do not look for a strong recovery to take hold in the housing strong recovery to sector until 2012 or later. take hold in the housing sector Strange Brew: High Prices, More Foreclosures until 2012 or later. We expect prices for existing homes to decline further in 2010, but there are a number of cross currents that may lead to seemingly contradictory assessments of the health of the housing sector. The expiration of the first-time homebuyer tax credit will reduce the share of lower-priced homes in the monthly sales figures, which we think will result in higher average and median sales prices. We also expect to see some modest improvement in the sales of higher-priced homes, reflecting the rebound in the equity markets and more attractive financing options on jumbo loans. An increase in the sales of higher-priced homes would also push up the average and median prices. These gains, however, could be at least partially offset by a rising volume of foreclosure sales. Figure 19 Figure 20 Home Prices Mortgage Delinquency Year-over-Year Percentage Change Percent of Loans Past Due, Seasonally Adjusted 24% 24% 10.0% 10.0% 20% 20% 9.0% 9.0% 16% 16% 12% 12% 8.0% 8.0% 8% 8% 4% 4% 7.0% 7.0% 0% 0% -4% -4% 6.0% 6.0% -8% -8% 5.0% 5.0% -12% -12% Median Sale Price: Oct @ $173,100 -16% Median Sales Price 3-M Mov. Avg.: Oct @ -9.0% -16% 4.0% 4.0% FHFA (OFHEO) Purchase Only Index: Sep @ -3.0% -20% -20% S&P Case-Shiller Composite 10: Sep @ -8.5% All Loans: Q3 @ 9.6% -24% -24% 3.0% 3.0% 97 99 01 03 05 07 09 1998 2000 2002 2004 2006 2008 Source: FHFA, NAR, MBA, S&P Corp, U.S. Department of Commerce and Wells Fargo Securities, LLC Measures of repeat sales, particularly the Case-Shiller indices, will likely see slightly larger price declines, particularly once the sales of higher-priced homes increase. The higher end of the market has been moribund for the past year, and price discovery will not occur until a significant number of transactions take place. We still anticipate housing prices bottoming in nearly every price measure during 2010. Prices will likely decline an additional 5–10 percent from current levels, bringing the peak-to-trough decline in home prices to roughly 38 percent by the Case-Shiller measure. Foreclosure sales should pick back up during the coming year. A large portion of the mortgage modifications that have been made in recent years have become delinquent in a relatively short period of time. The likely culprit is the unusually large number of people out of work for six months or more and the large number working fewer hours and receiving less pay, commissions 17
  18. 18. Annual Economic Outlook 2010 WELLS FARGO SECURITIES, LLC December 09, 2009 ECONOMICS GROUP and bonuses. The percentage of loans 90 days or more past due, loans in foreclosure and foreclosures started all set new highs during the third quarter of 2009. Slightly more than 4 million mortgages are now 90 days or more past due or in foreclosure, slightly exceeding the 3.8 million new and previously owned homes currently for sale. Overall residential real estate will perform better in 2010 than it did in 2009. However, volatility will remain as prices, construction and sales will vacillate before finding a new equilibrium. Commercial Real Estate: Storm Warnings Still Out Smooth sailing is not yet on the horizon for commercial real estate. In fact, commercial real estate remains in the midst of the storm. Nonresidential construction has pulled back significantly as many commercial projects have been delayed or canceled outright. Moreover, financing remains much more difficult to secure. In prior cycles, commercial real estate outlays have been a lagging indicator, declining well after the recession ended. Private nonresidential construction spending peaked in mid-2008, and since then, sectors such as lodging, office and commercial construction spending have all fallen significantly. As the demand for real estate is derived from the underlying growth in the economy, commercial construction does not tend to turn up until well after revenues improve and employment picks up. The rising tide of The ongoing correction in commercial real estate continues to hang over the economy as the defaults and rising tide of defaults and foreclosures on commercial properties pressure the financial system. foreclosures on The supply and demand fundamentals are still deteriorating. On the supply side, vacancy rates commercial are high and rising and there is still a huge overhang of leased but vacant space not included in properties continue vacancy rate statistics. As for demand, retail sales remain subdued, employment losses continue to pressure the and global trade has just begun to recover. As a result, rents are being negotiated lower and financial system. property values continue to fall. As for financing, lenders and servicers are focused on loan modifications and workouts and very little credit is available for new projects. The net result has been a substantial pullback in commercial construction that is expected to carry through next year. Figure 21 Figure 22 Commercial Real Estate Commercial Real Estate Asking Rent Growth Percent, Dollars per Square Foot Quarter-over-Quarter Percent Change 12% $180 4% 4% 3% 3% 10% $140 2% 2% 1% 1% 8% $100 0% 0% 6% -1% -1% $60 -2% -2% Apartment: Q3 @ -0.5% 4% Price: Q3 @ $130.1 per SF (Right Axis) Retail: Q3 @ -0.3% -3% Office: Q3 @ -1.0% -3% Vacancy Rate: Q3 @ 11.1% (Left Axis) Cap Rate: Q3 @ 7.8% (Left Axis) Industrial: Q3 @ -2.1% 2% $20 -4% -4% 01 02 03 04 05 06 07 08 09 2005 2006 2007 2008 2009 Source: REIS, Real Capital Analytics, Property Portfolio Research and Wells Fargo Securities, LLC Why Is This Cycle Different? While many of the challenges facing commercial real estate are well known, there are also important differences from previous real estate crunches. One of the most notable differences is that real estate is not nearly as overbuilt as it was in the late 1980s and early 1990s. Vacancy rates are lower than they were going into the previous real estate bust back in the late 1980s. Supply was much more constrained during the most recent cycle. Commercial development did not really get going until the last two years of the economic expansion, and significant office development was largely confined to a handful of markets. In other areas, however, retail development tended to follow housing and industrial development tended to grow along with imports. Both grew rapidly and the problems will take longer to correct this time. 18

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