Ethan Harris: No True Housing Recovery Until 2012

Includes: DIA, QQQ, SPY, XHB
by: Harlan Levy
Economist and author Ethan Harris is managing director, head of North America economics, and coordinator of global economics at Bank of America Merrill Lynch. Previously he worked at Lehman Brothers, where he was chief U.S. economist since 2003. Before that he worked at the Federal Reserve Bank of New York.
H.L.: Where is the economy headed, in light of the Federal Reserve’s statement last week about the weak economy, weaker-than-expected data from China, anemic job gains, tepid retail sales, and housing fears?
E.H.: The economy is clearly slowing down. I would describe this as a soft patch rather than a recession. In the first four quarters of the recovery Gross Domestic Product growth averaged a little above 3 percent. In the four quarters ahead we expect growth to be a little above 2 percent.
This is a very weak recovery by historic standards. Normally coming out of a major recession we would expect 7 or 8 percent growth, and with this weak growth we expect no improvement in the employment rate in the year ahead.
However, we think a recession is unlikely, because we think the Federal Reserve will continue to support growth, and many of the sectors that decline normally sharply area already at very weak levels. So it’s certainly a cautionary outlook ahead.
H.L.: Fears that Europe is slowing as well as the U.S. is making investors ultra nervous. What’s your outlook on the global economy?
E.H.: One of the big surprises in the data recently has actually been better data in Europe. In the second quarter Europe grew about 4 percent. So, for the first time in this recovery Europe grew faster than the U.S. But we think that European growth is lagging behind the U.S. The U.S. had its big growth at the end of last year, and Europe is having its big quarter now. Europe is likely to slow in the next year as they deal with their fiscal problems, but a recession is unlikely in Europe because of the strong performance of countries like Germany, with strong export industries.
For the overall global economy expect a modest slowdown in growth, growth this year of about 4.5 percent and about 4 percent growth next year. The economies of the emerging market economies are in much better health than the big developed economies like the U.S. and Europe. Emerging market economies – such a China and Brazil -- did not have the same housing and banking problems that we had, so they are likely to be somewhat of an engine of growth in the year ahead, while the U.S. and Europe will be riding the caboose. We’re at least on a train.
H.L.: The housing market is suffering a flood of foreclosures, weak sales, and large inventory. Are we at a tipping point?

E.H.: I don’t think the housing market will double-dip. What we’re seeing in housing is a bottoming out at very low levels of activity. So, we expect a very long U-shaped recovery in housing in the next year or two. We expect home prices to be down slightly across the country. We expect construction to be essentially flat, and we expect continued very high levels of home foreclosures. Right now the housing market is in a standoff with very cheap financing and very low prices, encouraging buyers, but a flood of foreclosures offsetting that demand. A true recovery in the housing market isn’t likely until 2012, when we see substantial improvement in the foreclosure picture.
H.L.: How long, if ever, do we have to wait before job gains of about 150,000 a month will match population gains?
E.H.: We think that the job market will slowly pick up in the next year, and by the end of this year job gains will be above 100,000. We don’t expect strong job gains, however, until the second half of 2011, and it’s only in the second half of 2011 when we expect to see sustained downward movement in the unemployment rate. So, a long, painful healing process lies ahead for the U.S. jobs market.
H.L.: The U.S. stock market seems stuck in a trading range below the June highs with very light volume. Can you make a bullish or a bearish case, or a little of both?
E.H.: There’s a very mixed picture for the U.S. stock market. The slowing in U.S. growth is bad for the market. However, corporations are doing better than the overall economy. Earnings remain strong, and many of the companies on the major indices do a lot of their business overseas. So the outlook for the stock market in the next year is a bit better than the outlook for the economy. The bottom line is we think there is a case for a mild further improvement in the stock market.
H.L.: Are there sectors of the market that deserve investment now?
E.H.: I think the main theme for the stock market is a focus on companies with high exposure to growth overseas. This includes many of the big multi-national companies in manufacturing and technology. We’re more cautious around domestically oriented companies, including the consumer sector.
H.L.: Will letting the Bush tax cuts for the wealthy expire at the end of this year cripple the economy, as the Republicans claim, or should we extend them?
E.H.: I believe that all of the tax cuts should be extended for one or two years. The timing is very important. The economy is in a fragile state. This is not a period where we either should be raising taxes or cutting spending. Once the economy returns to more normal growth patterns, then the long painful process of deficit reduction should begin.
To be a success it will probably require both higher tax rates and restraints on spending. This will be very difficult, because some very politically popular programs will have to be cut or constrained, including aid to the elderly, such as Social Security and Medicare, military spending, and taxes, but we’ve dug a big hole, and it will require a broad-based effort to dig ourselves out of the hole.
But I want to emphasize that these painful policy choices should wait until the economy is ready to handle the pain. In our view serious fiscal consolidation should probably start in 2012.
H.L.: What’s the most surprising thing you’ve encountered so far in the economy and the stock market?
E.H.: I think the big surprise and the big disappointment is simply the lack of job growth. Job growth is very important to sustaining the recovery. It’s important to helping banks heal. It’s important to the housing market, and it’s important to consumer spending. At the start of the year the job market seemed to be gaining momentum, but in the last three months we’ve had disappointing data. I expect and hope the job market will improve somewhat in the second half, but this is clearly the area of greatest disappointment of this year.

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