Resolving Uncertainties in the U.S. Economic Outlook
Most economic analysts would agree that the recession that began in March 2001 probably ended in early 2002. Based on current data, it appears that the U.S. economy has expanded for five consecutive quarters, beginning in the fourth quarter of 2001, following three quarters of contraction. U.S. gross domestic product (GDP) grew at an inflation-adjusted rate of 2.4 percent during 2002, far outpacing the 0.3 percent rate of growth in 2001.
Why the delay in declaring an end to the recession? Business cycle turning points are officially designated by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The official designation of the beginning or end of a recession is typically made some months after the fact, once revisions have been made to the relevant data. The NBER bases its calls on four main indicators: industrial production, real income, wholesale-retail sales, and employment. While the first three indicators were generally positive in 2002, the fourth--and arguably most important--indicator has not yet turned decisively upward. Accordingly, the NBER released a statement on February 12 saying that "additional time is needed to be confident" as to the direction of the economy.1 The lack of net job growth in 2002 has prompted comparisons with the recovery of 1991-92, the so-called jobless recovery.
Why the sluggish recovery? In spite of a strong performance by consumers and homebuyers, as well as considerable monetary and fiscal stimulus, two factors account for the lackluster recovery. One factor is the ongoing problems of the corporate sector. Earnings growth overall has been slow in a difficult operating environment, and certain troubled industry sectors are undergoing painful restructuring. At the same time, significant progress is being made toward leaner cost structures, lower levels of indebtedness, and improved profit margins--factors that should lead to greater hiring and investment spending and an improvement in corporate credit quality once the U.S. economic recovery gathers momentum.
A greater impediment to the current economic recovery appears to be the uncertainties associated with terrorism, Iraq, and corporate governance reform. These uncertainties make it difficult for investors and business executives to price transactions and make investment plans, thereby slowing economic activity. Although the banking industry on the whole has fared well in the recent slow-growth environment, bankers also must contend with these uncertainties. In a broad sense, the outlook for the economy and the banking industry in 2003 will be shaped by the progress that is made in restructuring troubled industry sectors and resolving uncertainties.
Cleaning Up from the Corporate-Sector Recession
While each recession is different, most downturns of the past 50 years have been associated with supply constraints or price shocks that raised inflation and interest rates and depressed business investment and consumer spending. For the most part, these traditional factors appear to be absent in the current downturn, with inflation and interest rates remaining at historically low levels. The recession that began in March 2001 might better be characterized as a corporate-sector recession, as most of the bad economic news has been corporate news. Corporate profits declined by 2.2 percent in 2000 and 7.2 percent in 2001 before stabilizing in the first three quarters of 2002. Business investment spending experienced the sharpest decline in a quarter century, with nonresidential business investment falling by 5.2 percent and 5.8 percent in 2001 and 2002, respectively.
In a sense, this latest downturn may be viewed as a product of forces driving the so-called New Economy of the late 1990s--as well as its excesses. During the expansion, some people used the term New Economy to claim that changes in market dynamics and the increasing importance of knowledge as a corporate asset were rendering traditional accounting methods obsolete as a guide to the true economic value of high-tech firms. These ambitious claims appear to have largely collapsed with the subsequent large-scale decline of equity prices among high-tech firms. However, others were using the term New Economy to refer to long-term structural changes that were taking place in the economy, including increased global competition, productivity-enhancing technological innovations, and a greater reliance on market-based financing.2 These changes appear to have had longer-lasting effects, bringing lower inflationary expectations, higher productivity, and greater market efficiency. The downside of these changes is a very difficult operating environment for the U.S. corporate sector and a drawn-out period of restructuring for -troubled industry sectors.
Corporate revenues and earnings have been hit hard by the recession, and, as a result, job growth and business investment in this recovery have been significantly weaker than the historical norm (see Chart 1). Global competition was a driving force behind the investment in new technologies and growth in merger activity in the late 1990s that helped U.S. corporations cut costs. But as inflation rates declined, global competition has increasingly placed downward pressure on output prices--first in manufacturing but increasingly in other sectors. Import prices for capital goods and consumer goods other than automobiles have fallen consistently since the mid-1990s.
As a result, revenue growth has slowed or even become negative. Output prices measured by the core producer price index (PPI) grew by a mere 0.1 percent in 2002, down from 1.4 percent in 2001. Net sales for S&P 500 companies grew by only 0.7 percent in the first three quarters of 2002 from the same period in 2001. Net income for the S&P began to recover slowly in the second half of 2002, after declining for five consecutive quarters.3 However, this modest recovery in earnings growth appears to be largely attributable to cost cuts and layoffs, which have hurt job growth and business investment spending.
3 As of mid-February 2002, Thomson First Call was estimating that earnings for S&P 500 companies had increased by about 11 percent in the fourth quarter of 2002 from the same quarter a year earlier.
Equity Market Bubble and Corporate Governance Scandals
During the period of rising stock prices leading up to early 2000, new companies by the hundreds issued equity to the public, while mature companies stayed ahead of competitors by investing heavily in new equipment and merging with rivals. This activity sparked a boom for financial markets and institutions that facilitated these transactions. Between 1997 and 2000, more than 1,500 new companies issued equity shares to the market. Corporate debt issuance totaled about $ 3.6 trillion during this period, and 36,175 mergers were consummated, with a total deal value of $4.6 trillion.4 At the time, this dynamic appeared to be a relatively healthy response to the challenges of intense competition and changing technologies, allowing new companies to pursue opportunities and older companies to restructure operations.
Despite the efficiency with which the financial markets facilitated these transactions, the collapse of the technology bubble and recent corporate governance scandals exposed serious flaws in the system. In retrospect, stock valuations based on so-called intangible assets were largely illusory. A series of corporate scandals revealed earnings overstatements and conflicts of interest involving senior management, boards of directors, auditors, investment bankers, and equity analysts. Just as the investing public was becoming comfortable with the idea of buying and holding equities for the long run, serious questions were raised about the quality of information upon which investment decisions are made and the trustworthiness of major players in the capital markets. Reflecting investor wariness, equity prices remain depressed. The tech-heavy National Association of Securities Dealers Automated Quotations (NASDAQ) index currently trades about 75 percent below its March 2000 peak. In sum, the market value of equity shares traded on U.S. exchanges has fallen by about $7.5 trillion since early 2000.
Many companies in the fastest-growing industries of the late 1990s used low-cost debt and equity capital to invest in new technologies and expand productive capacity. Annual U.S. growth in real spending on equipment and software averaged over 10 percent between 1993 and 1999. But by the late 1990s, companies found themselves with excess capacity as demand fell short of expectations. The overall capacity utilization rate for U.S. industries fell sharply beginning in third quarter 2000, hitting bottom at 74.6 percent in December 2001 and improving only a little in 2002. High-tech industries--telecommunications in particular--have experienced a rapid and uninterrupted decline in capacity utilization since mid-2000.5 The capacity utilization rate for the communications equipment industry stood at only 49.2 percent as of December 2002.
5 High-tech industries include computer and office equipment, communications equipment, and semiconductors and related electronic components.
Wide Credit Spreads
While low stock prices have significantly raised the cost of equity financing for publicly traded firms, a sharp rise in risk premiums in corporate bond markets has also increased the cost of debt financing. In particular, yield spreads between investment-grade and speculative-grade bonds widened significantly, signaling volatility in the capital markets. The yield spread between speculative-grade and investment-grade bonds, which was approximately 300 basis points in mid-1999, rose as high as 800 basis points following the September 2001 terrorist attacks and remained near 600 basis points as of early 2003.6 This adverse trend in the credit markets was especially bad news to low-rated firms that needed to roll over maturing debt, and many of them were forced to default on their loans.
6 Data from Merrill Lynch Global Bond Indices, Bloomberg.com.
Lower investor confidence affected not only speculative-grade borrowers but also some investment-grade borrowers. For example, the commercial paper market, which many investment-grade borrowers have used as a cheap source of funding, also appeared to be characterized by a higher degree of risk aversion beginning in early 2000.7 After reaching a peak of $351 billion outstanding in November 2000, the volume of commercial paper outstanding issued by nonfinancial companies had shrunk dramatically to $153 billion by January 2003. Some companies, fearing that sources of liquidity would not be available, secured term-out options for revolving lines of credit or backup commercial paper lines as a secondary source of liquidity.8
8 A term-out option allows the borrower to convert the revolving credit, which generally matures in one year or less, into a term loan and repay it over a longer period of time. A commercial paper backup line is a commitment to provide a liquidity support for a company's commercial paper program. The rationale is that the borrower does not intend to use the backup line, which generally costs more than issuing commercial paper, unless the commercial paper cannot be rolled over or repaid.
Impaired Credit Quality
Among the most telling measures of corporate distress are default rates and ratings trends on corporate bonds. The total default rate for U.S. bond issuers, which peaked in the last recession (March 1991) at a record-high 5.1 percent, rose again in the recent recession to as high as 4.9 percent (January 2002).9 The increase in default rates over the past two years has been attributed primarily to the low-quality issuers that came to market in the late 1990s. From 1996 to 2000, some 33 percent of new issuers were rated B+ or below. Already, 31 percent of those issues have defaulted. Of those that remain, 61 percent are rated B+ or below, and 20 percent are rated B- or below.10 But investment-grade issuers have also experienced higher default rates. The investment-grade default rate rose to a record high of 0.2 percent in 2001 and promptly set a new record with a default rate of 0.5 percent in 2002. Last year was also a record year for "fallen angels," as some 70 investment-grade companies with debt totaling over $200 billion were downgraded to junk status.11 On average, there were 18 new fallen angels per quarter in 2002--three times the quarterly average between 1995 and 2000.
9 Issuer-based default rates used here are 12-month trailing default rates calculated by Moody's Investors Service.
10 "Corporate Defaults Peak in 2002 Amid Record Amounts of Defaults and Declining Credit Quality--Hazards Remain," Standard & Poor's, January 23, 2003.
11Credit Trends Weekly Commentary, Moody's Investors Service, January 20, 2003.
Following a record high of 257 Chapter 11 bankruptcy filings by public companies in 2001, another 191 public companies filed for bankruptcy in 2002. The most common factor that ultimately causes companies to file for bankruptcy is a liquidity crisis brought on by financial weakness or suspicion of fraud. Moody's reports that 652 U.S. companies experienced ratings downgrades in 2002 (with a deterioration in liquidity being the most common cause), while ratings upgrades numbered just 132 (see Chart 2). Still, companies that have remained highly rated have managed to take advantage of the benefits of lower interest rates. Total issuance of corporate bonds was a record 1.25 trillion in 2001, a level that declined only modestly over the first three quarters of 2002.
Despite the problems of the corporate sector, strong growth in consumer spending and residential real estate activity kept the recession relatively short and mild. Real consumer spending grew by 2.5 percent in 2001 and 3.1 percent in 2002--a vastly better performance than during the last recession. Consumer spending accounted for nearly 90 percent of all economic growth in 2002, as the recovery began to take hold. Key factors supporting consumer purchasing power during this period have included low inflation, aggressive monetary and fiscal stimulus, and the continued productivity gains that are a byproduct of corporate restructuring.
Monetary policy has played a central role. After holding the federal funds target rate at 6.5 percent during the last half of 2000, the Federal Reserve reduced the rate eleven times in 2001, totaling 475 basis points. The additional 50-basis point rate cut in November 2002 brought the federal funds rate down to 1.25 percent. This aggressive policy of rate easing (fortuitously initiated two months before the recession officially began) pushed short- and long-term rates down to levels not seen for 40 years, which helped boost consumer spending in durable goods and housing.
In this favorable interest rate environment, many consumers have been able to reduce debt service and maintain household spending by refinancing existing mortgages at a lower interest rate. Homeowners refinanced some $2.58 trillion single-family mortgages in 2001 and 2002, in many cases reducing monthly debt payments.12 Many refinancing borrowers also chose to liquefy some of the built-up equity in their homes by "cashing out" an estimated $145.3 billion. In addition, homeowners added roughly $150 billion to home equity lines of credit and $161.7 in nonresidential consumer debt during this two-year period.13 A recent study by the Federal Reserve estimates that refinancing activities may have contributed some $23 billion to consumer spending between January 2001 and March 2002.14
12Mortgage Finance Forecast, Mortgage Bankers Association of America, January 7, 2003.
13 "The Economic Contribution of the Mortgage Refinancing Boom," Economy.com, December 2002, and the Board of Governors of the Federal Reserve System Consumer Credit Report (G.19).
Fiscal easing, in the form of the 2001 Economic Growth and Tax Relief Reconciliation Act, also turned out to be extremely well-timed. Tax rebate checks totaling $38 billion were mailed in mid-2001; they appear to have arrived near the deepest part of the downturn but before the recession was generally recognized. In addition, personal income tax cuts that took effect in 2002 helped offset weaker gains in wages and salaries. Personal tax and non-tax payments fell by 13.5 percent in nominal terms in 2002--the largest annual decline since World War II.15 Unemployment insurance benefits provided additional financial support to the household sector. Government unemployment insurance payments rose from $20.5 billion in 2000 to $31.9 billion in 2001. With the extension of eligibility for federal unemployment benefits in March 2002, these transfer payments nearly doubled in 2002 to $62.9 billion.
15 Non-tax payments to the federal government include a variety of fees, penalties, donations, and unclaimed bank deposits.
Even without the increase in federal unemployment benefits, personal income more or less held ground throughout the downturn. Although real total labor income declined in the second half of 2001 and the first quarter of 2002, it still managed to grow slightly on an annual basis during both years. By comparison, real total labor income fell on an annual basis during each of the past three recessions. The ability of real incomes to continue growing throughout the downturn in part reflects a combination of two key factors: low inflation, which increased the consumer's purchasing power, and large increases in productivity, which supported wage gains. The productivity of the business sector, as measured by output per hour, rose by 4.7 percent in 2002, the highest annual increase in over 50 years (see Chart 3). These gains in labor productivity help to explain why the total compensation of salaried workers rose 3.4 percent last year, or more than twice as fast as the rate of inflation.
A long-term increase in rates of productivity growth may be one of the lasting contributions of the New Economy. Although it is often accomplished through job cuts, as firms find ways to produce more with fewer workers, rising productivity growth over the long term makes the pie bigger in terms of corporate profits, labor compensation, lower consumer prices, or some combination of the three. In recent years, households appear to have captured much of the gains of higher productivity through lower prices and high rates of wage growth. The flip side of these gains, however, has been the near absence of net job growth--a fact that places the financial burden of corporate restructuring disproportionately on a relatively small number of U.S. households.
Banks Fare Well in the Slow-Growth Recovery
Thus far, the 2001 recession has had a limited net effect on the profitability of the U.S. banking industry. Despite significantly higher credit losses associated primarily with commercial loans to large corporate borrowers, U.S. commercial banks earned a record $23.4 billion in the second quarter of 2002, a mark that was nearly equaled in the third quarter. Insured thrift institutions managed to set earnings records in both the second and third quarters, at $3.9 billion and $4.0 billion, respectively.
Three key factors have helped to insulate the banking industry from the full effects of the corporate sector recession. One relates to how banks have managed risks. With generally strong capital positions and earnings, banks have had an incentive to recognize losses promptly and move impaired loans off the balance sheet. Chart 4 shows that provisions for loss by the industry have slightly exceeded net charge-offs, even as loan losses have risen sharply in recent years. In addition to reducing problems through charge-off, the ability to sell problem loans has been enhanced by the development of an active secondary market for loans. The 2002 Shared National Credit (SNC) report shows that nonbanks hold a disproportionate share of classified syndicated loans, suggesting that banks have been successful in selling riskier loans and participating out bigger shares to nonbanks. Banks have also managed risks in commercial loan portfolios by increasing the use of credit derivatives. The total notional value of credit derivative positions held by U.S. commercial banks has risen from virtually nothing in 1996 to $573 billion as of September 2002. These instruments have proved useful in reducing the net losses imposed on banks in large corporate defaults.
The second key factor mitigating the effect of problem loans on net income has been the changing structure of the income statement itself. Chart 5 shows that noninterest income rose from 32 percent of net operating revenue in 1990 to 43 percent in 2000.16 The increasing influence of noninterest income tends to offset the effects that loan loss provisions would otherwise have on bottom-line net income. For example, loss provisions totaled 19 percent of net operating revenue in both 1990 and 1991, but this ratio was held to just 12 percent in 2001 and in the first three quarters of 2002. Moreover, the benefits of strong fee income have not been restricted to large institutions. While revenues from capital-market-related activities declined in the first three quarters of 2002, fee income related to deposit services rose strongly, boosting noninterest revenues for the industry as a whole.
16 Net operating revenue is defined as the sum of noninterest income and net interest income.
The third, and perhaps most important, factor in boosting bank earnings has been the effect that a steep yield curve has had on net interest income. The average yield spread between ten-year and six-month Treasury instruments in 2002 was 2.94 percent--a full 125 basis points higher than the average for 2001 and a level that has been exceeded in only two years since 1960. The steep yield curve helped raise bank net interest income by $19.3 billion during the first three quarters of 2002 compared with year-ago levels, significantly exceeding the $7.2 billion increase in loan loss provisions and helping boost net income to $68.5 billion for the first three quarters of the year.
The ability of the banking industry to continue to earn record profits in the face of commercial loan losses of this magnitude is uncertain. However, there are signs that the credit quality picture may improve over the course of 2003. As noted above, significant progress has been made in restructuring troubled industry sectors and improving corporate profit margins. A pick-up in the pace of economic activity in 2003 would help this process and could lead to a reduction in the number of problem commercial loans on bank balance sheets by the end of 2003. One factor that should come into play this year is the fact that bank lending standards to corporate borrowers have been progressively tightened since credit problems began to emerge in 2000.17
Moreover, the factors that have helped to offset rising loan loss provisions--namely higher levels of noninterest income and net interest income--should remain largely intact over the course of the year. A factor that would threaten to impair net interest income is a substantial rise in short-term interest rates. Because the interest-rate sensitivity of bank portfolios appears to have risen in recent quarters, rising interest rates could significantly reduce net interest margins, particularly at smaller institutions. However, such an outcome would be unlikely to take place in the absence of a resurgence in economic activity that would bring offsetting positive effects on bank credit quality. So while the course of the economy in 2003 remains uncertain, it is reasonable to expect that the offsetting relationship between loan loss provisions and the other major components of the bank income statement will remain in place for the foreseeable future.
The Importance of Resolving Uncertainties
Before September 11, the greatest uncertainties facing the country were economic. When stock prices began to decline in early 2000, investors wondered how large the market correction would be and how business would be affected. Rising unemployment in early 2001 added job security to the list of concerns on the minds of consumers. After September 11, however, a number of noneconomic uncertainties emerged. The attack itself depressed consumer and business expectations for months, and the possibility of additional terrorist attacks has heightened the general level of uncertainty since that time. If this were not enough, the Enron bankruptcy in late 2001 marked the onset of public concern about corporate accounting practices that would intensify with the emergence of similar episodes; in particular, the $100 billion collapse of WorldCom in July 2002. During the past six months, the possibility of war with Iraq has become a growing source of concern, with unclear implications for the price of oil and the economy in general. The combined effects of these uncertainties is shown in Chart 6, which tracks steady declines in both stock prices and consumer confidence that began in early 2000 and as yet have shown few signs of reversing themselves.
For consumers and business executives, uncertainty complicates spending and investment plans. With greater uncertainty, it is harder to accurately predict future outcomes, including commodity prices and investment returns. If consumers and investors do not believe that they have enough experience and information to reasonably anticipate the future, they may choose to postpone transactions until the situation improves. Uncertainty, then, can impose real costs on an economy by delaying consumption and investment that would otherwise occur. Although it is not possible to quantify the costs of delayed spending and investment, they are widely perceived to be the key impediments to the economic recovery.
Experience suggests that the prospects for resolving these uncertainties during 2003 are reasonably good. In the case of governance reforms, the Securities and Exchange Commission adopted a set of new rules in January 2003 covering corporate disclosure, auditing, and conflicts of interest, as required under last year's Sarbanes-Oxley reform legislation. These rules come on the heels of new rules filed in 2002 by the New York Stock Exchange and NASDAQ that deal with codes of conduct, independent directors, audit committees, and other issues. While observers continue to debate the relative merits of these rules and the need for additional reforms, these developments mark significant milestones in moving beyond the governance scandals of 2001 and 2002 and restoring investor trust in U.S. corporations.
With regard to a possible conflict with Iraq, from an economic perspective it would clearly be preferable to resolve the surrounding uncertainty sooner rather than later. A reduction in the general level of uncertainty could provide a significant boost to the U.S. economy. In this regard, the best historical precedent would be the 1991 Gulf War, when a range of economic indicators moved sharply in the positive direction after the successful conclusion of the war. For example, the Conference Board reported that the expectations component of the consumer confidence index rose from a cyclical low of 55 in January 1991, as the air war in Iraq was beginning, to 101 in March 1991, after the successful conclusion of the war. While the precise outcome of the current crisis is difficult to predict, there are good reasons to believe that this particular source of economic uncertainty could be resolved in the first half of 2003.