SF Fed--FedViews...
frbsf.org
Corresponding charts (PDF):
frbsf.org
frbsf.org
.........................
S&P 500 P/E and P/D Ratios:
martincapital.com./chart-pgs/CH_per.HTM
=========================
>>>FedViews
June 17, 2002
Kevin J. Lansing, Senior Economist at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:
It appears likely that the trough of the recent recession will be dated in December 2001. Real GDP growth for 2002.Q1 was revised downward to 5.6% from 5.8% reported previously. More than one-half of this growth can be attributed to a slower drawdown of inventories in 2002.Q1 relative to 2001.Q4. It appears that the bulk of the inventory correction has now run its course. Hence we expect the growth contribution from inventory adjustments to be much smaller in 2002.Q2. We are projecting second quarter growth to be about 3%. After that, we foresee growth accelerating to about 4% as business investment spending recovers (Chart 1).
Since consumption accounts for about two-thirds of GDP, one of the factors that feeds into our growth forecast are measures of consumer sentiment which have continued to trend upwards during the first five months of this year. A closer inspection of the survey data suggests that consumers are still somewhat cautious about the strength of the recovery. Future buying plans for autos, homes, and major appliances dropped a bit in May relative to April. There also appears to be some lingering concerns about job security. About 22% of consumers surveyed reported that "jobs are hard to get"—about the same percentage that answered that way in January 2002. The preliminary June reading of the University of Michigan consumer sentiment index declined to a level about equal to the February 2002 value (Chart 2).
Real consumption growth remained positive throughout the recession in contrast to the behavior observed during the 1990-91 recession when consumption growth was negative for two consecutive quarters. Several factors help to account for the strong performance of consumer spending during the recent recession. Low mortgage interest rates allowed consumers to lower their monthly house payments, and in many cases, to extract equity from their homes in the form of cash-out refinancings. Fiscal policy stimulus in the form of tax rebates and cuts in marginal tax rates, as well as, falling energy prices, served to increase consumer disposable income. Finally, the zero-percent financing deals offered by domestic auto manufacturers gave a tremendous boost to consumer durables purchases in the fourth quarter of 2001. This shows up as a spike in aggregate consumption growth to about 6% in the fourth quarter of 2001. In the first quarter of 2002, aggregate consumption growth dropped back to about 3%. Going forward, we expect consumption growth to hover around 3%, which is below the average growth rate of 4.3% experienced from 1996 to 2000 (Chart 3).
The decline in business fixed investment during the recent recession was much more severe than the corresponding decline in the 1990-91 recession. This observation helps to provide some insight into one of the underlying causes of the recession. During the second half of the 1990s, businesses overinvested in acquiring new technology and in building new productive capacity in an effort to satisfy a level of demand for their products that, in retrospect, we now see as unsustainable. Once this became apparent, firms sharply cut back on their investment plans and they are now in the process of working off the excess capital that had been accumulated. In other words, firms are trying to make better use of the capital they already have rather investing in new capital. The recovery in business investment is obviously linked to the outlook for corporate earnings. To improve their bottom lines, firms have been aggressively cutting costs. In many cases, this has involved large reductions in employee headcount, particularly in the technology sector. Data for 2002.Q1 suggest that corporate earnings have bottomed out or have nearly bottomed out. Hence we expect business investment to recover over the next 1½ years (Chart 4).
The four-week moving average of initial claims for unemployment insurance bottomed out and started trending upward in March 2000, a full year before the onset of the recession. Another leading indicator of the recession was the stock market, which also reversed course in March 2000. The most recent data on initial claims suggests that the series has peaked and is now poised to trend downward as the economy recovers. The rate of decline in initial claims will depend on how many new jobs are created during the ensuing recovery (Chart 5).
One measure of new jobs is the change in nonfarm payroll employment. So far in 2002, the U.S. economy has experienced a net loss of 142,000 jobs. But the most recent data shows that 44,000 jobs were added in May. The sluggish job growth experienced so far in 2002 is somewhat reminiscent of the behavior observed in the months following the 1990-91 recession. In that recession, it took about one full year before job growth resumed in earnest. That episode has been referred to as the "jobless recovery" (Chart 6).
In May the unemployment rate fell to 5.8%. We expect the unemployment rate to increase slightly in the second quarter as our forecast for real GDP growth in 2002.Q2 is slightly below the economy's long-run trend growth rate, which we assume is 3.5%. After that, we expect the economy to grow a bit faster than the economy's long-run trend growth rate. Above-trend growth would reduce slackness in the labor market and bring about a gradual downward movement in the unemployment rate (Chart 7).
Given the slackness that exists in the labor market and the low levels of capacity utilization in the economy, we expect the various measures of inflation to remain subdued. (Chart 8).
The federal funds futures market is predicting that the funds rate will remain unchanged at both the June and August FOMC meetings. After that, the market is assigning about a 1 in 3 chance of a 25 basis point hike at the September 24 FOMC meeting. The expectations embedded in the futures market suggest that there is still a fair amount uncertainty on the part of investors about the strength of the recovery. Mortgage interest rates have dropped down below 7% recently. Further declines would be expected to set off another round of mortgage refinancings. The risk spread between low grade corporate bonds and riskless Treasury securities has widened a bit recently. This likely reflects investor concerns about the integrity of corporate financial statements, uncertainty about future earnings growth, and the ability of firms to service high levels of corporate debt, particularly in the telecommunications sector (Chart 9).
As of June 17, the S&P 500 is down by about 33% from the peak reached in March 2000. So far in 2002, the index is down by about 11%. The drop in stock prices in 2002 contrasts sharply with the behavior that is typically observed in the months following the end of a recession when stock prices generally rise. In the 5 ½ months following the end of the 1990-91 recession, for example, the S&P 500 increased by about 4% (Chart 10).
One key difference between then and now, however, is the valuation level of the market. At the end of the 1990-91 recession, the P/E ratio of the S&P 500 index was around 17. At the end of 2001, the P/E ratio of the index was around 45 for the version based on reported earnings and around 29 for the version based on operating earnings. Reported earnings are governed by generally accepted accounting principles while operating earnings exclude various one-time charges such as goodwill write-downs stemming from prior corporate acquisitions (Chart 11).
The housing market exhibited amazing strength during the recent recession. Real house price growth remained positive throughout the recession, in contrast to the typical pattern observed during recessions when real house prices generally decline. Part of the reason for the strength in the housing market may be a portfolio rotation effect as investors shift funds out of stocks and into real estate. Very low mortgage interest rates have also played a role, however. The strength in the housing market was probably an important factor in limiting the severity of the recession. Studies suggest that the wealth effect on consumption from rising house prices is actually much stronger than the wealth effect from rising stock prices. We would expect house price appreciation to slow at some point because ultimately, house prices can rise only as fast as people's incomes. Income growth, in turn, is ultimately tied to the growth rate of the economy (Chart 12).
Since hitting a peak in February of this year, the nominal dollar has declined by about 6%. One possible explanation for the weaker dollar is that foreign investors have decided to reduce their portfolio weights on U.S. dollar denominated assets, perhaps due to concerns about the strength of the recovery. This portfolio reallocation may also help explain some of the recent weakness in the stock market. In the past, high levels of the trade deficit relative to GDP have typically been associated with subsequent downward adjustments in the value of the U.S. dollar. Currently, the trade deficit represents about 4% of GDP, a figure which would be considered high from a historical perspective (Chart 13). <<< |
