The Economic Outlook: Growth Rotates

1. The Economic Outlook: Growth Rotates David Wyss Chief Economist Standard & Poor’s November 2006

2. The U.S. Recovery Is Slowing • After a strong 2004 and 2005 • Growth has slowed to below trend. • The economy is rotating from consumer- and housing-led growth to investment-led growth. • The Fed is through hiking interest rates, and will probably have to reverse next year. • The housing market peaked last summer, but is more stalling than plunging. Starts are expected to drop 25%. • Oil prices are coming down from record highs, restoring some purchasing power. • Katrina rebuilding has been slow. • Stronger European growth and a weaker dollar should mean less drag from the trade deficit.

3. Oil Prices Hit New Highs ($/barrel, WTI and deflated by CPI; household energy purchases as percent of disposable income) Source: BEA

4. The World Is More Energy Efficient (Tonnes of oil equivalent per $1000 dollars (2000 dollars) of real GDP) Source: OECD

5. The Fed Is Moving Toward Neutral (Percent) Source: Federal Reserve

6. Interest Rates Had Converged (Long-term government bonds) Source: Bloomberg

7. Quality Spreads Grind Tighter (Spread over Treasury yields, basis points) Source: S&P

8. Financial Risk Is Greater Source: S&P

9. World Growth Is Steady (Real GDP, % change) Source: Global Insight and S&P

10. And Comes Mostly From Asia (IMF purchasing power weights, 2005) Percent of World Growth Percent of World GDP Source: IMF

11. Fiscal Deficits Almost Everywhere (Government balance as percent of GDP, 2004) Source: IMF

12. The Future Looks Bleak (Government debt as % of GDP) Source: S&P

13. Aging Populations Will Boost Government Spending (Ratio of over 65 population to labor force) Source: OECD

14. US Trade Deficit Balances Surpluses Overseas (Trade balance as percent of GDP, 2005) Source: Global Insight

15. US Borrows From Abroad to Offset Weak Savings (Percent of GDP) Source: BEA

16. European Productivity Growth Trails (Output per hour, percent change, 1995-2005) Source: BLS

17. Other Countries Are Catching Up (Percentage of tertiary degrees by age group, 2003) Source: OECD

18. Educated Workers Earn More (Ratio of income of tertiary graduate to high school graduate, men 30-44) Source: OECD

19. Can the Consumer Keep Spending? • Consumer spending has led the expansion • The tax cuts provided extra income • Lower mortgage rates freed up funds • Confidence is up • But the saving rate is negative • Tax cuts are over • Interest rates are up • Home prices are dropping • Net result will be a slowdown, not a retreat • Helped by lower energy prices • The saving rate will remain low

20. But Wealth Continues Strong, Helped By Housing Markets (Percent of after-tax income) Source; Federal Reserve

21. Debt Service Now Above 1986 Record (Household obligations as percent of after-tax income) Source: Federal Reserve

22. Debt Repayments Are Evenly Distributed (Average debt repayment as percent of income by income percentile) Source: SCF

23. Household Debt By Country (Percent of income, 2005) Source: IMF

24. US Is Actually Low-Debt (Assets as percent of GDP, 2004) Source: IMF

25. A Housing Bubble? • Housing remains affordable • Thanks to low mortgage rates • But what happens when rates go up? • Home prices have outpaced incomes • Ratio of home price to income is at a record high • There are big local bubbles • E.g., New York, California, Boston, Florida • And higher mortgage rates will cause starts and sales to drop • Housing looks less overvalued than other assets

26. Home Prices Are High Relative to Household Income (Ratio of average home price to average household disposable income) Source: BEA

27. Bubbles Are Everywhere (Percent increase in home prices, 1997-2005) Source: The Economist and S&P

28. The Stock Market Will Recover, But Slowly • Market rose over 20%/year from 1995 -99 • But dropped from March 2000 through June 2003 • Biggest drop since 1929-32 • Double-digit earning gains for a record 17 quarters; profits are a record high relative to GDP • Earnings must slow • Share prices cannot continue to outpace earnings • As interest rates rise • Stocks will thus yield less in the future than in the recent past. • But the current rally is being spurred by strong earnings and dividend tax cuts

29. Largest Stock Markets Remain Below 2000 Peaks (Change in S&P stock indexes since March 2000 peak) Source: S&P

30. Most US Sectors Have Recovered From The Bear Market (Change in S&P 500 sectors since March 24, 2000 peak) Source: S&P

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