(December 8, 2006) Both the California and U.S economies have slowed in response to restrictive monetary policy, high energy prices and a weakening housing market, according to the latest quarterly report of the California Chamber of Commerce Economic Advisory Committee (EAC).
The CalChamber’s EAC expects economic growth to remain subdued in 2007 as the decline in home valuations has an impact on consumer spending. But a recession should be avoided as consumer spending is supported by moderate gains in jobs and income.
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Interest Rates
The Federal Open Market Committee (FOMC) is 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 2.4 percent in September, above the Fed’s comfort zone of 1-2 percent. Also worrisome to the Fed has been a sharp acceleration in unit labor cots, driven by slowing productivity and rising compensation. But FOMC members have indicated that they believe inflation will moderate over the coming year.
Financial markets have registered more concern than the Fed about slowing economic growth and thus place a low probability on additional Fed tightening. EAC members share this view and believe that the Fed will remain on hold until mid-2007 and will entertain rate cuts at that time.
California
Last year the California economy slightly outpaced the national economy, after trailing the nation by a small margin earlier in the economic expansion.
Job gains totaled 164,000 between October 2005 and October 2006, only 8 percent of the U.S job gain during that period. California’s unemployment rate has, however, fallen to 4.5 percent, the lowest since the state’s employment series was established in 1976. This is slightly above the U.S unemployment rate of 44 percent.
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. While job growth in housing-related industries is tapering off, remaining job growth is becoming more balanced across industries, with notable improvements in high technology and tourism-related sectors over the past year. Strong growth is also occurring in business services, health and education, and there has been renewed growth in government employment, especially at the local level.
Growth is also more balanced across regions, with a notable improvement in the San Francisco Bay Area economy and labor market. Although venture capital spending is well below levels seen during the dot-com boom, the EAC observed increased start-up activity in the Silicon Valley and subsequent increased demand for technically trained workers. The Southern California economy is also seeing a housing-induced slowdown, but it continues to benefit from its diversity, with solid performances in international trade, technology, aerospace and tourism. Despite the recent slowdown, EAC members still believe that California’s highly diverse business structure will enable it to withstand the ongoing slowdown in the housing market.
The EAC identified several developments that should offset more negative economic forces affecting the California economy in coming months. First, there is a healthy pickup in non-residential construction and real estate, which will partly offset the slowdown in residential real estate markets. Second, there has been a pickup in U.S. capital spending in this quarter. The EAC believes that this will benefit California’s high technology companies. Third, California’s key export markets remain healthy. Exports from California-based firms increased 10.8 percent in the first nine months of 2006, after expanding 6.2 percent for all of 2005.
Industry Highlights
Real Estate: The U.S housing market has continued to deteriorate, with existing homes sales down 14 percent from a year ago in September. Yet home sales, running at a 6.2 million annual rate in September, are still high by historical standards and at risk for a more protracted decline. Home inventories have risen sharply, but have shown signs of stabilization of late. Sharp price reductions — especially for new homes — have improved home affordability and helped work off inventories. Fixed mortgage rates have declined in recent months, cushioning the decline in housing demand.
The California real estate downturn has been more severe than the nation as a whole, but this was expected given the strength of the housing upturn in the state. Statewide home construction permitting was off 20 percent during the first nine months of 2006, with single-family permitting down 29 percent.
All major regions have seen sales declines exceeding 20 percent, with several regions seeing declines of more than 30 percent. Some regions (Monterey, Central Valley, Santa Cruz, Palm Springs) have seen sales declines of 40 percent or more.
U.S. commercial real estate markets continue to improve and are providing an economic offset to the deteriorating residential real estate market. Non -residential construction activity is up more than 20 percent over 2005 levels, with particular strength in office and hotel construction. Construction of industrial facilities — which lagged during the current business cycle — has picked up in recent quarters. The apartment sector could see further improvements in response to declining home affordability. Vacancies in the retail property sector which is the most vulnerable to a slowdown in consumer spending — will rise as construction has caught up with absorption.
Markets remain very healthy in Los Angeles and Orange County. Northern California markets are generally not as strong as Southern California, but the Oakland market is solid and there continues to be steady improvements in other parts of the Bay Area. Oversupply conditions are developing in the San Diego area.
Tourism: California’s tourism sector has remained strong, despite big summer increases in gas prices and high airfares. Hotel occupancy rates have continued to rise and there is solid activity report at key Northern and Southern Californian 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, it is likely that the state will see slower growth in tourism over the coming year.
Banking: Home equity lending and mortgage refinancing activity have declined over the past year, but have stabilized as of late. Lending standards to households and business are a bit tighter, according to Federal Reserve surveys. Mortgage lending standards will tighten following bank regulators’ recent issuance of new “guidance” which will limit 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 very strong. Although bank loan credit quality and profits will likely diminish in 2007, the EAC expects the banking sector to remain healthy.
Agriculture and Resources: California agriculture remains in decent shape. Agricultural commodity prices are firm and foreign demand for California agricultural products remains healthy. But agricultural profits have been increasingly squeezed by rising interest rates and increased costs of energy and labor.
California water supplies remain abundant following last year’s wet winter. Flood control and levee repair remain key state priorities, and should move forward following recent voter approval of associated bond issues. 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.
The recent decline in natural gas prices has provided some relief to California ratepayers, with about half of the state’s generating capacity fueled by natural gas.
Risks: Risks to the outlook revolve around the possible intensification of the three economic headwinds: interest rates, the housing market and energy prices.
Although the Fed is on hold, it has left the door open for additional rate hikes if core inflation does not take off.
Home price deflations could also intensity and cause further weakness in consumer spending. A mild recession cannot be ruled out if the housing market downturn deepens and the Fed feels compelled to maintain restrictive monetary policy to contain inflation.
A rebound in crude oil prices above the $70 per barrel level could also tip the economy into recession.
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Staff Contact: Dave Kilby