After the Recession:How Hot?

David WyssChief Economist

212-438-4952David_Wyss@standardandpoors.com

TVBNew York

September 8, 2004

2

The Recovery Is Finally Accelerating

• After two years of sluggish expansion

• Jobs are finally materializing

• Up to now, the recovery has run on two legs – consumer and government spending

• Now capital spending is rising despite excess capacity

• Higher interest rates will slow housing and consumers

• Tax cuts are over, and the saving rate is already low

• Federal deficits will level off

• Higher oil prices could stall the expansion

• Especially if world economic stagnation still widens the trade gap

3

Energy Costs Have Dropped from Prewar Highs

0

10

20

30

40

50

60

70

80

1970 1975 1980 1985 1990 1995 2000 2005

1%

2%

3%

4%

5%

6%

7%

8%

9%

$/Barrel 2000 prices Energy cost/disposable income

($/barrel, refiners acquisition price and deflated by CPI; consumer energy as percent of disposable income)

4

0

1

2

3

4

1993 1995 1997 1999 2001 2003 2005 2007

CPI Excluding food and energy

(4-quarter percent change)

Inflation Is Beginning To Creep Up

5

0

2

4

6

8

1993 1995 1997 1999 2001 2003 2005 2007

Federal Funds Rate 10-Year Treasury Bond Yield

(Percent)

The Fed Has Begun to Tighten

6

Long-Term Deficits

51

144

17

8241 57 6040

287

036 17

89 85

158

718

68

136

55

260307

0

50

100

150

200

250

300

350

400

US Japan Australia Canada UK France Germany

2000 2020 2050

(Government debt as % of GDP)

7

Capital Spending Follows GDP

-2%

0%

2%

4%

6%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008-15%

0%

15%

30%

45%

Real GDP (left) Equipment spending (right) High-Tech (right)

(4-quarter percent change)

8

Weak Employment Means Weak Construction

-2%

-1%

0%

1%

2%

3%

4%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008-30%

-20%

-10%

0%

10%

20%

30%

Employment Nonresidential Building

(4-quarter percent change)

9

8%

10%

12%

14%

16%

1993 1995 1997 1999 2001 2003 2005 2007

Exports Imports

(Percent of GDP)

The Trade Gap Yawns Wider

10

0.7

0.8

0.9

1.0

1.1

1.2

1993 1995 1997 1999 2001 2003 2005 2007

Industrial Developing

(Real trade-weighted dollar)

And The Dollar Remains Strong

11

World Growth Is Improving

-2

0

2

4

6

8

US Canada Europe Japan OtherAsia

LatinAmerica

2002 2003 2004 2005

(Real GDP, % change)

12

10%12%14%16%18%20%22%24%

1970 1975 1980 1985 1990 1995 2000 2005

Total saving Private saving Investment

(Percent of GDP)

We Borrow From Abroad to Offset Weak Savings

13

Other Countries Are Catching Up

0

10

20

30

40

50

60

Canada

France

Germany

Italy

Japan

Korea

Mexico UK US

25-34 45-54

(Percentage of college graduates by age group)

14

Can the Consumer Keep Spending?

• Spending has led the expansion

• The tax cuts provided extra income

• Lower mortgage rates freed up funds

• Confidence is improving

• But the saving rate is low

• Tax cuts are over

• Interest rates are rising

• And gasoline at a record high

• Net result will be a slowdown, not a retreat

• But the saving rate will remain low

15

Household Debt By Country

0% 50% 100% 150%

US

UK

Japan

Italy

Germany

France

Canada

(Percent of income, 2001)

16

8

10

12

14

16

18

20

1980 1983 1986 1989 1992 1995 1998 2001 2004

Financial Obligations Debt

Debt Service Now Above 1986 Record

(Household obligations as percent of after-tax income)

17

Household Net Worth By Country

0% 200% 400% 600% 800%

US

UK

Japan

Italy

Germany

France

Canada

(Percent of income, 2001)

18

A Housing Bubble?

• Housing is the most affordable it has been since the early 1970s

• Thanks to low mortgage rates

• Home prices have outpaced incomes

• But ratio of home price to income is only moderately high

• There are local bubbles– E.g., New York, Bay area, Boston, DC

• And higher mortgage rates will cause weakness

• But housing looks less overvalued than other assets

19

More Affordable Housing Allows More Households To Own Their Home

0.60

0.80

1.00

1.20

1.40

1.60

1980 1983 1986 1989 1992 1995 1998 2001

60

62

64

66

68

70

Homeownership Rate (Right scale) Affordability (Left scale)

20

Home Prices Are High Relative to Household Income

2

2.5

3

3.5

4

1975 1979 1983 1987 1991 1995 1999 2003 2007

New Existing

(Ratio of average home price to average household disposable income)

21

The Stock Market Will Recover, But Slowly

• Market rose over 20%/year from 1995 -99• But dropped from March 2000 through June 2003• First three consecutive down years since 1939-41• Biggest drop since 1929-32• Profits cannot continue to outpace GDP• 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 a near-term rally is being spurred by earnings

recovery and dividend tax change

22

Stocks Aren’t Overvalued Any More

0

5

10

15

20

25

30

35

1990 1995 2000 2005

P/e ratio Bond yield (inverse)

(10-year Treasury yield vs price/earnings ratio, S&P 500 operating earnings)

23

Profits Are At Record Level

0%

2%

4%

6%

8%

10%

12%

1980 1984 1988 1992 1996 2000 2004 2008

After-tax Economic

(Profits as percent of GNP)

24

-5

0

5

10

15

20

1946-66 1966-81 1981-2000 2000-2012

Nominal Real

Long Bull Markets Are Followed by Periods of Weakness

(Percent return on S&P 500 and corrected by CPI)

25

High P/Es are Concentrated in Tech

0 10 20 30 40 50 60

S&P 500

Cons Discr

Cons Staples

Energy

Financials

Health Care

Industrials

Technology

Materials

Telecomm

Utilities

(Based on 12-month forward operating earnings, Today vs. March 2000)

26

-15

-10

-5

0

5

10

15

20

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Magazine Newspaper TV Total

Advertising Comes Back

(Percent change)

27

Bottom Line: The Economy Recovers, But Slowly

• Consumers are spending near max• Businesses will not take over the lead yet• But strong stimulus from fiscal policy• Interest rates rise gradually next year• Housing prices and starts slow• Weak recovery for stock market• Risk of recession remains if:

– Further terror attacks damage confidence– War disrupts oil supplies– World deflation sucks the US into slower growth

28

Risks to the Economy

-2%

0%

2%

4%

6%

8%

2000 2001 2002 2003 2004 2005 2006 2007

World deflation Oil & terror Baseline

(Real GDP, percent change year ago)

29

Unemployment Rates Are Moderate

4.5-5.4 Under 4.5

5.5 – 5.9 6.0 +

(Unemployment rate, July 2004)

30

Manufacturing States Suffer Most

0.1 – 1 Down

1.1 – 1.9 2 +

(Change in unemployment rate, July 2004 vs. Oct 2000)

31

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