Why the Recession Is Here to Stay
When U.S. marshals put Bernie Madoff's Long Island mansion on the block last month, few expected much action. Sales of luxury homes have been as dead as the lowly subprime market - and surely the oceanfront playground of a disgraced Ponzi fraudster would be hard to move. Then something astonishing happened. A furious bidding war erupted, and the house sold in mid-September for US$8.75 million in cash, well over the asking price. Madoff's US$65-billion scam may have embodied all the lying, cheating and greed that got us into the Great RECESSION, but the frenzy for Bernie's old digs shows that the froth is back, alive and well.
Evidence of reawakened exuberance is everywhere. Bidding wars are breaking out all over North America. In Costa Mesa, Calif., one 1,300-sq.-foot home drew 68 offers and sold for nearly US$100,000 above the asking price. In Vancouver, dozens of potential buyers reportedly drove the price of a tiny bungalow in the popular Kitsilano neighbourhood up $180,000 above the asking price, to $1.14 million. Condo projects that looked gaudy and excessive amid the new frugality of April are now back on the block as the latest must-haves. Toronto's struggling 1 Bloor megaproject surged back to life last week with new developers. In Vancouver, the radio waves are filled with ads for home-equity loans and marble countertops, and luxury retailers are beating down the doors in Calgary. Next month Holt Renfrew will open a new store there, three times larger than its existing one, and featuring a boutique from French luxury giant Hermès, famous for its $7,000 Birkin bags. Conspicuous consumption didn't die after all. It was just hibernating.
Barely six months after fretting about the end of the world, analysts and economists are suddenly transfixed by a more welcome finale: the end of the recession. Along with the HOUSING market comeback, retail sales, a key measure of how the all-important American consumer is feeling, are on the rise. Most economists now forecast that, at least for the next few quarters, U.S. GDP will expand at a rate as high as four per cent, while Canada already saw a 0.1 per cent uptick in June. But the surest sign of euphoria can be seen in the raging markets. The S&P 500 has jumped a whopping 58 per cent since bottoming out in March; its counterpart in Toronto is up 53 per cent. Even if markets haven't fully recovered from their recession lows, the surge in prices has suddenly made people feel a lot wealthier and more confident again, and that's helped drive everything from auto to home sales. "We're clearly out of a very dark hole," says Glen Hodgson, chief economist with the CONFERENCE BOARD of Canada.
So why, then, does it all seem too good to be true? It's hard to swallow the notion that "the worst crisis since the GREAT DEPRESSION," as it was repeatedly described last winter, could, seemingly overnight, become little more than "the most inconvenient downturn since 1991." The only truly substantive change has been the rebound in consumer confidence and investor sentiment. In other words, investors are driving the rally with their hearts, and not their heads.
Which is why some experts are warning there is still a lot more pain to come. In many cases, they were the same rare voices who accurately predicted the subprime MORTGAGE collapse, credit crisis and recession. Just as the phenomenal rise in stock markets is built on hope, and not fundamentals, improvements in the economy are due almost entirely to the wheelbarrow loads of government stimulus money, and nothing more. A real, sustainable recovery is still five or 10 years away. Which means we should be preparing for America's lost decade. What that means for Canada is painfully clear. We may have avoided the worst of the crisis - our banks are sound, UNEMPLOYMENT is lower here and the housing market more stable - but Canada remains inextricably linked to the U.S. economy, and continued pain there threatens to drag this country's economy down further. (See CANADIAN-AMERICAN RELATIONS, ECONOMIC.)
"It's not a case of being bullish or bearish, it's being totally realistic about what happens after an epic US$14-trillion loss of household net worth," says David Rosenberg, chief economist at GLUSKIN SHEFF + ASSOCIATES in Toronto. "It doesn't mean we're going back into a recession, it means that we're going to have a period of stagnant U.S. economy that's going to have an impact across the globe, including Canada."
This past July, the U.S. government rolled out an incentive program called the Car Allowance Rebate System, better known as "cash for clunkers." The idea was simple. Over the next four months, it would spend US$1 billion offering people as much as US$4,500 to turn in their beaters and buy new, fuel efficient vehicles. So many jumped at the offer that, within a week, the money was gone. Another US$2 billion was added to the program. By late August, that was gone too, as nearly 700,000 cars were purchased with the help of Uncle Sam. Cash for clunkers, which single-handedly reversed years of auto industry floundering in less than 30 days, will likely go down as one of the most successful examples of government stimulus, ever.
The economic growth that has buoyed so many hopes of a turnaround has been driven - particularly in the U.S. - almost entirely by this kind of public spending. It's brought key economic indicators like retail sales back to life, and forecasters have eagerly jumped on this as a sign the worst is over. But there are crucial elements integral to a healthy economy that are completely absent from this recovery picture, like the return of private investment and jobs. As successful as direct government handouts have been in the U.S, there's little indication of progress on either front. "As long as the government is giving money away, people are going to spend it," says Mike "Mish" Shedlock, of Sitka Pacific Capital Management. "Those are not conditions that cause a sustainable recovery."
Managing this kind of artificial growth presents a difficult balancing act for governments, says the Conference Board's Hodgson. If stimulus spending is shut down too early, it could quickly throw the economy straight back into recession (what's known as a double-dip recession). Keep spending too long, and suddenly the government is competing with the private sector, overheating the economy as it drives up input prices and, eventually, interest rates. Jack Ablin, chief investment officer at Harris Private Bank in Chicago, argues that stimulus spending is clearly working, and could pave the way for as many as four quarters of growth. But he likens this to someone running a marathon on a diet of crullers. "It's hard to know how much of this recovery is real and how much is just fuelled by these doughnuts," he says. "A year from now, we're going to be at a crossroads."
This was the same challenge facing policy-makers during the Great Depression. Through the 1930s the U.S. government spent heavily to stimulate the economy. When it stopped, another steep recession followed in 1937. Similarly, Japan suffered a recession relapse in 1997 - seven years after its economy crashed - when it tried to tighten up its fiscal situation, notes Rosenberg.
To add to the difficulty, the U.S. will have to come to terms with the trillion-dollar deficits this spending is helping create. Many economists worry that America's creditors will stop lending in the face of such impossibly huge debts, forcing a spike in interest rates, inflation and maybe a whole new crisis.
But perhaps most discouraging of all is the fact that the conditions behind this short-term recovery look eerily similar to those seen during the lead-up to the crash in late 2007. At that time, consumers were over-leveraged, borrowing on credit cards and against their mortgages, buying homes they couldn't afford with zero per cent mortgages and cars with money they didn't have. That was driven by a long period where interest rates were kept too low for too long. That tactic is still being used today to try to encourage reluctant consumers. Only this time, consumers are in no condition to play along. In Canada, debt levels are still rising. Bankruptcies were up 36 per cent in July. In a recent survey, the Canadian Payroll Association found that more than half of Canadians say they are living paycheque to paycheque. The U.S. consumer is even more beaten, says Shedlock. "We still have rising credit card defaults, rising foreclosures. Neither of those conditions have been addressed."
All this could play out with predictably disastrous results. And nowhere is that more obvious than in America's troubled housing sector.
The recent flurry of REAL ESTATE bidding wars on both sides of the border has emboldened those who claim the housing crisis is over. But for every drooling homebuyer, there are hundreds of thousands of homeowners trapped in houses they're struggling to afford. And the situation, especially in the U.S., is about to get much, much worse.
Just like in the auto sector, it's Uncle Sam who's driving the supposed rebound in housing, says Rosenberg. Last winter Congress introduced a US$8,000 tax credit for first-time homebuyers, and the program has proved wildly popular. Rosenberg estimates 85 per cent of the housing activity in the U.S. right now is being supported by Washington. (We saw just how fragile the housing recovery was last week, when both new and used home sales failed to meet economists' rising expectations.) So it's no surprise the real estate industry in America is lobbying hard for the credit to be extended beyond its Nov. 30 deadline, and even expanded to US$15,000. If Washington pulls the plug, it could send the housing market spiralling again.
What the housing stimulus hasn't been able to do is offer any support to the growing number of Americans underwater on their mortgages. According to a report last month by Deutsche Bank, by the year 2011 as many as 25 million Americans, or 48 per cent of those with mortgages, will owe more than their homes are worth. The situation isn't expected to improve for a long time to come. Moody's, the rating agency, predicts average house prices won't return to their 2006 peak levels until at least 2020.
That suggests we won't see a slowdown in foreclosure activity any time soon. As it is, the rate of foreclosure is near record highs, according to RealtyTrac, a real estate research firm. In August, 358,000 houses went into foreclosure in the U.S., 18 per cent more than in the same month last year, when the meltdown was in full force and the world was gripped by foreclosure horror stories. The problem is, even as America struggles to cope with the fallout from the subprime debacle, a second and third wave of foreclosures is about to hit. Daren Blomquist, with RealtyTrac, says the next wave will be triggered by the continued rise in unemployment levels. We're already seeing signs of that. Until recently, the foreclosure crisis had mostly struck those cities in Sunbelt states like California, Arizona and Florida, where the housing bubble was most egregious. But recently, cities with high unemployment levels in Oregon, Utah and Idaho have started popping up on RealtyTrac's monthly list of the top 10 hardest hit areas.
And a third wave of foreclosures is expected to hit next year, when huge numbers of "Alt-A" and "option ARM" loans come due. Those loans were used by buyers who either weren't able to provide necessary documentation or couldn't afford the higher-end homes they wanted to own. "It's going to prolong the pain we're going through," says Blomquist.
Unfortunately, housing isn't the only problem in the real estate market. Though it receives far less attention, the commercial real estate sector is in dire straits, and the repercussions for the economy are even greater. As with housing, commercial property values have been in free fall over the last two years. The Moody's/REAL Commercial Property Price Index, which tracks the sector, is down 39 per cent from its all-time peak in 2007. Likewise, banks, hedge funds and institutional investors are all heavily exposed to the commercial market through their loans and investments in the sector. Yet an increasing number of buildings sit empty. It's not just a problem in the U.S. Last week CB Richard Ellis, a brokerage firm, revealed office vacancy rates have risen almost 50 per cent in Canada in the past year. In some markets, like Calgary, as much as 13.1 per cent of space now sits empty - a remarkable reversal from the city's boom days.
As prices crumble and vacancy rates soar, more and more borrowers are failing to keep up with their payments. It's left some economists worrying about yet another banking and credit crisis as financial firms grapple with these massive losses. According to a report by Richard Parkus, a commercial mortgage analyst at Deutsche Bank, as many as 65 per cent of commercial mortgages coming due in the next five years won't qualify for financing. As such, banks may have to write off 10 per cent of the US$1 trillion in commercial real estate loans sitting on their books. Such a scenario could be avoided if employers started hiring again to fill up all that empty office space. But as it is, companies are axing employees by the hundreds of thousands a month, and there are few signs that's about to change.
Last week, workers at the Caesars Windsor casino in Windsor, Ont., were warned by their union that layoffs could be on the horizon as business continues to slow. Meanwhile, in Plattsburgh, N.Y., 200 workers at a Bombardier railcar plant were given notice that layoffs could begin in December. For tens of thousands of workers across the United States and Canada, the prospect of more job losses still looms large. America's unemployment rate now sits at 9.7 per cent, a 26-year high. When the latest job figures came out in September, some diehard optimists grasped for any faint sign of hope - at least job losses slowed slightly in August, compared to the month before, they said. Unfortunately, that trend may not hold. New Labor Department data shows that mass layoffs (job cuts involving 50 or more employees) actually jumped sharply in August after improving in previous months. But even if the bad news about jobs does become a little less bad, says Rosenberg, it doesn't really matter. "You can't feed your kids or pay your bills with less negative data."
In the U.S., 15 million people are now out of work and a third of them have been without a job for six months or longer - a record high. Meanwhile, rates of underemployment (the laid-off banker who has found work as a waiter) are also at record highs. In hard hit areas, the unemployment rate is staggering. California hit a new postwar high in August of 12.2 per cent unemployment. By some estimates, Michigan's unemployment is set to hit 15 per cent. Canada is struggling too, with 1.6 million people out of work. According to a recent report from the Organisation for Economic Co-operation and Development, unemployment could hit 10 per cent next year, up from the current rate of 8.7 per cent. Among young Canadians between the ages of 15 and 24, unemployment is already over 16 per cent - an 11-year high.
Economists often say that unemployment is a lagging indicator, meaning that the economy must improve before we see companies confident enough to start hiring again. But the reality is that unemployment is only getting worse. Many jobs in manufacturing, construction and finance that only existed because of the bubble are gone for good. "Now what?" asks Shedlock. "Where's the driver coming from for jobs?"
This is a question with no easy answer. "Unemployment is probably going to keep rising for much of the next year. People aren't going to think of it as a recovery," says Dean Baker, an economist with the Center for Economic and Policy Research in Washington, who correctly foresaw the recession. Even if the economy grows at a healthy rate of three per cent, that creates between 100,000 to 150,000 jobs a month, says Ablin, the CIO of Harris Private Bank. At that rate, it would take four years to get back all the jobs that have been lost over the past year and a half. Efforts by government to create jobs through make-work stimulus projects are also at best temporary measures.
Many of these problems loom largest in the United States. In most respects, Canada has weathered the downturn far better. Job losses are not as severe, the housing market hasn't crashed, and credit markets never completely dried up. "There's a very significant difference between what we've seen in Canada compared to the U.S.," says Sherry Cooper, the chief economist with BMO Capital Markets. "This was not a made-in-Canada recession by any stretch." As such, the Canadian economy will be stronger than the U.S. economy in the coming quarters, she adds.
But that's not to say roadblocks to a recovery don't exist here, too. A good portion of the jolt the Canadian economy has felt in recent months has come thanks to the same thing that's been juicing the stats in the United States: government dollars. Take the cash for clunkers program. The demand for cars in the United States almost single-handedly pushed up manufacturing sales in Canada by 5.5 per cent in July (the biggest monthly jump since 1998). Wholesale sales in Canada were also up thanks to auto exports. It's hard to find a positive growth number in Canada that hasn't in some way been driven by consumer demand in the U.S. Ultimately, Canada must face the same tough question as its main trading partner: what happens when the free-money tap is shut off and U.S. consumers stop buying?
In 2007, there were plenty of onlookers who watched the United States slipping into recession, and who argued that Canada would be immune to the coming crisis. The strength of Alberta's oil wealth alone could keep Canada in the black, they argued. Even esteemed economists floated the possibility that if the U.S. sneezed, Canada might not catch a cold. That proved to be fanciful thinking. By the same token, there will be no quick recovery in Canada without recovery in the United States. "We are along for the ride," says the Conference Board's Hodgson.
The most optimistic forecasters still cling to the hope that we're experiencing the beginning of a V-shaped recovery. As quickly as the economy nosedived, it will surge upward again on new-found consumer confidence and carefully timed government spending. The bears predict we're due for more of a W-shape, where a rebound is followed by another dive into recession. Others point to a more gradual U-shape or even a long, drawn out L-shaped recovery. But the real outcome may well be an alphabet soup of all of these things, strung together over the coming years so that the economy and capital markets never really grow.
It has happened before. People may be feeling richer as they watch the markets rebound and their net worth rise again, but to some observers, this is the same kind of false start that has haunted Japan for so long. That country suffered a "lost decade" in the 1990s after its housing bubble burst. It continues to struggle to this day. "The reality is a 60 per cent jump in six months is not the hallmark of a bull market, it's generally what you see in a secular bear market," says Rosenberg. "Japan has had no fewer than four of these 50 per cent plus rallies, in the context of a market that's down over 70 per cent from its peak." Shedlock puts it in even starker terms: "This is the most massive suckers' rally since the Great Depression."
The unfortunate reality is that until households get their finances in order and are capable of spending again, the corporate sector won't rebound and neither will jobs. That's a healing process that could take years. So as bullish analysts and pundits feverishly ramp up their forecasts, maybe it's time instead to listen to what those who predicted the crisis the first time around are warning - look out below.
Maclean's October 12, 2009