Prospects for the US and Global Economy in 2007 and Implications for Israel

1. Prospects for the US and Global Economy in 2007 and Implications for Israel Nouriel Roubini Stern School of Business, NYU and Roubini Global Economics www.rgemonitor.com November 2006

2. Main Arguments • Debate of whether the U.S. growth slowdown in 2006 will end up in a recession in 2007: “hard landing” or “soft landing”? The hard landing scenario is becoming more likely. The risk of a recession is sharply rising • The Fed will ease rates if the economy slows down more than expected; but such easing will not prevent the US recession • The rest of the world would not “decouple” from a US hard landing. Decoupling would occur only in the soft landing scenario

3. Main Arguments • Emerging market economies have benefited for the last few year from favorable global conditions (high global growth, high commodity prices, low interest rates). Thus, a US recession and global slowdown will hurt emerging markets, especially those that have serious macro vulnerabilities. • Israel’s economy and its growth rate are sensitive to the U.S. business cycle given its trade links with the U.S., its trade openness and its sensitivity to the U.S. and global tech cycle. A U.S. recession would negatively affect Israel’s growth even if it would not lead to an outright recession. • Risky assets would under-perform in US and the rest of the world in the hard landing scenario

4. Hard landing or soft landing of the US economy in 2007? • Current economic slowdown in the US. • Economic slowdown driven by three bearish forces: • Housing bust • Fed Funds rate tightening “in the pipeline” • Oil still very high at $60 a barrel • Economy slowed from 5.6% in Q1, to 2.6% in Q2, to 2.2% in Q3 • Q4 growth rebound or further slowdown? • 2007 soft landing or hard landing with a recession?

5. Arguments in favor of a soft landing • Betting against the US consumer has proven a wrong bet over and over again. The consumer is very resilient • Oil prices are now falling towards $60 • Wealth effects of housing slump will be modest. There is still plenty of untapped home equity. • Income generation is still robust • Labor market is tight and generating jobs at a sustained rate • Monetary and credit conditions are not that tight and long rates are now falling.

6. Arguments in favor of a soft landing • You need a credit/monetary crunch to get a recession. Real rates are not that high. • Corporate sector is highly profitable and with strong balance sheets. Corporate investment may take the slack from slumping housing and slower consumption growth • Equities have been rising recently signaling soft landing optimism and providing a positive wealth effect

7. Arguments in favor of a soft landing • Soft landing is still a majority view among forecasters and investors • Housing may be close to bottoming out • There are still trillions of untapped equity in the households’ wealth • Experience of UK, Australia, New Zealand shows that a bursting of a housing bubble does not need to lead to a hard landing • The current slowdown more likely to end up like the 1994-95 mid-cycle slowdown and soft landing rather than the 2000-01 bust and recession

8. Hard Landing Scenario:Three main bearish forces • Housing sector bust (slump is too mild) • All indicators from housing sector are sharply down now, also including prices • Still high oil and energy prices in spite of lower ones recently • Lingering inflationary pressures on the economy • Delayed effects of Fed interest rate increases • Long rates have been up again relative to 2005 as the “bond conundrum” has fizzled away

9. How “consumer burn-out” could lead to a hard landing • These three bearish shock are hitting a consumer that is experiencing: • Flat or falling real wages (at the median level) • Mediocre employment growth (see October payrolls) • Negative savings • High debt ratios • High and rising debt servicing ratios • Weakening confidence

10. Causes of 2001 recession • Bursting of the tech stock bubble that had led to overinvestment in tech capital goods; investment bust followed bursting of the bubble • Oil rising from low teens to about $30 • Fed tightening by 175bps btw 6/99 and 6/00 • Note: Peak of business cycle was 3/01, six months before 9/11

11. Causes of 1990-91 recession • Real estate bubble busting and leading to S&L Crisis • Credit crunch and monetary tightening following inflation pressures • Oil shock following Iraq’s invasion of Kuwait • Note: Peak of business cycle was in 6/90 before the invasion

12. A recession in 2007 could be more severe than the one in 2001 as: • Effect of housing bust likely to be larger than tech bust • Oil is now close to $60, not $30 • Fed tightened by 425bps. • Caveat: nominal and real rates matter • Nominal rates are now lower than the 2000 peak; and real rates are also lower

13. Why oil may matter now for growth if oil at $60 did not matter in 2004-2005 • Then: • oil was high because of strong demand • rates were low (1%) and housing was bubbly • Now: • Oil is still high in part because of supply (geopolitical risks) • You have a triple whammy (housing bust, still high oil, rising interest rates to 5.25%)

14. Are recent lower oil prices good news or bad news? • Oil, energy and commodity prices have recently fallen from their July peaks leading to growth and consumption optimism. • Is the soft landing optimism generated by this fall justified? • That summer spike was due to Lebanon War, Iran confrontation issue and North Korea tension • They have now fallen to pre-summer levels. • Recent sharp fall is a sign of US and global growth slowdown reducing the demand for commodities. • So it could bad news rather than good news. Commodity prices fall in slowdowns and recessions. • It would be good news if the fall in prices is driven by positive supply shocks or the fall in speculative demand

15. Three reasons why housing bust could have more severe effects than the tech bust • Direct effects of fall in residential investment will be similar or larger (about 2% of GDP fall) than the fall in tech goods investment in 2000-01 • “Wealth effects” of housing are likely to be larger as housing is – unlike tech stocks - a significant fraction of households’ wealth. • Crucial role of Home Equity Withdrawal (HEW) in driving consumption • Employment growth role of housing is much larger than labor-scarce tech employment. 30% to 40% of employment growth since 2001 is due to housing, directly or indirectly

16. Is the housing recessionbottoming out? • Some (Greenspan) argue that the housing bust is bottoming out as: • Mortgage applications are flattening • Housing starts were up last month • New home sales were up last month as lower prices drove buyers back • Mortgage rate are now lower • But evidence suggest that the worst of the housing bust may be still to come. • October housing starts fell a staggering 14% while building permits fell 6% • Housing starts have fallen only 27% relative to peak while in previous downturns they fell 40-50% • Building permits (leading indicator of starts) are still falling sharply with no sign of stabilization. • New home prices are now falling at a 10% annualized rates; and these figures do not even include the massive seller-side subsidies (such as a $40K free swimming pool for a $400k home) that are becoming a norm in a slumping housing market. • The vicious chain of busting housing is still spiraling lower: lower permits leading to lower starts, lower construction spending, lower home sales, lower prices, lower mortgages, lower employment in housing, lower wealth, higher debt servicing ratios as ARM reset occurs, negative spillovers to non residential construction and to consumer durables.

17. Housing is not bottoming out • Home Depot is in serious trouble with earnings sharply down, a "gloomy" forecast for 2007 and same store sales now down 5.1% • Cancellations are sharply up in the housing sector • DR Horton, the second largest home builder in the US, reported a fall of 51% in its net income, a 4.4% revenue fall and a sharp rise in cancellations. • Homeowners' vacancy rates (i.e the percentage of homes that are owned but empty) are sharply up to 2.5% from the 1.5% average in 1992-2000. • The housing recession is now spreading to non residential construction: no one will build shopping centers and offices in the “ghost towns” • The seasonally unadjusted mortgage applications figures are distorted by two factors: an increasing number of cancellations and seasonality. Seasonally adjusted applications are still falling • The sellers of homes are becoming so worried that they are now relying on Divine Providence to help them sell their homes: sales of statues of St. Joseph are skyrocketing; it is has been a long-time popular belief that burying a statue of St. Joseph in the basement of your home helps you sell your home when housing is in trouble. • So, there is no evidence of housing bottoming out.

18. Can recessions be predicted early one? • Usually not early on, especially as the downturn is often sudden and rapid • In 2000 Q2 growth was 5%; by Q4 was 0% and by Q1 of 2001 we had a recession • The downturn was rapid and unexpected led by the tech bust

19. The Fed missed the boat in 2000 • The Fed missed the coming recession in 2000. • Even by fall 2000 (Sep and Nov FOMC) it worried more about inflation than about growth • Only after terrible Xmas sales and once NASDAQ collapsed on 1/2/01, the Fed started easing aggressively but it was not able to prevent the recession

20. Would Fed easing avoid a recession? Unlikely • No. In 2000 Fed stopped tightening 6 months before the recession and aggressively eased as soon as the recession started. But recession was not prevented as there was a glut of tech capital goods. • In spite of Fed Funds pushed down from 6.5% to 1% btw 2001 and 2004, real investment fell by 4% of GDP given the glut of capital goods. • Today a glut of housing stock and consumer durables. Thus, Fed easing may not work, as it did not work in 2001. Fed easing may just put a floor on the recession, not prevent it. • When you have a glut of capital/durable goods, the demand for these goods becomes interest rate insensitive until the glut is worked out • Then, easing is ineffective as it is like pushing on a string

21. Q2:2006 components of aggregate demand • Residential investment falling at rapid rate • Durables consumption not growing • Inventories up as sales growth slowing • Net exports not a drag on growth anymore but not much stimulus • Gov consumption weak • Non-residential investment in software and equipment falling

22. Will investment pick up as housing and consumption slow? • Argument that investment pick up as housing slumps and consumption slows: • Firms are flush with profits and have strong balance sheets • Credit and monetary conditions are still very easy • They are ready to invest more and able to do so. • But Q2-Q3 figures do not confirm this • Firms are highly profitable and flush with cash • But there is an “investment strike” as there are not many good real investment opportunities with demand slowing down • The collapse of durable goods orders in October suggest that real investment will fall in Q4 of 2006. • Why to invest more? • You got instead the biggest share buyback bonanza in US history • Also real Q3 earnings growth for S&P500 firms is down to 6.5%, not the headline “17%”.

23. Q3 growth: a weak 2.2% • Housing investment falling at 17% annualized rate • Net exports again a drag on growth • Inventories investment still large suggesting a downward inventory and production adjustment in Q4 • Real non-residential investment slowing down sharply and expected to slow down more in quarters ahead • Durable consumption adjustment to come in the next few quarters as housing slows • Mystery of 26% increase in motor vehicles; without it Q3 growth would have been 0.7% lower

24. Arguments for a Q4 Growth Rebound • Soft landing consensus discounts the weak Q3 and argues that we will have a Q4 and 2007 growth rebound because of: • Oil prices falling 25% • Stock market increasing • Long rates now falling • Income and employment generation being still sustained

25. But early data on Q4 suggest a further slowdown to 0% growth • Regional Feds leading indicator reports (Philly, Richmond, Chicago were weak) • October payrolls were weak • Manufacturing production is falling for three months now • The crucial ISM is signal near recession in manufacturing • Spillovers of housing fall to other components of non residential construction • Manufacturers survey signal pessimism • Wal-Mart, Home Depot and other same-store sales showing weakness in spite of lower oil prices. • Falling oil and long rates are a signal of the slowdown; thus they are bad rather than good news. • Spread of the housing recession to other sectors, especially consumer durables (autos, furniture, home appliances, retail) • Inflation (PPI) rate is falling as firms have weak pricing power in a soft demand environment. CPI inflation is also easing • October sales were down and they look weak at the beginning of the holiday season • Consumer confidence is falling in spite of lower gasoline prices • Durable goods orders – a proxy for capital spending by the corporate sector – were sharply down in October.

26. Do you need a credit/monetary crunch to get a recession? • Not necessarily. • Note that some tightening has occurred (425bps on the short end, 100bps on the long end) • Currently credit supply conditions have not tightened but credit demand – in housing – is starting to fall • In 2000 the bust of the tech sector occurred without a credit crunch. Once a bubble burst the overinvestment during the bubble leads to underinvestment to work out the excess capacity.

27. Do you need a credit/monetary crunch to get a recession? • Today, the same will happen with housing • Once that bursting occurs credit tightening increases as you get delinquencies, defaults and foreclosures. • Note that the bursting of the real estate bubble of the 1980s lead to a bust and to an eventual credit crunch (S&L crisis) that contributed to the 1990s recession • Risks of a broader systemic banking problems, starting with the sub-prime lenders, and then transmitted to other banks and financial institutions

28. Where is the housing mortgage risk concentrated? • In banks that still hold it directly or indirectly with MBSs • Asset managers and hedge funds that hold tons of MBS • The counterparties – prime brokers – of these highly leveraged institutions • The GSEs (Fannie & Freddie) that hold tons of mortgage credit risk and carry also the market risk • Foreign central banks that piled tons of agency debt Risk of a systemic crisis episode if the housing slump becomes even more severe.

29. Ability of macro policies to prevent recession more limited than in 2001 • In 2001 and after: • Aggressive monetary easing (6.5% to 1%) • Aggressive fiscal easing (from a 2.5% of GDP surplus in 2000 to a 3.5% deficit in 2004) • Sharp US dollar fall in 2002-2004 period Rogoff: “the best recovery money can buy” • Today: • Monetary easing is limited by inflationary pressures • Fiscal easing is limited by a large structural deficit • Exchange rate moves limited as $ has already fallen a lot relative to floaters and cannot fall much relative to BW2 members if they continue forex intervention

30. Rest of the world would not decouple from a US hard landing • Dollar fall imparts deflationary effects on ROW • Trade links are important, both direct and indirect ones (i.e. via China) • Oil is much of a shock to EU, Japan and Asia as it is to the Us • Monetary policies are tightened everywhere • Limited role of macro policies to counter a slowdown • Housing bubbles around the world • Business and consumer confidence is heading south • EMs got lucky with high global growth, high commodity prices and low interest rates

31. Implications for Emerging Market Economies • Emerging markets (EMs) have gone through cycles of boom and busts of capital flows in the last three decades. • Boom cycle I: early 1990s after the Brady plan • Bust cycle I: Mexico crisis and Tequila effect 1994-1995 • Boom cycle II: Spread compression and capital flows to EMs and Asia in 1996-97 • Bust cycle II: Crisis in East Asia and other EMs (Russia, Brazil, Ecuador, Argentina, Turkey, Uruguay, DR, Pakistan, Ukraine) in 1997-2002

32. The latest boom-bust cycle • Boom in capital flows to emerging markets since 2003: surge of private flow, booming stock markets, shrinking sovereign spreads, strengthening currencies. • Boom associated with better macro fundamentals (current account surpluses, less financial vulnerabilities, structural reforms) • Was the markets turmoil of May-June 2006 a temporary blip or the beginning of a new bust cycle? • Recovery of EMs after the spring turmoil may be fragile if global conditions worsen • The answer depends on the causes of the recent good performance of EMs.

33. Causes of the good performance of EMs since 2003 Two views on this: • EMs (including Latin America) have entered in a “new paradigm” era of sound macro and financial policies that will lead to sustained high growth and graduation to investment grade status for most EMs (El-Erian) • Luck/external conditions explain this growth: • High global economic growth (US and China) • Low interest rates in the G7 • High commodity prices

34. Implications of the “external luck” view • It was hard, even for poor credits, to get in trouble given favorable global conditions • If, as likely, in 2007 the global economy were to slow down sharply, G7 interest rates go sharply up and commodity prices fall, many EMs will feel some pain, if not outright distress

35. Israel’s successfuleconomic performance • Very good economic performance of Israel in the last few years • High economic growth • Very low inflation • Credible and sound monetary policy committed to price stability • Fiscal consolidation and reduction in the budget deficit (even if some pick-up of the deficit after the war) • Current account surplus • Stronger shekel • Large FDI inflows • Privatizations and structural market-oriented reforms • Competitiveness in high-tech sectors • Resilience of financial markets to Middle East geopolitical shocks (such as the war with Lebanon in summer of 2006)

36. Challenges of the Israeli Economy • Increased income and wealth inequality and increase in poverty • Dual labor markets with very skilled highly-educated workers and very unskilled and poorly educated workers • Changes in tax and social spending policy – however necessary – have aggravated this income gap • Technological changes - shift toward technology-intensive sectors - also drove this increased inequality • Social and cultural factors limit labor force participation rates of the poor (mostly the Arab population and the ultra-orthodox)

37. Challenges of the Israeli Economy • Arab poverty depends on low education, discrimination in the labor market and the low level of participation of women in the labor force • Among the ultra-orthodox, poverty is related to large family size and the low level of labor force participation of men • Greater equality is an essential ingredient of long-term prosperity. • Thus, government policies – including greater spending on education and training – that can help to narrow this gap are necessary • Policies to increase labor force participation rates – such as Earned Income Tax Credits – are also important

38. Other issues and challenges for Isreal • Still very high level – if falling – of public debt relative to GDP • Need for further reforms in the financial sector, in the structure and level of taxation and in the efficiency of the public sector • Also need to improve some aspects of the business environment (see WB’s Doing Business Report )

39. Israel’s vulnerability to a US slowdown • The US tech bust of 2000-2001 severely affected the Israeli economy that has a comparative advantage in tech goods • The contribution of exports to aggregate demand growth has been shrinking from 2004 on. • So Israel now relies more on domestic demand and less on external demand for growth • Still Israel is an economy very open to trade. A US and global slowdown would negatively affect Israel’s economic growth • Since the trigger for a US downturn would be the housing bust – rather than the tech bust of 2000-2001 – Israel is less vulnerable now compared to 2001 to a US economic slowdown or downturn

40. Conclusion: U.S. Hard Landing Risk is Rising • While the consensus view is one of a soft landing, the risk of a hard landing of the US economy in 2007 is increasing • Housing today, like the tech bust in 2000-01, may have macro effects • US consumers may be close to a “tipping over” point • Fed easing will not be able to prevent a recession if forces leading to a recession become dominant • The rest of the world would not be able to “decouple” from the US even if it will not experience an outright recession. • Israel – while being a strong and resilient economy – is still vulnerable to a US and global economic slowdown