Morgan Stanley: No V-shaped recovery

May 22, 2009

Economist Richard Berner lays out the case why the recovery won’t be a pretty sight:

First, financial conditions will stay relatively restrictive. Losses are still rising at lenders, limiting risk appetite and balance sheet capacity, and thus restraining the availability and boosting the cost of credit.  A slow cleaning up of lenders’ balance sheets will keep lending capacity low and the cost of using it comparatively high, and increased regulatory oversight will reinforce that restraint.  We think that such lingering restraint will affect all credit-sensitive areas of the economy, including housing, consumer durables, capital spending and working capital for businesses large and small.  As evidence, the National Federation of Independent Businesses just reported that, in April, credit was harder to obtain by small businesses than at any time in the past 29 years.  And while loan-to-value ratios at auto finance companies rose slightly in April – to 89% from 86% in January-February – required downpayments were still more than double what lenders wanted last year.

Moreover, the lags between the change in financial conditions and the economy will prevent rapid progress.  To be sure, as Morgan Stanley interest rate strategist Laurence Mutkin argues, when more capital comes into the financial system, and securitization revives, competition will erode the high rates lenders are able to charge for the use of their balance sheets today.   In our view, however, that time may be far off, and both the scars from the crisis and the regulatory response to it probably will keep those costs permanently higher than pre-crisis norms.

Second, the imbalance between supply and demand in housing is still significant and likely will remain a drag on home prices and housing activity into 2010.
The single-family vacancy rate in existing homes is double the 1.2% historical average through 2004.  Given the persistently tight financing backdrop, vacancies might undershoot that old 1.2% norm for a while to bring down the supply/demand imbalance quickly, especially as foreclosures rise again.  Consequently, prospective buyers need to start occupying roughly 750,000 single-family vacant homes before the housing market and home prices stabilize.  In turn, this implies that new and existing home sales must rise by roughly 20-25% from the current pace.  Likewise, in commercial real estate, vacancy rates and cap rates are rising and rents are falling.

Third, consumers have only begun the process of deleveraging and repairing their balance sheets and saving positions, and we believe that the personal saving rate, currently at 4%, will rise to 7-10% in the next few years. This process will mean slower growth in US demand.  Some argue that pent-up demand for vehicles and durables is strong following the recent retrenchment in sales.  We disagree.  It’s true that to maintain the stock of vehicles on the road (245 million light vehicles) given normal scrappage would require about 13 million vehicles sold annually.  But with financing constrained, we think that consumers can endure 3-4 years of sales below those levels, since we spent the last 13 above them, especially with 15% more light vehicles on the road than licensed drivers.

Finally, the breadth of the recession limits the cushion from any stronger sectors. For example, while growth appears to be improving in Asia, the global recession will limit US exports.  Unlike the experience since the crisis began nearly two years ago, in which net exports contributed more than a full percentage point on average to real US growth, we expect that the cyclical contribution to US growth from overseas activity will be flat to down over the next 18 months.

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