Overview

Christopher Thornberg

When I wrote my first East Bay outlook report a number of years ago, the region was in turmoil. The crazy heady days of the late nineties, when IPO’s flowed, venture capital poured into the region and office rents soared, were all built on the false promise of ‘the new economy’. Of course there was no new economy; it was just the old economy with an .html attached to the end of it.

The painful shift back to normality over the first few years of the new century was a stark reminder that the same fundamental rules of profit and investment still applied to business no matter how neat the technology or how slick the interface. At the time I made two clear predictions. This first was that the East Bay, which had not been swept up in the furor as much as it’s two neighboring economies, would not fall as far and would recover quicker. The second was that the Bay Area overall would recover and maintain its position as one of the premier centers of technology in the world, despite fears of outsourcing and change. Both predictions have proven to be true. And in the midst of this recovery the economy has emerged as an equal to its two neighbors, and the East Bay is not just a bedroom community and center for blue collar operations.

Now as I write the introduction for my final report for the EDA, again we are looking at more economic turmoil in the region and nation. The roots of this current set of problems were clearly set in those heady days of the late nineties. While businesses and stock investors learned the importance of fundamentals, the lesson never spilled over to the consumer side of the economy. Households, having bought into the myths of the new economy, calculated that saving for the future was old-school. Consumer spending grew nearly as fast as business spending. And when the investment bubble broke, despite job losses and shrinking income and wealth, consumers fueled by cheap credit and tax cuts kept on spending like we were still heading for that mythical new economy...

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The Nation & The State: A Fragile Economy

Christopher Thornberg

With low unemployment rates, a strong stock market and government coffers full of unexpected revenues, it certainly seems hard to think of the economy as fragile. Sacramento’s recent battles have been about what to do with their unexpected windfall. Indeed, the second quarter GDP numbers were recently released, and all in all, growth was not too bad.

The economy expanded at a 2.5% pace SAAR (Seasonally Adjusted Annualized Rate). Admittedly this is slow relative to the to torrid 3.8% rate averaged over the previous three years, but it still is within the statistical range of error of the long run average of 3.1%. And of course it is larger than the 1.8% rate hit in the fourth quarter of 2005, a number that was functionally dismissed as an anomaly when I wrote this report in the early part of the year. Indeed the economic spin-maestros have even proclaimed the second quarter number to be good news, saying that it implies inflation pressures will subside and reduce the need for the Fed to continue to tighten interest rates.

Contributions to GDP Growth % Terms, SAAR

	3 Yr Avg.	Q4 05	Q2 06
Gross domestic product	3.80	1.80	2.50

Personal consumption	2.57	0.53	1.74
Durable goods	0.59	-1.08	-0.04
Nondurable goods	0.84	0.79	0.34
Services	1.15	0.83	1.43
Gross investment	1.24	2.51	0.28
Nonresidential	0.70	0.52	0.28
Structures	0.08	0.31	0.36
Equipment software	0.63	0.21	-0.07
Residential	0.46	-0.06	-0.40
Change in inventories	0.07	2.05	0.40
Exports	0.79	0.97	0.35
Imports	-1.18	-2.04	-0.03
Government	0.36	-0.21	0.11

Alas, the true story of these second quarter numbers is a bit more ominous, and clearly reflects the impact of the many imbalances in the economy beginning to reach their breaking point. The following table shows contribution to GDP growth by the various sources of spending from within the economy. Consumer spending’s contribution was 1.74 percentage points, higher than in the fourth quarter of 2005. However, the dip in the final quarter of last year was all in durables, an extremely volatile source of growth for the U.S. economy. This time there is some decline in durables, but it has been accompanied by a slowdown in spending on non-durables, this being primarily driven by the large run-up in prices for gasoline. But for a surprising increase in spending on services this could have been much worse.

Also surprising has been the slowdown in business spending. Spending on structures remains decent for now, but there has been a slowdown in spending on equipment and software. Some of this is driven by a slowdown in spending on transport equipment, namely planes. But spending on less volatile information technology goods also dipped into negative territory. Residential investment has also, not surprisingly, begun to be a drag on the economy...

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California: Singing the Housing Blues

Christopher Thornberg

The great housing bubble of the 00’s has finally popped. Overall sales activity, one of the leading indicators of the market, has fallen by 23% in the Bay Area and 16% in Southern California over the past year and with this decline, inventory levels (homes currently for sale) are rising rapidly. That downward trend is expected to continue for some time. Home price appreciation, which typically lags market activity by six months to a year, has stopped completely across the state.

The same trend is occurring nationally with slowing existing home sales and a record inventory of new homes for sale. The once loud debate over the existence of the bubble has now been replaced by a debate over how hard a landing it will be, whether home prices will drop, and most importantly what it means for the rest of the economy. What we do know is that we have not come close to the bottom of the market, and it promises to be painful. Even the California Association of Realtors recently retracted their prediction of a ‘soft landing’.[2]

Source: Construction Industry Research Board

With all the discussion about bubbles in the news, we should be clear about what one is. As past readers of the Quarterly Forecast know, a bubble is when the market price of an asset becomes misaligned with its fundamental value. In the case of housing the fundamental value is the net present value of the rental streams the house offers to its owner over its life. Such mis-valuation is driven by speculators who are betting not on changes in underlying values but simply expected appreciation.

This self-fulfilling prophesy can drive the market for a short period of time but must eventually come to an end. What a housing bubble is not, is a period of time when asset prices fall sharply. This may happen at the end of a bubble in stock markets, but the fixed costs of transactions in housing markets causes overall market liquidity, rather than prices, to fall rapidly when the bubble ends. Housing prices fall slowly as a result. This suggests prices will remain overvalued for years...

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Sluggish Bay Area Job Markets Show Signs of Life

Ryan Ratcliffe

Overall, Bay Area employment is still reeling from the 2001 recession, long after the rest of the state has recovered. Total non-farm payroll employment in the Bay Area’s three metropolitan areas (San Francisco, San Jose, and the East Bay) is still down 11% from the beginning of 2001. However, 2006 so far has offered a glimmer of hope in the midst of this otherwise dismal picture: year-to-date, the Bay Area is the only region in California to see faster job creation in 2006 than in 2005.

Non-Farm Payroll Employment (1,000s, Seas. Adj.)

The recent history of Bay Area labor markets differs significantly from previous recessions. In previous downturns, the region has shown a more typical business cycle: a shock to the economy leading to a contraction in labor demand, creating a period of slow job growth and higher unemployment. As the recovery began, demand for workers recovered, with unemployment falling and total employment recovering to the pre-recession level...

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Per Capita Incomes Still High, Sales Growth Accelerating

Ryan Ratcliffe

While the recent Bay Area labor market history has been dismal, recent developments in per capita income have been more of a “good news, bad news” story. The good news is that even with the emigration seen in the wake of the recession, the share of the Bay Area’s population with at least a bachelor’s degree has actually risen since 2000. And it is still substantially higher than the state as a whole.

Not surprisingly, the Bay Area per capita income of $47,000 is still the highest in California. However, the continued drag on wage growth from the weak regional labor market has kept income growth weak in recent years. The most recent data available for 2004 shows Bay Area income growth picking up steam, and the acceleration of job growth in 2005-06 suggests this trend has continued.

Population 25 and older with a Bachelor’s Degree

Annual Growth in Nominal Per Capita Income

Taxable sales growth also points to a strengthening economy throughout the Bay Area. Preliminary estimates of year-over-year taxable sales growth in 2005 averaged a healthy 6-7% across the region, corresponding to the recovery of retail employment in the region. Sales growth on the peninsula outpaced the East Bay, reflecting a recovery of spending power in San Jose and San Francisco.

The slowdown in taxable sales growth in 2005Q4 looks a bit ominous, but there are two reasons to take this with a grain of salt. First, only the Q1 number is final: the preliminary estimates for taxable sales are notoriously volatile, with extremes in both directions generally being revised back to a more consistent average. But more fundamental than that, this slowdown in taxable sales growth likely reflects the same weakness shown in 2005Q4 real GDP growth (1.6%) – a weakness that was more than wiped out by the strong 5.6% GDP growth in 2006Q1...

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Bay Area Real Estate: A Post-Bust Mini-Boom

Ryan Ratcliffe

While the rest of California’s housing markets barely paused during the recession of 2001, the severity of the local downturn meant that Bay Area housing took a more substantial tumble. Sales fell by almost 25% in the first half of 2001, and median sales prices dropped in the first half of 2002. The Bay Area was the only region to see median home prices fall in California, reinforcing the historical evidence that nominal home prices only tend to fall in severe local recessions. Given this unique mini-crash, the housing boom in the Bay Area has been markedly different than the rest of California.

Extremely low interest rates caused the same surge in sales volumes seen in other regions, but price appreciation remained relatively muted compared to white-hot Southern California markets. The more moderate pace of price appreciation likely came from two sources: the explosion of appreciation immediately before the recession coupled to the overall weakness of the economy in its aftermath. Of course, median home prices in the Bay Area remain among the highest in California, and this moderate price appreciation paired with weak income growth has squeezed affordability in the region.

Total Home Sales Index (Seas. Adj., 2000=100)

Since it was a little late getting started, it’s no surprise that the Bay Area housing market hit its peak a little later than the rest of the state. While sales activity hit a peak in late 2003 in Southern California, sales did not peak in the Bay Area until the summer of 2004. Similarly, Bay Area price growth was still accelerating even through the beginning of 2005, six months after appreciation had slowed in Southern California. But while the timing was different, the end results have been the same in both markets in 2006: sales volumes are off 20-30% from their peaks. Both the Office of Federal Housing Enterprise Oversight’s (OFHEO) quality adjusted Home Price Index and DataQuick’s median sales price data show home price appreciation has dropped into single digits across the state...

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Looking Ahead: Real Estate Slowdown + Continued Recovery = Moderate Growth

Ryan Ratcliffe

The main short run economic question for California is how the real estate slowdown will play out: will we see a “soft landing” with lower sales volumes and stable prices, or will we see a repeat of the 1990’s, with a collapse in sales and a 10% decrease in average home prices? The answer depends on the overall economy: average nominal home prices historically have only fallen in the wake of severe local recessions – like the Bay Area experience in 2001. It seems highly unlikely that the Bay Area will experience another downturn of this magnitude in the coming years. Thus, the most likely scenario for average home prices in a cooling Bay Area market is flat but not falling: up one month, down one month, but not consistently lower.

As housing markets continue to cool, construction activity slackens and the real estate finance craze abates, growth through most of California should also slow. This is some cause for concern in the East Bay economy, as a significant portion of the 2005-06 growth spurt has come from the construction boom. However, the recoveries in San Jose and San Francisco should be insulated from the direct effects of the real estate slowdown, since construction and finance have played only minor roles in recent job growth there. Put it all together: spillover effects from improvements in the peninsula’s economy should offset some of the real estate drag in the East Bay. While there is some downside risk, the outlook for the East Bay is some slowing, but no radical departure from current trends...

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July 2006

East Bay Forecast

Overview