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“This is not the end or even the beginning of the end, but maybe it is the end of the beginning.”
– Winston Churchill, November 1942, following the Battle of El Alamein

The U.S. economy is in a mild recession that is being driven by a de-leveraging of the banking system. Fed rate cuts have sent the dollar down 13 percent since August. At the same time, inflationary expectations are rising, as prices of commodities like gold and oil have hit record levels. Consumer spending is impaired by high debt levels, declining employment, falling home prices and rising energy prices. Business spending has held up well as nonfinancial businesses still have strong balance sheets and good business prospects outside of the U.S.

At the end of the day, how will we know when this is over? There are several financial and real economy pieces of data that will give us some clue to the duration of the current downturn. The financial market problems began in the housing market. Falling home prices are depressing both household and bank balance sheets.

On the financial side, keep an eye on the Fed’s Term Auction Facility (TAF). This is a special source of funds for the banks. When the banks no longer need this extra liquidity, it will be one sign of improved financial market stability. In many ways, this financial crisis started when the banks began having problems turning over their asset-backed commercial paper (ABCP). Beginning in early August of last year, the volume of commercial paper outstanding shrank for 18 weeks in a row. More recently, it has shown some signs of stabilizing. A recovery in the ABCP market would be another sign of financial market stability.

Bank losses are being driven largely, although not exclusively, by losses in the mortgage market. In order to stabilize bank balance sheets, home prices need to stabilize first. For that to happen, we need to see more balance between home supply and demand.

The long-run demand for homes is driven by three different factors. The biggest of these is demographics. Over the past decade, the growth in households has averaged a little better than 1 percent. That in turn creates an underlying demand for 1.2 million new homes. Demolitions account for another 200-300K in new home demand. And, finally, second home purchases add yet another 100-200K a year. In total, new home demand in an average year runs 1.5 to 1.7 million units.

New and Existing Inventory of Unsold Houses
In Thousands of Units

Source: U.S. Bureau of Census and National Association of Realtors

At present, there are 4.5 million new and existing homes on the market for sale. Since July 2007, that number has come down by nearly 600K units as many existing home sellers have taken their properties off the market, a monthly reduction of roughly 75K. To stabilize home prices, the market needs to get back to where it was in early 2006 when there were roughly 3.5 million homes for sale. Were the market to continue to reduce supply at the same pace, market equilibrium would be reached in roughly 13 months or sometime next spring.

Another way to look at this is that, at present, new home construction is adding about 1.2 million new units to the market on an annualized basis but can be expected to decline to less than 1 million over the course of this year. Assuming demand to be 1.5-1.7 million units, that means -- under the best of conditions -- the excess inventory will be absorbed at a monthly rate of 60K, taking about 17 months, with recovery coming sometime next summer.

In the post-WWII era, the average recession has lasted 11 months while the longest recession on record went on for 16 months. If you compress the 1980 and 1981-82 recession into a single event, hard economic times lasted for 23 months. The current downturn probably started in December 2007. If it were to last until the summer of 2009, a duration of 18-20 months, that would make it one of the longer downturns in modern times. For retailers of all stripes, the lesson is clear. Plan for an economy that will be weak; consumers who will be very price-sensitive; suppliers who will be cost-pressured; and real estate developers who will be eager to close any deal.

Comments? csteidtmann@deloitte.com