The Economic Recession: Trying to Find a Bottom

Martha Gilchrist Moore

April 1, 2009

The old saying, “What goes up must always come down,” isn’t only about Newton’s law of gravity. In economics, this aphorism can be applied to the various equilibria that govern our economy. The housing bubble, the collapse of which sparked the financial crisis and subsequent world recession, originated in the early part of the decade. After the 9/11 attacks, U.S. interest rates fell to historic lows in an effort to prop up demand during the 2000?01 recession that affected mainly the manufacturing sector. These low interest rates effectively lowered the cost of purchasing real estate, generally considered among the safest investments. Home prices, already accelerating, took off as demand for housing grew. With relaxed lending standards and the proliferation of nontraditional mortgage instruments, hundreds of thousands of new homeowners and investors purchased residential real estate. Even borrowers with poor credit or no income verification could get loans through the subprime market. By 2006, nearly half of all mortgages were subprime. Growth in housing prices soon fell out of line with income growth. But with home prices up, consumers felt wealthier and many homeowners refinanced their mortgages during this time to withdraw some of the accrued home equity. This fueled consumer spending.

To make all this borrowing possible, U.S. mortgage markets had to attract capital from the rest of the world. Because economic growth in the rest of the world was booming, foreign investors poured money into high-yielding, U.S. mortgage-backed securities. By the beginning of 2007, the United States was spending $1.06 for each $1 of income it produced. The housing bubble was supported by the following three key assumptions:

  • Incomes would remain stable
  • Interest rates would not rise
  • Housing prices would continue to advance

However, interest rates did rise during 2007, suddenly making housing less affordable. Many borrowers with adjustable-rate mortgages found themselves unable to keep up with their payments as their loans reset to the higher rates, and they put their homes up for sale. The sudden shift from buying to selling caused home prices to drop, and the spiral that fueled the housing boom reversed. A large number of financial institutions had portfolios stuffed with seemingly safe, mortgage-backed securities, including many outside the United States. These banks quickly discovered that these investments were now worth a fraction of their previous value. The era of easy lending was over, as banks tightened lending standards and scrambled to assess the true extent of their losses as the value of their asset base fell.

In 2008, higher interest rates, tighter lending standards, and dwindling consumer confidence pulled the plug on consumer spending, and the U.S. economy slowed. Industries tied to housing (such as construction and mortgage finance) started to decline first. Soon suppliers and related businesses saw smaller order books themselves, and sales, employment, and production declined across much of the industrial sector. The National Bureau for Economic Research (NBER), the official arbiter of U.S. business cycles, announced last fall that the U.S. economy peaked in December 2007 and has been in recession ever since. The recession was mild initially, and for several months it seemed as if the bulk of the financial crisis could be contained in the financial sector. Then the collapse of Lehman Brothers in September triggered a full-blown crisis of confidence in the banking sector and, ultimately, the U.S. economy. The downturn that began the previous December accelerated. With job losses mounting, housing prices continuing to freefall, and credit still difficult to come by, consumer spending (which makes up more than two-thirds of the U.S. economy) fell sharply. The American consumer, who powered the economy through the previous recession, had left the building.

As consumer spending contracted, inventories built up along the supply chain. As a result, manufacturing production dropped and was off by double digits from that of a year ago. For automakers, 2008 was the worst year since 1982. Housing starts finished the year at 550,000 units, the lowest level since the 1940s and less than a quarter of the peak levels of 2006. By the end of 2008, home prices were down 25 percent from the peak. Since the recession began, the U.S. economy has lost around 4 million jobs, and with the flood of announced layoffs earlier in the year, the carnage is not yet over. The unemployment rate rose to the highest level since 1993 and is expected to continue to rise through 2010. Gross Domestic Product (GDP), which declined by a modest 0.5 percent in the third quarter, contracted by 4 percent in the fourth quarter. As demand dropped, so did the steep price pressures the economy faced during mid-2008. Concerns about inflation have been replaced by fears of a broad deflation.

Looking into 2009, economic growth is expected to contract during the first half of the year, with another steep decline in first-quarter GDP as the vicious circle continues. Should this recession extend past April, as many expect it will, it will be the longest recession since the Great Depression. The consensus among many economists is that the economy will bottom out sometime this summer, especially if the long-promised stimulus package goes to work. But since other world economies have followed the United States into recession or, in the case of many emerging markets, the worst downturn in a decade, global GDP is expected to decline for the first time since World War II. The International Monetary Fund projects that as many as 50 million jobs could be lost globally.

Energy

It is a well-known fact that most postwar recessions were preceded by a spike in oil prices. Oil prices peaked at $147 per barrel in July 2008 before crashing to below $31 per barrel at the end of December. The cause of the price spike has been hotly debated, but most analysts agree that while speculation may have played a part in the short-term volatility of oil prices, the fundamental upward trend (and subsequent collapse) was demand driven. As global demand has fallen sharply, so have the prices of oil and natural gas (which is tied to oil). Looking forward, however, when the world economy recovers and growth resumes, there will once again be pressure on oil supplies. According to the Energy Information Administration (EIA), the price of oil (West Texas Intermediate), which averaged $99.57 per barrel in 2008, is expected to fall by more than half in 2009, averaging $43.14 per barrel before rising to $54.50 in 2010. Demand for natural gas, a heavily used fuel in the industrial sector, also fell during 2008. The EIA expects its use by industry to fall by an average of nearly 1 billion cubic feet per day during 2009 before modestly increasing in 2010. As a result, the price of natural gas (Henry Hub), which averaged $9.13 per thousand cubic feet (mcf) in 2008, is projected to fall to $5.01 per mcf in 2009 before recovering to $5.93 per mcf in 2010.

In the United States, several proposals to limit emissions of energy-related carbon dioxide and other greenhouse gases are receiving serious attention in Congress. President Obama has made increasing energy efficiency a goal of his administration. This can only benefit the insulation industry.

Outlook for Key End-Use Markets for Insulation

The outlook for key insulation end-use markets is not especially encouraging. Following 3 years of double-digit growth in private, nonresidential construction, there is now an overhang in vacant office, commercial, and lodging buildings. In the manufacturing sector, steep declines in new orders and an uncertain business environment will curtail production expansions. As capacity utilization rates have tumbled and are likely to remain depressed, this will affect the sector’s profitability and, therefore, capital investment potential over the next several years.

The one bright spot for the insulation industry is continued attention on energy efficiency. Even as energy prices have subsided due to depressed demand globally, the drive to reduce energy consumption and carbon emissions remains a priority. As a result, the trend toward energy efficiency in new building and equipment design is likely to persist. In fact, a portion of the federal stimulus package is destined for energy efficiency projects.

Chemicals

Despite a softening of demand domestically, exports of chemicals were up sharply during the first half of 2008. As global demand collapsed and the decline in the U.S. manufacturing sector accelerated, chemicals output sank. In 2008, chemicals output fell by 4 percent. As demand remains weak during 2009, chemicals output is expected to fall farther by 5.4 percent before returning to modest growth in 2010.

Food Processing

Demand for food is relatively inelastic and, thus, food production is generally recession-proof. The composition of consumers’ dinner tables, however, does change in economic downturns. As unemployment rises, consumers will buy less expensive brands and spend less on ready-to-eat and convenience foods. Production of food, beverages, and tobacco slipped 0.3 percent during 2008 and will fall 0.5 percent during 2009 before resuming growth in 2010.

Refining

Gasoline demand fell sharply during 2008, due to the combined effects of record high gasoline prices and less demand for refined petroleum products from both consumers and industrial customers. Refining output slipped 0.2 percent in 2008 and will fall a further 2.1 percent before growing in 2010.

Pulp and Paper

Production of paper and paperboard also declined in 2008. Paper production fell 5.1 percent, and paperboard was off 3.6 percent for the year. Reducing paper consumption is one way businesses are cutting costs in this uncertain climate. In addition, the paper and paperboard used in packaging is down as trade sales remain depressed. Paper, paperboard, and pulp output declined 3.4 percent in 2008 and is expected to contract by 4.6 percent in 2009 before resuming growth during 2010.

Gas Processing

As discussed earlier, industrial consumption of natural gas has fallen sharply as the recession has knocked a substantial portion of the U.S. manufacturing sector offline. However, the supply of domestically produced natural gas has surged over the past 2 years, with the development of shale gas deposits and new production coming in from deepwater Gulf of Mexico. Because production of shale gas is relatively more difficult to dial back in times of weak demand, the EIA projects that U.S. natural gas production is expected to increase through 2009 before slowing in 2010.

Shipbuilding

Following the initial shock of the financial crisis unfolding, international trade came to a virtual standstill as the credit markets that facilitate international transactions seized up. World trade has dropped sharply as demand worldwide has contracted. New orders for ships and boats have fallen sharply in recent months. Shipbuilding production was off 11 percent in 2008, with overcapacity and declining trade volumes, and shipbuilding will continue to decline through 2010.

Conclusion

For all the comparisons to the 1930s, this downturn shares more in common with the deep 1973?1975 recession. Both came on the heels of record oil prices and featured a collapse in housing and a banking crisis. The economy made it through those dark years, and strong economic growth returned in the 1980s and 1990s. This time is no different. The economy will continue to contract during the first part of 2009 as the imbalances of the past several years are brought back into alignment, but the virtuous circle will take over and spending, employment, and growth will return.