(March 9, 2007) The United States economy has entered 2007 with renewed vigor, while the California economy slightly underperformed the national economy in 2006, according to the latest quarterly report of the California Chamber of Commerce Economic Advisory Council (EAC).
The U.S. Gross Domestic Product (GDP) expanded a respectable 3.4 percent in 2006, which is impressive considering that weakening home construction subtracted 1.2 percent from growth during the second half of the year. Although off its peak, growth in consumer spending still looks healthy, with retail sales holding up nicely outside the auto sector. Even housing-related sectors - such as home improvement and furniture - are proving resilient.
Business spending, which expanded a sub-par 7.4 percent in 2006, continues to disappoint. Nevertheless, the EAC anticipates somewhat slower job growth in 2007, another reason to expect slower growth in consumer spending.
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Interest Rates
The Federal Open Market Committee (FOMC) remains on hold following the last hike in the Fed funds rate to 5.25 percent in June 2006. FOMC members continue to express concern about inflation. Core inflation, as measured by the core personal consumption expenditure (PCE) deflator, was 2.2 percent in December, above the Federal Reserve’s comfort zone of 1 to 2 percent. But core inflation has decelerated since mid-2006, in part due to slower growth in rent. Still, the Fed remains wary of a potential up-tick in inflation due to tight labor markets.
There is considerable excess liquidity in global financial markets, making it very difficult for the Fed to consider cutting interest rates. Although most investors expect the Fed to remain on hold throughout 2007, there remains a prospect of a rate cut in the second half of the year if inflation continues to decelerate and economic growth moderates. But if core inflation were to revive unexpectedly, the Fed will not hesitate to raise interest rates.
California
The California economy slightly underperformed the national economy in 2006, after outperforming in 2005. California’s unemployment rate stood at 4.8 percent at the end of 2006, down from 5.1 percent at the end of 2006. This is a bit higher than the national unemployment rate of 4.5 percent. In March 2007, California will release its benchmark payroll job revisions for the year ended March 2006. Substantial upward revisions are anticipated in line with already-released national payroll job revisions which exceeded 700,000 jobs.
California’s job growth may remain subdued relative to the rest of the country, mainly because the state’s recovery has been more dependent on construction and real estate jobs in recent years. Last year the state saw a net decline of 9,000 construction and real estate jobs , following a 69,000 decline in these job categories in 2005. This decline in construction and real estate was offset by a 180,000 increase in other jobs, with the biggest gains in leisure and hospitality, business services, health care and education. But this increase fell below the prior year’s gain of 219,000 jobs outside construction and real estate. With housing markets stabilizing, construction and real estate job growth may flatten in 2007, while job gains in other categories may slow somewhat.
California growth has become more balanced across regions, with a notable improvement in the San Francisco Bay Area economy and labor market. While the Southern California economy has seen a housing-induced slowdown, it continues to benefit from its diversity, with solid performances in international trade, technology, aerospace and tourism. Despite the recent slowdown, the EAC still believes that California’s highly diverse business structure will enable it to withstand the ongoing slowdown in the housing market.
The ongoing pickup in non-residential construction in California should be sustained in 2007, and this should partly offset the slowdown in residential real estate markets. And although U.S. capital spending is expected to remain subdued, California will continue to benefit from its focus on high technology capital goods which are in strong demand both nationally and abroad. California exports expanded at a double-digit rate in 2006, although exports may slow somewhat in 2007. Higher interest rates will likely slow growth in Europe and Asia, but growth will remain strong enough to ensure California export growth on the order of 7 to 8 percent in 2007.
Industry Highlights
Real Estate:
The U.S. housing market recently has shown signs of stabilization. Existing home sales have settled at around a 6.2 million annual rate, well below the peak of 7.3 million rate in mid-2005, but still very healthy by historical standards. Declining home prices combined with stable mortgage rates have improved housing affordability, helping to cushion sales.
New home sales have begun to increase again as homebuilders steeply discount homes and provide other incentives to reduce their inventories. Existing and new home inventories are well above their cyclical lows, but below their peaks during previous housing cycles.
The combination of price depreciation and upward adjustments in variable rate mortgages is leading to increased mortgage delinquencies and foreclosures. The EAC expects these problems to worsen, and possibly spread to prime mortgages. Furthermore, future home sales are expected to be limited by more stringent mortgage lending standards. But the EAC does not expect a disaster in the mortgage markets, as long as growth in jobs and income growth remains healthy.
The California housing market has also shown signs of stabilization. But California’s housing downturn remains more severe than the nation as a whole. Statewide home construction permitting was off more than 20 percent in 2006. The California Association of Realtors (CAR) reports single family home sales were down 15 percent year/year in December, compared to 7 percent decline at the national level. CAR reports the sharpest sales declines have been concentrated in the Central Valley (-27 percent), Sacramento (-26 percent), High Desert (-39 percent) and Riverside/San Bernardino (-41 percent) regions.
U.S. commercial real estate markets have continued to improve and are providing an economic offset to the deteriorating residential real estate market. Non-residential construction activity has been rising at double digit rates, with particular strength in office and hotel construction. The office sector should remain strong, with the main risk being a significant slowdown in payroll job growth. Construction of industrial facilities - which lagged during the current business cycle - has also picked up in recent quarters.
The apartment sector was very strong in 2006, but could soften somewhat in 2007 as the glut of condominiums leads to some re-conversion to apartment rental units. Vacancy rates in the retail property sector may rise as consumer spending slows and new construction catches up with absorption. But the retail sector could surprise on the upside if consumer spending sustains its recent rapid pace.
Similar trends are evident in California commercial real estate markets, with activity remaining vibrant throughout the state. Markets remain very healthy in Los Angeles and Orange County. Northern California markets are generally not as strong as Southern California, but have been improving rapidly. There has also been a recent pickup in public construction, both in California and nationwide.
Tourism:
California’s tourism sector remained strong in 2006, helped by sharp declines in gas prices during the second half of the year. Jobs increased 2.2 percent in California’s leisure and hospitality industries last year, faster than any other sector.
Hotel occupancy rates continued to rise, and there is solid activity reported at key Northern and Southern California tourist and convention destinations. There is a considerable amount of hotel construction underway in the state, in large part to serve the convention business. But with the economy slowing, the EAC believes California will likely see somewhat slower growth in domestic tourism over the coming year.
Banking:
Home equity lending and mortgage refinancing activity have declined over the past year, but recently have stabilized. Lending standards to households and business are a bit tighter, according to Fed surveys. Mortgage lending standards will tighten further as delinquencies rise and as lenders react to recent issuance of new regulatory guidance discouraging creative financing techniques such as interest-only loans and option adjustable rate mortgages.
Commercial and industrial lending - which has lagged in the current business cycle - is growing more slowly but remains strong. The slowdown in consumer lending, the flat yield curve, and deteriorating asset quality (due largely to rising mortgage delinquencies) has begun to weigh on bank profits, which have been heavily reliant on household sector lending. Although bank loan credit quality and profits will likely diminish in 2007, the council expects the banking sector to remain healthy.
Agriculture and Resources:
The big story in California agriculture has been the recent freeze, which destroyed approximately $1 billion of the state’s citrus crops and had an impact on the avocado harvest. Consumers will face resultant higher prices for these commodities. Dairy and beef producers have faced higher feed costs due to the rapid run-up in corn prices (due to rising ethanol demand), boosting prices for these commodities.
Below-average rainfall (snow pack is 40 percent of normal to date) has reduced California water supplies. But water supplies are sufficient following last year’s wet winter. But if California does not see above average late winter rain and snowfall, the state likely will experience some supply constraints in the coming year.
Electricity supplies look sufficient in the short term due to some new capacity and rising electricity imports resulting from transmission line improvements. Still, California’s medium- and long-term electric reliability problems and peak-capacity issues are unsolved.
Risks:
A key risk going forward is the sustainability of consumer spending. Although consumers have shown amazing resilience, home price depreciation and rising debt burdens will weigh on them in coming quarters. This risk could intensify if California sees a rebound in energy prices.
Although the market consensus on oil prices has moved lower, the oil market remains highly vulnerable to supply shocks in unstable oil producing countries.
Another risk revolves around Fed’s interest rate policy. Although the Fed appears content with its current monetary setting, it would not hesitate to raise interest rates if inflation re-accelerates due to tightening labor markets or other causes.
Finally, there is a risk that the economy could see a negative event in the credit markets, which could lead to widening spreads in mortgage corporate bond markets. Rising finance costs would weigh on consumer and business spending.
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Staff Contact: Dave Kilby