Dr. Martin Regalia: ECON 101

 

As we sputter through the first half of 2007, the economy continues to overcome obstacles in its path, but the lack of momentum has clearly raised anxiety levels among commentators, the media, and some economists. I still believe that the economy will gradually accelerate through the year and approach its long-run potential growth rate by year-end, but it is likely to be a nail-biter.

 

Final official figures indicate that real GDP increased at an annualized rate of 2.5% in the fourth quarter, propelled by renewed consumer spending and a little help from our trading partners abroad who increased their purchases of our goods and services by nearly 11% while we cut back on our imports by 2.6%. 

 

GDP growth was slowed by residential investment, which contracted nearly 20% in the last three months of the year. There's no question that housing has been in recession since last year, but there are signs that the worst may be over. Housing starts were down 28.5% in February from a year earlier, the 11th consecutive year-over-year decline. However, on a month-to-month basis, starts have increased three out of the last four months, with February's gain amounting to 9%.

 

Data on home sales are mixed. While existing home sales rose each month between December and February, sales of new homes lost ground in both January and February. Moreover, the inventory of unsold homes for both new and existing homes remains elevated. Not surprisingly, data on home prices are also mixed. New home prices rose each month between December and February and currently stand 10% higher than their trough last September. While prices of existing homes gained some ground in February, they are still 8.6% below their peak in July 2006. In general, these data are consistent with our thesis that the housing market bottomed out over the last few months and will hover around that bottom for much of this year. 

 

Recently, expectations about an eventual housing recovery have been dampened by news of troubles in the subprime mortgage market. Subprime mortgages, generally obtained by people who cannot qualify for a conventional loan, are thus more risky than conventional mortgages. While subprime loans traditionally carry higher interest rates, the more recent vintage contained many adjustable rate mortgages, interest-only loans, and low- or no-documentation loans. Some even were issued at low initial teaser rates, making them even riskier.

 

The main worry is that holders of these mortgages won't be able to afford their loan payments once the rates reset. Furthermore, some people worry that the subprime troubles will spread to the rest of the mortgage market and eventually to the entire economy. It's still too early to know whether this will definitely happen, but we believe that it will not.

 

According to some estimates, the subprime share of total mortgage originations was more than 20% in 2006, with about 60% of those mortgages having adjustable mortgage rates. However, as a percentage of the total outstanding loans, the share of subprime mortgages is still relatively small, having risen from about 5% in 2003 to about 13% in 2006.

 

According to the Mortgage Bankers Association, the delinquency rate for subprime mortgages has increased from about 10% at the end of 2004 to a little more than 13% at the end of 2006. While that is a notable increase, it applies to a relatively small percentage of the overall mortgage market and has yet to trigger a corresponding increase in prime loans. Delinquency rates for prime mortgages rose from 2.2% in early 2005 to 2.6% in late 2006.

 

Federal Reserve data on residential real estate loan delinquency rates also show an increase, albeit of more modest proportions from 1.4% at the end of 2004 to 1.9% in the fourth quarter of 2006.

 

In addition, if the subprime mess were to be spreading, we would likely notice an increase in delinquencies in consumer loans, excluding real estate. Federal Reserve data show, however, that the delinquency rate for all consumer loans remained subdued at less than 3% at the end of last year, just a bit higher than the 2.7% level in the fourth quarter of 2005.

 

So while we remain guardedly optimistic about the eventual stabilization in the housing market, followed by a mild recovery in 2008, there are other sectors in the economy that cause us more worry.

 

Total business investment weakened significantly at the end of last year and has been lackluster at best in early 2007. Overall business investment dropped at an annual rate of 3.1%, pulled down by a 4.8% decline in equipment and software and an anemic 0.9% growth in structures.

 

Orders of nondefense capital goods, excluding aircraft, which are a proxy for the underlying trend in capital spending, dropped four out of five months between October and February. However, since these orders had risen 39% between January 2004 and September 2006, the recent drop puts orders about 10% below the September peak.

 

With funding readily available and interest rates still historically low, this lack of investment is troubling and likely indicates a lack of confidence in the economy. The last time we saw such a dearth of confidence was in 2003 when Congress and the administration passed a tax cut to stimulate investment. With a different makeup on Capitol Hill though, this time around we seem to be fighting against tax increases rather than for tax cuts.

 

Investment in structures rose at a very weak annualized rate of 0.9% in the fourth quarter, down sharply from a 16% rise in the third quarter, but data for early 2007 are showing some signs of improvement. Monthly data for private nonresidential construction increased at an annual rate of nearly 10% between December and February vis-à-vis the preceding three months.

 

While housing construction has been a significant drag on total construction spending, strength in the nonresidential construction sector is compensating some of those losses and may increasingly continue to do so as the year wears on.

 

So our outlook for this year continues to call for slow growth early, grudgingly giving way to faster growth in the year's second half. We don't see the subprime troubles derailing the forecasted improvement, but the lack of investment could prove a somewhat greater hurdle. Job growth will likely remain subdued with a modest rise in the unemployment rate, and inflation should continue to moderate after a first quarter upward blip. Interest rates will be flat at the short end of the spectrum as the Fed isn't likely to cut them unless growth is significantly weaker than we expect.