(June 1, 2007) Recently, California job growth has moved slightly ahead of the United States, according to the latest quarterly report of the California Chamber of Commerce Economic Advisory Council (EAC).
The U.S. economy has moderated to a 2 percent average growth rate over the past three quarters. The persistent slowdown in housing is largely responsible, with declining home construction subtracting around 1 percent from gross domestic product (GDP) growth over the past three quarters.
Problems in housing have not yet had a serious impact on other sectors of the economy. To the contrary, consumer spending expanded at a robust 3.8 percent annual rate in the first quarter of 2007, down slightly from 4.2 percent growth in the fourth quarter of 2006.
Going forward, the EAC believes there will be slower growth in consumer spending due to tighter credit conditions, variable mortgage rate adjustments, and lower home valuations. Still, members of the advisory council believe a recession will be averted, largely due to the healthy labor market and adequate gains in personal income.
The EAC also expects to see some acceleration in business spending in coming months. In recent quarters, business investment has disappointed as firms have used large cash hoards for share buybacks and mergers. If a recession is averted, then businesses should regain confidence and begin to replace aging equipment and software.
Read full report.
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 have continued to express concern about inflation, accentuated by recent increases in food and energy prices. Productivity growth has decelerated and the unemployment rate has declined to 4.4 percent, putting upward pressure on wages. Under these conditions, the Fed is inclined to sit tight.
The massive amount of excess liquidity in the global capital markets also makes it difficult for the Fed to ease monetary policy. Indeed, there remains a risk of additional Fed rate hikes if inflation accelerates. Most likely, the Fed will stay on hold for the remainder of this year, with an outside chance of a rate cut toward the end of the year when there is more conclusive evidence of lower inflation.
California
California’s manufacturing sector has seen a modest decline in employment over the last year. But the state’s manufacturers have fared better than other parts of the country due to their concentration in high tech capital goods and export-oriented industries. California export growth accelerated from 6.2 percent in 2005 to 9.4 percent in 2006.
Exports to China increased 27 percent last year, solidifying China’s position as the state’s fourth largest export destination (after Mexico, Canada, and Japan). With China still booming, another strong trade performance is expected this year.
California’s personal income expanded 6.4 percent in 2006, slightly above the 6.3 percent gain at the national level. Personal income tax receipts came in below Department of Finance estimates during the July 2006-March 2007 period, which could indicate somewhat slower growth. Regardless, it is expected that the state economy will slow in line with the U.S. economy this year.
The San Francisco Bay Area has continued to show stronger economic improvement than other major California regions. There has been vibrant job growth in Silicon Valley, although employment levels remain below peaks of the dot-com era.
While the Southern California economy has seen a housing-induced slowdown (including considerable layoffs at large mortgage lenders in the area), it continues to benefit from its diversity, with solid performances in international trade, technology, aerospace, and tourism.
Going forward regional growth differentials will likely reflect differences in housing market performance.
Industry Highlights
Real Estate
The U.S. housing market remains depressed. Average home prices are down slightly from last year, but this hides substantial regional differences. Fortunately, mortgage rates have remained stable, so that price declines have improved housing affordability. Home builders continue to manage their inventories with substantial price and in-kind discounts, putting downward pressure on existing home prices as well. Rapidly rising foreclosures are also contributing to price weakness.
Tourism
Based upon recent job reports and anecdotal information, it appears that California’s tourism sector has held up in 2007, following a very strong 2006. State payroll data indicate 40,000 leisure and hospitality jobs created in the year ending March 2007. Including other tourist-related sectors (such as retail trade), the job contribution is considerably larger. Hotel occupancy rates have also continued to rise, although this could reverse given the considerable amount of hotel construction underway in the state.
Banking
Mortgage and home equity lending continues to be crimped by the housing slowdown. As subprime mortgage delinquencies have risen, there has been a notable tightening of mortgage lending standards. New regulatory guidance is discouraging creative financing techniques such as interest-only loans and option adjustable rate mortgages. As home equity lending has declined, there has been some pickup in credit card borrowing, which has slowed considerably over the last couple of years.
Commercial and industrial lending - which has lagged in the current business cycle - remains robust. Fed surveys show continued lax lending standards for commercial and industrial loans although these may also tighten up as the economy slows. Although bank loan credit quality and profits are expected to diminish further in 2007 (especially for smaller regional lenders), the EAC expects the overall health of the banking sector to remain sound.
Agriculture and Resources
California agriculture continues to face cost pressures deriving from several sources, and it is unlikely that farmers will be able to fully pass on these costs to retail customers. The run-up in corn (and related grain) prices - resulting from soaring ethanol demand - has pushed up feed costs. Rising energy costs and farm labor shortages have also hurt profit margins. Farmers also face substantial water supply cutbacks during the coming year.
Below average rainfall (the Sierra snow pack is about 40 percent of normal this year) has reduced California water supplies. Although current water supplies (including reservoirs) are sufficient following last year’s wet winter, most water districts are requesting voluntary (and in some cases mandatory) cutbacks this year. Farmers face 50-85% of normal water allocations this year.
The state’s 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
Once again a key risk is oil and gasoline prices, which still have an upward bias tied to geopolitical events. With home valuations and home equity borrowing falling, higher energy prices will probably impact consumer spending more than they did last year. Another risk revolves around Federal Reserve interest rate policy. Finally, there is a risk that a negative event in the credit markets, could lead to widening spreads in mortgage and corporate bond markets. Rising finance costs would weigh on consumer and business spending.
Read full report.
Staff Contact: Dave Kilby