In an uncertain economy, the worst may not be over yet

Next year will be marked by uncertainty, and that bodes ill for the Arizona economy. Lee McPheters, professor of economics and director of the JPMorgan Chase Economic Outlook Center at the W. P. Carey School of Business, and Elliott D. Pollack, President of Elliott D. Pollack & Company, discussed the challenges facing the Arizona economy at the 44th Annual Economic Forecast luncheon on Dec. 5.

The key message about Arizona's economy at this year's 44th Annual Chase/W. P. Carey Economic Forecast Luncheon was: 2008 will be marked by uncertainty, and that bodes ill for the economy. "The big picture is that there's a lot of uncertainty — nationally and in Arizona," said Lee McPheters, professor of economics and director of the JPMorgan Chase Economic Outlook Center at the W. P. Carey School of Business.

"We're watching the consumer closely, because when consumers step back from big ticket purchases like new cars, that's bad for the economy." Indeed, consumer spending accounts for 70 percent of the nation's GDP. And consumers seem to be more worried, as the Consumer Confidence Index has fallen steadily in 2007.

What's keeping consumers up at night

McPheters says that five factors affect consumer outlook: the credit crunch; foreclosures; gas prices; the housing market; and the labor market. The credit crunch affects consumers, McPheters said, because it has resulted in tighter lending standards, making it "a bit" harder to get a loan. But consumers don't face big losses, McPheters said — that's more of a Wall Street problem than a Main Street problem.

"The mortgage-backed debt instruments are held by hedge funds, banks and asset managers; these aren't investments the average family holds," he said. Foreclosures, too, make daily bad news headlines. But "foreclosures won't bring the economy down," McPheters said, adding that foreclosure numbers are a misunderstood indicator. "If we saw a lot of job losses that caused people to lose their homes to foreclosure, that would be a problem for the economy."

But the foreclosures we see now largely affect borrowers who couldn't really afford a home loan to begin with — and that doesn't have the same negative effect on the economy, he said. Gas prices, on the other hand, do affect most consumers on a regular basis. "Gas prices affect consumers' budgets every day," McPheters said. "As gas prices rise, if incomes stay the same, people feel poorer."

Supply and demand in the housing market

Housing prices are another big concern. "There's a sense among homeowners that their homes aren't worth what they were. And for those looking to sell, they have to sell into a weak market." But McPheters said the concern about housing prices may not be well-founded for many families. "People put more emphasis on the recent past — on price declines.

They don't consider the fact that before housing prices dropped 5 or 10 percent, they increased 50 percent or more. Many consumers, focusing on recent price declines, worry that prices will continue falling forever." Economist Elliott D. Pollack, President of Elliott D. Pollack & Company, was much more blunt about the Phoenix area housing market. "The housing slump isn't over yet. 2008 will be ugly. Prices will continue to fall."

"The lesson is that supply and demand really works," Pollack said. "The housing market in Greater Phoenix is over-supplied. That puts downward pressure on prices." It also means that the market will eventually reach an equilibrium and prices will stabilize. When will that happen? "It's going to be a while," Pollack said.

He suggested that even if the housing market bottoms out in 2008, as some experts predict it will, it could take three to five years after that to return to normal. And it all depends on three factors: how much new housing starts slow in 2008; how fast population grows; and how much of the buyer pool disappears because of tighter credit rules.

Housing starts have slowed; Pollack said that builders stopped overproducing in the second half of 2007. And that's a good thing — the sooner builders stop overproducing and the excess inventory of houses gets eaten up, the sooner the market will return to normal. But population growth has slowed, too, which reduces the number of homebuyers that can absorb the excess supply of homes in Greater Phoenix.

Pollack estimates a 20 percent reduction in the buyer pool because population inflows have slowed. "If people can't sell their homes in California, they can't move to Arizona," Pollack said. The buyer pool has also shrunk because of the credit crunch.

Stricter lending standards have made it more difficult for some borrowers to finance a home purchase; some people who would have been able to buy homes two years ago are now stuck renting. According to Pollack's estimates, tighter lending standards shrank the buyer pool by another 20 percent. Pollack estimates that there are between 30,000 and 40,000 excess homes on the market in Greater Phoenix right now.

Typically, there's a demand for between 40,000 and 42,000 homes, but with slower population growth and tighter lending standards, Pollack sees demand for only about 25,000 to 30,000 new homes. If builders only build 20,000 new homes or so, then the excess supply will shrink, but it will still take a while to return to a balanced market — three to five years in Pollack's estimation.

The lowest unemployment rate ever?

An even bigger concern for consumers than housing is employment. The value of consumers' homes is important, it seems, but jobs are paramount. As far as jobs go, 2007 has been another good year, with about 85,000 new Arizona jobs. The unemployment rate in Arizona hit a record low in October of 3.5 percent — far lower than the national average of 4.7 percent. Yet few people celebrated.

"Despite a strong labor market in 2007, people are still gloomy. The other worry factors — the credit crunch, gas prices, housing, and foreclosures — overwhelm the reality of strong labor markets," McPheters said. Uncertainty about the future of the labor market is the main concern driving consumers' outlook right now, said McPheters.

"That uncertainty about the future will have an effect. It casts a big, dark cloud over the economy," he said. That uncertainty has led many consumers to rein in spending. While the Arizona Blue Chip Forecast predicts that retail sales will grow 5.3 percent in 2008, compared to an estimated 5.5 percent in 2007, McPheters thinks a forecast of 5.3 percent for 2008 is much too optimistic.

And he thinks that retail sales in 2007 may be far from estimated levels. "Actual retail sales for 2007 may not even hit 5 percent over last year. The consumer has stepped back, and is taking a more cautious view," he said.

The $64,000 question: how will consumers react?

While consumers worry about the credit crunch, foreclosures, gas prices, the housing market, and the labor market, three factors will determine whether their worries intensify or fade in 2008: the level of housing inventory, population growth, and the likelihood of a national recession. Pollack says that there's no question that home prices will continue to decline in 2008 as excess inventory lingers.

If that happens, consumers could become even more concerned and reduce retail spending further — which could really dampen the economy.Even though supply and demand are out of balance, continued strong population growth could save the day. "The ace in the hole for Arizona is population growth," McPheters said. "That's why we're so different from other states; people are continuing to move here."

But both McPheters and Pollack expect population growth to slow in 2008 — the Arizona Blue Chip Forecast has population growing 2.9 percent in 2008, compared to 3.0 percent this year. "In order to move to Arizona, most people have to sell their house in some other state. If the housing market is stagnant across the United States, that will slow down the speed at which people can relocate here," explained McPheters. What we don't know about the future overshadows what we do in the 2008 forecasts.

The huge number of houses on the market in the Phoenix area may continue to push prices down. Unemployment has been at record lows but it could increase next year, because Arizona job growth has slowed sharply in recent months. And if the national economy falls into a recession, Arizona won't be immune.

"A national recession would halt job growth in Arizona; tourism — which is a big part of Arizona's economy — would go down; population growth would decline; retail spending would be flat; and the state budget would be in big trouble," McPheters said.

"I'm not saying that a national recession is going to happen," he qualified. "It's simply another uncertainty." "We do know that 2008 won't be anywhere near as robust as 2007," McPheters said. "Across the board, economic indicators will be weaker...The worst isn't over yet," said Pollack.

Bottom Line:

• 2008 will be marked by uncertainty, and that bodes poorly for the economy.
• Five factors affect consumer outlook: the credit crunch, foreclosures, gas prices, the housing market, and the labor market.
• The Greater Phoenix housing market is over-supplied, and that puts downward pressure on home prices.
• How long it takes to return to a normal housing market depends on three factors: how significant the slowdown in new housing starts is in 2008; how fast population grows; and how much of the buyer pool disappears because of tighter credit rules.
• The Arizona labor market is strong, but consumers are still gloomy. There is uncertainty about future job growth even though the unemployment rate hit a record low in October, 2007.
• What we don't know about the future overshadows what we do in 2008 forecasts. The economy in 2008 will hinge on the state of housing inventories, population growth, and whether or not there is a national recession.