The past year was good, but not great. The East Bay continued to lead the recovery with solid job growth, and rapid increase in taxable sales not to mention the continued frantic pace of home building. San Jose has balanced out, and with an expected upward revision to the job numbers will likely show positive job gains for 2005. San Francisco lay somewhere in between these two economies. The job growth and overall expansion of the economy is largely due to continued consumer spending, although the tech industry that plays such an important role in the region is starting to regain some traction with solid profits and rising exports.
With the recovery and solid revenue growth the new budget for the state is heavy on education and lighter on health. No substantial reform to the budgeting process has been achieved, as the calm has lulled the need to tackle difficult political issues. It still leaves a gap between revenues and expenditures of about $6.5 billion, an amount to be made up by the remaining $7 billion left over from Propositions 57 and 58. Even with modest expectations about gains in revenues and a modest increase in the total budget, this still leaves the State, and by definition the local governments, on a razor edge. Any slowdown in the economy during the coming year could easily undermine the revenue projections and put the state back into dire fiscal straights.
As for the year ahead, look for an up and down economy. The external sector, driven both by continued growth in the information technology industry and biotechnology and a mild recovery in the East Bay’s manufacturing sector will be offset by a slowdown in both new homes being built and overall consumer spending as the real estate market will continue the cooling trend that began in late 2005.
Taxable sales growth will slow, but still be positive, in the 4% range. Interest rates and inflation will remain stable. Employment in the East Bay will stay on its current course, and pick up about 1.5% growth according to the payroll numbers, and slightly more according to the household survey. Unemployment will remain stable. San Jose and San Francisco, still in recovery mode, will grow about 1% each. Towards the end of 2006 things will become more uncertain, depending critically on the speed of readjustment in consumer spending and the housing market. Our new Fed chairman will likely face his first test even as we approach the end of the year. We can hope that his challenge is not too severe.
2005 is over, and while the last few statistics are yet to come in, by any measure, it was clearly a solid year of economic growth for the nation. This was reflected by the continued recovery of the economy in the Bay Area. Consider the national economy first. The new 4th quarter numbers were fairly poor, coming in at only a 1.1% growth rate (seasonally adjusted and annualized). Still, third quarter GDP growth was a solid 4.1% rate, the 10th straight quarter of above average growth for the US economy, with an average pace of 4.1%. While the late nineties had a faster growth rate (between 1997 and 1999 the nation averaged an astonishing 4.7% rate) it never had 10 straight quarters of above average growth. The 1.1% growth rate is a low number, but some return to normalcy was in the works. The big question is whether this number represents the beginning of a new trend, or just a reversion to the long run mean. This we will discuss further on.
S&P 500 Price Earnings Ratio
Despite the disappointing GDP report in the final quarter, there was plenty of other good news from 2005. One was the continued expansion of the manufacturing sector, and business spending in general. Manufacturing output rose by 4% in 2005, the second such year of strong gains. New orders for manufactured goods also strengthened in the last few months of the year. On top of this, corporations continue to rake in record profits. In aggregate, real (GDP deflator adjusted) corporate profits have risen 60% since 2001. While the stock market has been doing quite well in recent months, the market is not overheated the way it was in the late nineties. Indeed the P/E ratio for the S&P 500 actually fell over the last three quarters. While this is not a recommendation to ‘buy’, selling clearly isn’t imperative either.
One reason for the high level of profits is that business spending has remained low relative to profits. The graph below shows this ratio starting in the late eighties. If you pull out the massive run-up in business spending that began in 1997 (and led ultimately to the 2001 recession) you can see a slow downward drift in this statistic. Currently it is running about 1 to 1, down from 1.4 to 1. A recent article in the Economist noted this same trend across the developed world, and concluded that 2006 might see a surge in business spending. The problem here is that it is easy to confuse nominal and real trends. These data do not say that real business spending is slowing, only that the ratio of nominal spending to profits has been declining....
US Business Investment/Profit Ratio
(Click here for more on the year behind analysis)
The state added a solid 190,000 payroll jobs through 2005 (Q4 to Q4), a 1.3% growth rate. The Bay Area also enjoyed a decent, but not spectacular 2005. The East Bay employment is currently estimated to have grown almost 2%, faster than the state, adding close to 20,000 new jobs over the course of the year. San Francisco added 6,500 jobs bringing the MSA’s total new jobs up to 26,500. San Jose, which had started to show some positive growth in the end of the year slipped back yet again, and ended up flat, growth wise.
Bay Area Payroll Employment
Of course these numbers have to be taken with some degree of caution. The estimates of local area payroll jobs are based on a survey of companies that is recalibrated every year on the basis of the much more thorough but slower arriving ES202 payroll statistics collected through the unemployment insurance program. The re-benchmarking of the current sample occurs at the start of each year, and these changes can be substantial.
In any case, while it is difficult to say what the final revisions will be, a preliminary analysis shows that the East Bay is likely to see its overall level of employment remaining the same after the revisions, while San Francisco’s will be reduced by a marginal amount (less than one half of one percent). San Jose will be the winner in the revisions, likely to see an upward revision of something less than 1%, making 2005 a positive growth period if not a period of strong growth.
Still the labor markets both in the Bay and across California look stronger than the payroll numbers would indicate on their own...
(Click here for more of Jobs In California and the East Bay" analysis)
Of course the driver of California growth has been, in large part, the continued boom in the residential real estate industry. Where this is heading will speak volumes about the growth of the economy in 2006. But before discussing this, let’s first take a look at the non-residential markets in the Bay region. The building boom of the late nineties created a huge surplus of commercial space in the region, pushing vacancy rates up close to 25% in San Jose and San Francisco. The East Bay got off comparatively lightly, with vacancy rates hitting only 17%. Vacancy rates have been dropping in recent months, falling below 20% in San Francisco. Still, they remain at historically high levels, and rents remain flat in all three regions.
Non-Residential Markets
Office Vacancy
Office Rents ($/s.f./year)
Industrial Vacancy
Industrial Rents ($/s.f./year)
Retail Vacancy
Retail Rents ($/s.f./year)
Source of Data: Portfolio & Property Research
When will rents start to rise and new construction start again? The magic level of vacancy rates seems to be about 10%. When vacancy rates fall below this level the market starts to warm up again. How long until this happens? Unfortunately it will take a while. The last time vacancy rates were this high was in the early eighties, following the construction boom in the seventies. It took over a decade for the excess space to be absorbed. Expect office markets to remain tepid at best for the foreseeable future.
Industrial and retail markets paint a somewhat better picture. Industrial space enjoys single digit vacancy rates in all three markets, and overall rates are not that far above where they were in the late nineties. Still, rents remain flat here and the pace of absorption is still relatively slow with the exception of San Jose. Retail has remained the strongest component of non-residential property, on the back of ongoing consumer spending. In the East Bay retail vacancy rates are actually lower than they were during the boom years of the late nineties. In San Francisco retail vacancy rates are where they were in 1999, and they are only slightly higher in hard-hit San Jose. This remains the one market where building is still going on. This is due in large part to the frenetic pace of home building occurring at the moment. When the housing markets begin to cool, you can look for retail to follow along...
(Click here for more on Construction and the Economy)
Looking ahead in 2006, growth is likely to continue for the first part of the year, though not at the pace we have seen over the past three years. Not all is right in the mighty US economy, and Greenspan’s legacy is not yet assured. These issues include the real estate bubble, as already discussed, the ongoing current account deficit and the continued decline in personal savings rate. The final income statistics for 2005 are in, and for the first time since 1933 the personal savings rate (defined as disposable income minus total current expenditures divided by disposable income) has dipped into negative territory. The trade deficit remained overall at a -5.5% of overall GDP, and the government deficit continued to accrue at a $300 billion dollar a year pace.
All these are related—they reflect a nation on a spending binge that simply cannot last. Part of this spending binge is the fault of Congress and the President. Deficit spending can be helpful during economic downturns to stabilize the economy. Clearly the economy has not needed stabilizing over the past three years, with the solid growth rates seen. These massive deficits don’t threaten the economic health of the nation directly, but what they do represent is a massive inter-generational transfer of wealth. The legacy of those on the verge of retiring will be a massive amount of debt to be paid off by the following generations, not to mention the cost of supporting Social Security and Medicare. The personal part of the spending binge is being driven by consumer who feel house rich, and want to spend some of that wealth on current consumption through reduced savings.
The general consensus is that the bubble is going to begin to deflate in 2006, accompanied by a slowdown in new homes being built and continued declines in market activity. We may be experiencing the beginning of the decline now, but the market still feels stable because most people attribute the current weakness to the natural slowdown in market activity that occurs around the holidays. The softening of the market will be more apparent when the spring surge doesn’t come with the expected strength it normally does.
The big question over the coming year is what it means for the rest of the economy. This of course boils down to the speed of adjustment. If the market continues its gentle slowdown and prices simply flatten, the overall impact may be a general weakness across the economy. Construction and financial activities will take a large hit, but the continued increase in strength in the external portions of the economy can balance this out.
If, on the other hand, the coming slowdown in housing is rapid, we all better lookout. A consumer shock combined with rapidly declining demand for new homes could cause a recession on par with, if not worse than, the nation’s last one. Moreover, in the Bay region, the pattern of pain this time will be largely reversed from 2001 with the East Bay taking the largest hit of the three regions.
The forecast for the Bay area in 2006, then, is steady as she goes for the first portion of the year. Expect employment to continue at about a 1.5% pace for the East Bay, while San Francisco and San Jose will see about a 1% gain. Taxable sales will grow at a more normal pace, slowing from the rapid gains seen over the course of last year. Home building will slow through the year, and apartment vacancies will continue to fall. The non-residential sector vacancies will continue to drop, but there is no major recovery on the horizon for new building activity, and the one major driver of growth—retail—will start to cool as spending growth slows.
Toward the end of the year the situation definitely looks shakier. How fast the market cools will determine what the end of the year looks like. Keep an eye out and look for the next quarterly report.
