Recessions Typically Hinder Productivity
Over the long-term, growth in productivity—a measure of total output per unit of labor (i.e. hours worked)—is what ultimately drives real economic growth for developed economies, such as the United States. However, the rate of productivity is cyclical, and typically has declined at the beginning of past recessions because businesses were slow to lay off workers and cut costs as the economy contracted. Historically, in the early stages of a recovery when the economy emerged from a downturn and output picked up, the lower cost base has resulted in accelerated growth in the amount of output per worker (increased productivity).

2008-‘09 Recession: A Break From the Past
Productivity grew at an annualized rate of 6.6% during Q2 2009—the fastest pace since the economic recovery in 2003. This large bounce in productivity was unusual because it occurred during the recession, and suggests that businesses were quick to cut labor costs during the economic slowdown. In fact, despite the severity of the 2007-2009 recession, the rate of productivity growth stayed fl at-to-positive throughout the downturn. By comparison, the annualized rate of productivity growth had previously turned negative in every U.S. recession dating back to the early 1950s. The higher level of productivity growth this time around shows that businesses slashed payrolls and cut costs even faster than output declined during the recession.

Leaner Companies Poised for Higher Profits?
Swift cost-cutting has contributed to a rebound in corporate profits during 2009. During the first two quarters of 2009, sales declined by a collective $68 billion for all of the companies in the S&P 500 yet net income increased by a total of $285 billion. This increase in profitability shows that, despite shrinking top-line revenues, companies regained profitability due largely to adept cost-cutting. While the productivity gains thus far have accrued to companies (profits) and not workers, productivity growth provides a more auspicious backdrop for employees. In theory, as businesses become more profitable they are more likely to provide higher compensation, and to potentially hire more workers. In addition, should domestic economic growth continue to improve, some companies that aggressively cut labor into the downturn may discover they reduced their labor forces too much, prompting them to rehire.

Investment implications
The recent recession caused a dramatic decline in corporate revenues, but it appears that many companies were able to cut costs at a faster rate, which has allowed them to return to profitability. With companies leaner and better positioned to boost profits, continued productivity growth may make them more likely to expand their businesses and rehire workers as the economic recovery attempts to gain traction. A continuation of the trend in higher productivity growth would likely provide a positive backdrop for corporate profits, stock prices, and the values of other economically sensitive asset classes.

Key Takeaways: 

• Worker productivity rose during the recent recession as companies reduced labor costs at a faster rate than their revenues declined.
•  Higher productivity growth leaves companies leaner and better positioned to boost profits and potentially add workers as the economic recovery takes hold. 

This post is from Fidelity’s Market Analysis, Research & Education unit.
Download from them directly here:
http://personal.fidelity.com/products/funds/content/pdf/productivity_gains_surprisingly_strong.pdf

The Market Analysis, Research and Education (MARE) group, a unit of Fidelity Management & Research Co. (FMRCo.), provides timely analysis on developments in the financial markets.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Past performance is no guarantee of future results.

Dramatic improvement, but risks remain

By Dirk Hofschire, CFA

As the U.S. financial crisis unfolded in the fall of 2008, policymakers rushed to provide emergency support to the financial system, whose provisioning of credit is the lifeblood of any economy. In the months and years to come, the revival of the financial system will be critical to the magnitude of the economic recovery, and therefore influential to the performance of various asset classes.

Rapid turnaround as conditions improve

There is no question that the financial system is in dramatically better shape than one year ago, with credit markets coming off life support and demonstrating continuous improvement during the past several months.

Borrowing conditions in the capital markets have improved markedly since the end of 2008 (see MARE article, U.S. Credit Markets: Borrowing Costs Continue to Decline). Issuance of new debt, particularly by corporations, has expanded dramatically and the cost of new borrowing has declined precipitously from record high levels one year ago. According to the Bloomberg Financial Conditions Index, which measures the cost and availability of borrowing, the overall stress in the U.S. money market, bond market, and equity market is back to late-2007 levels (see Exhibit 1). High-quality corporate issuers now access the investment-grade bond market at 2% spreads above Treasuries, down dramatically from the near-record 5% spreads a year ago.

Many large banks in particular have returned to profitability and bolstered their balance sheets. Stalwarts such as J.P. Morgan and Goldman Sachs have paid back the emergency TARP money loaned to them by the government one year ago, and they have parlayed trading gains and other capital markets activities into stellar corporate earnings results for the third quarter of 2009. In addition, several large banks—even those that have yet to repay TARP funds—were able to ride the improvement in market sentiment by issuing new equity shares during the past several months, thus replenishing their capital positions.

Meanwhile, the conditions for future profitability remain extremely supportive. The Federal Reserve (Fed) continues to maintain short-term interest rates near 0%, which contributes to making the yield curve—the difference between short-term and longterm interest rates—extremely steep (see Exhibit 1). At 2.36 percentage points, the Treasury bond yield curve at the end of Q3 2009 was roughly three times as steep as the average since 1976 (0.77 percentage points). Steep yield curves provide a favorable backdrop for bank lending profitability because banks are typically able to borrow (attract deposits) at lower short-term rates while making loans at higher longterm rates. The Fed recently indicated its intention to hold short-term interest rates near zero percent.

Other more extraordinary monetary policies also remain supportive for the financial system. For example, the Fed plans to finish purchasing $1.45 trillion of agency bonds and mortgage-backed securities. Maintaining an extraordinary level of credit to the financial system by keeping its balance sheet well above historical norms continues to be accomplished by unprecedented growth in U.S. banking reserves. Most of these reserves are “excess reserves” that represent extra money (above the required reserve ratio) that banks keep in deposit with the Fed, indicating banks have more than enough funds available to make loans.

Not out of the woods yet

However, for now, much of the extraordinary increase in bank reserves is sitting idle, as banks remain generally cautious because growing loan defaults still act as a threat to their capital positions. The banking system is a far cry from being completely healed.

The biggest problem, even for the larger banks, is that delinquencies and defaults on many loans are still rising. High and still-rising loan default rates, particularly in real estate and consumer loans, have continued to force banks to divert profits into adding provisions to guard against future loan losses (see Exhibit 2). With delinquency rates (loans with overdue payments that are not yet in default) still ascending, loan defaults are broadly expected to keep rising in the near-term. This may keep many banks more focused on preserving capital and protecting their balance sheets, rather than new lending.

The largest source of concern is commercial real estate loans. While residential housing prices have showed signs of stabilization, commercial real estate prices have continued to drop, and now have fallen back to early-2003 levels. As a result, commercial real estate loan defaults have continued to rise significantly, forcing write-downs on bank balance sheets. Commercial real estate loan losses have been particularly hard on small- and mid-sized regional banks that generally had a larger exposure to this loan category.

The stress on small- and mid-sized banks is demonstrated by the steady increase in bank closures throughout 2009. The Federal Deposit Insurance Corporation (FDIC) has closed more than 100 banks so far this year, the highest number since 1992. Although the number of bank failures is nowhere near levels reached in the aftermath of the bank and savings and loan crisis in the late 1980s and early 1990s, it is expected to continue to rise, as the FDIC currently lists more than 400 banks on its “problem institutions” list of troubled banks. With the growing number of bank closings straining its finances, the FDIC recently proposed making member banks prepay three years’ worth of fees to replenish its deposit insurance fund.

As concerns about future loan losses potentially depleting capital linger, banks have continued to tighten lending standards for new loans (see Exhibit 2). Underwriting standards have tightened most noticeably in the areas of real estate and consumer loans.

Are financial conditions supportive of an economic recovery?

Ultimately, the true test of the health of the financial system is whether it is providing adequate credit to support the incipient U.S. economic recovery. In this respect, the one-year report card remains mixed. Large corporations, which have ample access to issuing debt in the recovering bond markets, have enjoyed a dramatic improvement in their access to credit at reasonable terms. Smaller businesses, which remain largely dependent on their smaller, regional banks to provide loans, are facing much more restrictive credit conditions, as these banks generally remain preoccupied with rising loan losses and balance sheet concerns. According to a recent sentiment survey, small businesses feel credit conditions are roughly as bad now as at the height of the financial crisis in October 2008, representing the worst borrowing conditions in nearly three decades.

For U.S. consumers, borrowing costs are reasonable but underwriting standards are significantly stricter. Due in part to extraordinary support from the Fed, mortgage rates—in addition to rates on credit cards and other consumer loans—are extremely low. However, they are only low for those consumers who qualify for loans, which is a dramatically lower number of people today than before the crisis. Most experts agree that underwriting standards have been appropriately tightened following the mortgage
and consumer lending binge that resulted in record-high consumer debt levels and contributed to the economic aftermath of the financial crisis. In the aggregate, consumers in general do need to continue to “deleverage” their balance sheets by bringing debt levels down, meaning the problem may be due as much to a lack of demand from creditworthy borrowers as it is to a lack of supply of credit.

Investment implications

Historically, economic downturns that follow financial crises have tended to be longer-lasting and more severe than other downturns, with recoveries that take a long time to get back to previous levels of output and employment. One major reason for the lingering impact of a financial crisis is that it tends to leave an impaired financial system that does not provide sufficient credit to support a quicker economic recovery.

After two decades of massive increases in the levels of debt in the U.S. economy, some de-leveraging—particularly of the financial system and consumers—is probably necessary. However, the real test for the financial system is not whether it is providing the same level of credit as before, but rather whether creditworthy borrowers can access credit inexpensively. One year after the financial crisis, large corporations and consumers may indeed be close to meeting this standard. However, smaller businesses, which historically have been critical for new job creation, may be facing tougher credit conditions due to continued difficulties in the banking sector. More than half of all private sector jobs are in small businesses, and this sector of employment has been growing more quickly than overall employment since 2000. While dramatic improvement in the financial sector over the past year has contributed significantly to the rebound in stock and bond markets during the past several months, more progress will be needed to achieve a vibrant credit sector that is fully supportive of economic recovery.

Key Takeaways:

• One year after the U.S. financial crisis peaked, some areas of the
  credit markets have staged a dramatic recovery and systemic
  stability has returned.
• However, ongoing loan losses continue to impair bank balance
  sheets and keep credit standards tight, particularly among
  smaller banks that tend to be major lenders to small businesses.
• The road to recovery continues for financial firms, but the credit
  system needs to continue to make progress to become fully supportive of the economic recovery. 

This post is from Fidelity’s Market Analysis, Research & Education unit.
Download from them directly here:
http://personal.fidelity.com/products/funds/content/pdf/one_year_after_crisis.pdf

The Market Analysis, Research and Education (MARE) group, a unit of Fidelity Management & Research Co. (FMRCo.), provides timely analysis on developments in the financial markets.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Past performance is no guarantee of future results.

Negative Impact on U.S. Economy Seen Abating; Supply Pressure Lingers

The U.S. housing market has been at the epicenter of financial turmoil for the past several years. Drastically falling home prices across the country have shaken the confi dence of consumers, caused enormous price declines for mortgage-backed securities, contaminated the balance sheets of financial institutions, and clipped growth from the economy. Stabilization in the residential housing market is critical to a more positive outlook in all of these areas.

Housing poised to ease negative impact on economic growth

The primary impact of housing on U.S. economic growth is residential fixed investment, more commonly known as residential home construction. Amid the housing bust during the past three years, a sharp decline in construction activity has sapped the economy of roughly one full percentage point per year of real gross domestic product (GDP) growth—the largest detraction on record. This decline can be represented by the number of permits issued for building new single-family homes, which hit an all-time low in January 2009, after settling 81% below their peak in 2005.

Historically, there has been a close correlation between the following: home sales, the issuance of building permits and the contribution of home construction to U.S. economic growth (see Exhibit 1). Since January when both measures had bottomed, building-permit issuance and the number of homes sold have increased 33% and 14%, respectively. In July, each measure rose 6% from the prior month. The sustained upward trend in sales and permits implies that residential home construction is likely to be less of a drag to quarterly GDP growth in Q3 2009 and beyond, and it could even become an outright positive contributor.

Part of this potential positive contribution stems from the fact that construction activity is improving from an abysmally low level that, in the long run, was unsustainable given that it was below the historical pace of home destruction (supply removed from the market due to deterioration with age and other factors) and inadequate to keep up with current U.S. population growth. So while construction activity may remain at a low level, continued incremental improvement would represent a positive contribution to economic activity.

The housing market has razed consumer wealth and finance

Falling home prices have had negative and far-reaching implications for many actors in the economy, including homeowners and financial institutions holding mortgage loans and mortgage-backed securities. In the aggregate, residential home prices have fallen a staggering 32% from their peak in 2006. This massive decline in home prices has created an unprecedented negative wealth effect for most homeowners, which can have a dampening effect on consumer spending. In addition, many banks and other financial institutions continue to hold large amounts of mortgages or mortgage-backed securities on their balance sheets, with falling housing prices continuing to deplete capital and inhibit their ability and willingness to lend. Stabilization in home prices therefore would relieve tremendous pressure on consumers and the U.S. financial system.

Challenges still in play

There are still numerous headwinds pressuring home prices. In particular, a high and upwardly trending jobless rate (9.4% in July) puts more households at risk of not being able to service their mortgages. The growing number of homeowners that are saddled with mortgages that are “underwater” (meaning the value of the collateral— the home—has fallen below the outstanding mortgage amount) are particularly at risk. In addition, the supply of unsold homes remains high. Although the inventory of unsold homes on the market has fallen some since June 2008, at the current rate of sales it would still take nearly nine months to sell all of the inventory on the market—well above the 4.5 months average from 2000-2005. Elsewhere, mortgage underwriting standards continue to tighten, with Fed member banks surveyed having said they’ve tightened their lending standards during the past 12 consecutive quarters.

Given these issues, home foreclosures have been increasing at a brisk pace, which puts additional supply on the housing market and further pressure on home prices. Foreclosed properties, a large portion of which have come from people who have been underwater on their mortgages, are typically put on the market by lending institutions at distressed prices, which places additional downward pressure on prices. The pace of mortgage-payment delinquencies—a leading indicator of foreclosures—increased in the second quarter of 2009 and remained at an historic rate. Thus, foreclosures themselves continue to accelerate, and likely will for some time in the months ahead. For the quarter ended in June, more than 4% of the total U.S. housing stock was in foreclosure—an all-time record number of homes (see Exhibit 2). Until the pace of foreclosures diminishes, there is likely to continue to be ongoing supply pressures on the housing market, which will continue to pressure prices.

Positive developments

Despite the ongoing negative factors pressuring home prices, there have been some factors that have improved in recent months. For example, the falling ratio of home prices relative to income shows that home affordability has returned to a more reasonable level seen prior to the boom earlier this decade (see Exhibit 3). Historically low mortgage rates have helped boost affordability. The Federal Reserve (Fed) has stated its intent to keeping market interest rates low to foster economic recovery on several fronts, including the housing market. To help drive down mortgage rates, the Fed has purchased $650 billion of mortgage-backed security (MBS) and agency bonds in 2009.x The federal government is also taking a friendly policy stance towards home buyers, notably with a tax credit for first-time home buyers. Recent signs of stabilization in the overall economy also may prove supportive of a potential recovery in the housing market if the backdrop for employment and other factors stop deteriorating.

Outlook for home prices

Overall, the rate of home price declines appears to be in the neighborhood of reaching a bottom, as each progressive month has shown less-severe declines than the prior one dating back to January. Although prices in all regions are still declining on a one-year basis, at the end of June (most recent data) 15 of the 20 metropolitan regions tracked by the S&P/Case-Shiller home price index exhibited outright price appreciation on a month-over-month, seasonally adjusted basis. Historically, during previous housing downturns, home prices have stopped declining after a bottom in sales and the issuance of building permits. Given the improving data on these indicators in recent months, it’s likely that the worst of the home price declines are in the past. However, home prices are still down 15% from a year ago. The severity of the recession, coupled with rising delinquency and foreclosure rates, suggests that prices, in the aggregate, may remain under pressure, with limited prospects for price appreciation in the short-term.

Investment Implications

Due to its far-reaching influence at the epicenter of the U.S. economic recession and financial crisis, stabilization in the housing market is a tremendously positive development for various key economic entities. These include the distressed construction sector that has subtracted from economic activity, banks and financial institutions whose mortgage-asset exposure contributed to the financial crisis, and consumers who will need to rebuild their balance sheets after the loss of trillions in wealth. Though any upside in the housing market may be limited in the near-term, the worst of the housing market decline appears to be behind us, which has positive implications for a wide variety of asset categories that benefit from
an improved economic and financial environment.

Key Takeaways:

• Residential housing activity looks poised to end its drag on U.S. economic growth, as rates of sales and new construction have risen from recent lows.
• Home prices still face considerable headwinds, but they seem to have passed their worst rate of decline and have begun to exhibit signs of stabilization.
• This stabilization is occurring at a somewhat muted rate, and rising current foreclosure rates and high unemployment may inhibit the strength of any potential recovery.
• However, for the first time in three years, the U.S. housing sector may be in position to ease its negative pressure on economic output as well as the balance sheets of consumers and financial firms.

This post is from Fidelity’s Market Analysis, Research & Education unit.
Download from them directly here:
http://personal.fidelity.com/products/funds/content/pdf/glimpses_stabilization_offer_hope.pdf

The Market Analysis, Research and Education (MARE) group, a unit of Fidelity Management & Research Co. (FMRCo.), provides timely analysis on developments in the financial markets.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Past performance is no guarantee of future results.