Five Key Questions

SPECIAL COMMENTARY

February 10, 2009

Five Key Questions for Decision-Makers John Silvia, Chief Economist [email protected] 704-374-7034

Executive Summary 1 For decision-makers in both the private and public sectors there are five economic issues that demand our attention. Each of these five areas will be reviewed in turn in this report. 2 ƒ

First, the strength and character of the general economy

ƒ

Second, the specific issues associated with housing

ƒ

Third, the role of financial and credit markets

ƒ

Fourth, the impact of fiscal stimulus

ƒ

Fifth, the international response to our economic and policy choices

I. Signs of Recovery and the Changing Character of Domestic Demand Since the credit bubble burst in August 2007, banks and other lenders have grown increasingly restrictive in their lending practices. As a result, our outlook is framed by the character of America’s credit cycle, which will dictate the pace and nature of the economic recovery. The pattern of this credit cycle and its focus on risk avoidance dictates a deleveraging of the American financial system on both the demand and supply sides. On the demand side, consumers must strengthen their balance sheets by paying down debt, boosting savings and rebuilding equity in their homes. All of this will require the consumer to reduce spending. On the supply side, the banking system must rebuild its capital base, which means it must sell stock and restrain lending. The result is below-trend growth for the next two years (Figure 1). Deleveraging compels strapped consumers to repair their balance sheets. Real personal consumption expenditures tumbled at nearly a four percent annual rate for the second half of last year. We look for further retrenchment over the next few quarters. Consumers have turned exceptionally cautious in light of the recent spike in the unemployment rate and abrupt tightening in credit. Significant declines in house and equity prices this past year have eroded household wealth, which has and 1 Presentation to the American Bankers Association’s LLAC Winter Conference, Feb. 5, 2009 in Washington, DC. Thanks are due to Sam Bullard, Jay Bryson, Azhar Iqbal, Mark Vitner and Adam York for their contributions. 2 These five questions were suggested as the focus for my comments by the ABA staff.

This report is available on www.wachovia.com/economics and on Bloomberg at WBEC

We expect below-trend growth for the next two years.

Five Key Questions for Decision-Makers February 10, 2009

SPECIAL COMMENTARY

should continue to weigh on consumer spending. Consumers are not the only ones feeling rattled. Businesses will likely tighten spending in reaction to depressed demand by continuing to pare back fixed investment spending and by drawing down inventories, which will depress growth in coming quarters. Figure 1

Figure 2 Real GDP

Bars = Compound Annual Growth Rate

8.0%

Line = Yr/Yr Percent Change

6.0% Forecast

4.0%

Real Personal Consumption Expenditures 8.0%

8.0%

6.0%

6.0%

Bars = Compound Annual Growth Rate

Line = Yr/Yr Percent Change

8.0% 6.0%

Forecast

4.0%

4.0%

4.0%

2.0%

2.0%

2.0%

0.0%

0.0%

0.0%

0.0%

-2.0%

-2.0%

-2.0%

-2.0%

-4.0%

-4.0%

-6.0%

-6.0%

2.0%

-4.0%

GDPR - CAGR: Q4 @ -3.8% GDPR - Yr/Yr Percent Change: Q4 @ -0.2%

-6.0% 2000

2002

2004

2006

2008

-6.0% 2000

2010

-4.0%

PCE - CAGR: Q4 @ -3.5% PCE - Yr/Yr Percent Change: Q4 @ -1.3% 2002

2004

2006

2008

2010

Source: U.S. Department of Commerce and Wachovia

The combination of deteriorating employment prospects and tightening credit is a powerful one-two punch.

U.S. Consumer: From Economic Driver to Economic Drag Consumer spending is expected to be a significant drag on economic growth throughout 2009 (Figure 2). During the previous recession, consumer spending remained steady thanks to the solid underpinning of rising home prices and easy credit. This cycle will be different as home values have dropped and credit availability has been cut. Consumers have turned exceptionally cautious in light of the recent spike in the unemployment rate and the abrupt tightening of credit. The combination of deteriorating employment prospects and tightening credit is a powerful one-two punch that has led to substantial cutbacks in discretionary purchases (Figure 3). Spending for big-ticket items has been hit hardest, especially motor vehicle sales. Consumers are also ratcheting back purchases of big-ticket items such as furniture, household appliances and home electronics. Figure 3

Figure 4 Consumer Discretionary Spending

Discretionary Spending

Share of Total Consumption

December-2008

47.0%

47.0%

46.0%

46.0%

45.0%

45.0%

44.0%

44.0%

43.0%

43.0%

Other Discretionary 19% Housing Away from Home 1% Alcohol & Tobacco 3% Clothing & Shoes 4%

Discretionary Share: Dec @ 42.8% 42.0%

42.0% 1998

2000

2002

2004

2006

2008

Recreation 4%

Non-Discretionary 57%

Furniture & HHEquip 4% Motor Vehicles Food Away from 3% Home 5%

Source: U.S. Department of Commerce and Wachovia

Consumers have also cut back on restaurant dining, travel, clothing purchases and are making fewer trips to the shopping mall. Despite lower prices for many consumer goods, purchasing power will likely still be constrained by slower income growth. The wealth effect will also cut into purchasing power, with falling home prices and the stock market collapse cutting household wealth. A conservative

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Five Key Questions for Decision-Makers February 10, 2009

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estimate of the wealth effect would cut spending between $300 and $400 billion this year. A retrenchment in consumer spending is long overdue, in our opinion. Consumer spending had risen faster than income during the past several years, with purchasing power being bolstered by abundant and inexpensive credit. The credit boom helped to send the saving rate to roughly zero percent. At its peak, consumer spending and residential investment accounted for 76.5 percent of GDP, some three percentage points above the average maintained since 1990. The ending of the housing boom began to send the consumption/GDP ratio back toward its historic norm. Even when spending begins to rise again, we expect the rate of growth to remain slightly below income growth, thereby allowing for the saving rate to gradually recover. Recession Probability Dictates Continued Recession Unfortunately, the probability of recession for the next six months remains high (Figure 5). Our model looks at a very broad set of predictors and these suggest the current recession will likely continue through at least the first half of this year. 3 Economic problems began to show up in our model in the fourth quarter of 2007 as the recession probability rose sharply to 75 percent and since then the probability has remained extremely high.

The current recession will likely continue through at least the first half of this year.

Figure 5

Recession Probability Based on Probit Model Two-Quarter Ahead Probability

100%

100%

80%

80%

60%

60%

40%

40%

20%

20% Two-Quarter Ahead Recession Probability: Q4 @ 99.4%

0%

0% 80

84

88

92

96

00

04

08

Source: Wachovia

John E. Silvia, Huiwen Lai, and Sam Bullard, “Forecasting U.S. Recessions with Probit Stepwise Regression Models”, Business Economics, January 2008, pp. 7-18.

3

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Five Key Questions for Decision-Makers February 10, 2009

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Figure 6

Signs of a Recovery: Indicators to Watch

ƒ First-time jobless claims remain at a very high Initial Claims

ƒ

600,000+ level. We would expect these claims to begin to drop towards 500,000 sometime in the spring suggesting that job losses will diminish as the year moves along.

ƒ The index is computed such that a reading of 50 is ISM Manufacturing Index

ƒ

considered break-even. This monthly survey is currently in the mid 30s. We would expect this index to remain below 50 through the second quarter and show signals of expansion by midsummer.

ƒ Profits are a longer lagging indicator, and at Corporate Profits

ƒ

present are declining at a 20 percent-plus pace. We expect the year-over-year declines to turn around. Improvement by midsummer would signal growth in employment and business investment by early next year.

Source: Wachovia

Rising unemployment, plunging stock prices and tight credit conditions are hardly a formula for increased home sales.

II. Housing Markets: Prices, Inventories and Regional Impacts One of driving factors of the credit crunch was the housing market as the lack of available credit made it tougher for potential homebuyers and builders to qualify for new loans. This put downward pressure on housing prices and led to even tighter lending standards making it tougher still for potential homebuyers to qualify. This vicious cycle is still playing out as home values are falling across the country and the pool of qualified potential homebuyers is growing smaller. New home construction is likely to fall further. Rising unemployment, plunging stock prices and tight credit conditions are hardly a formula for increased home sales. Housing remains a very weak link in the U.S. economic outlook. Not only is residential construction activity continuing to decline, but falling house prices and rising mortgage delinquency rates also continue to put pressure on credit markets (Figure 7). A vicious negative feedback loop has been in play for some time. Tightening credit conditions will likely lead to a further slowdown in sales. This will be followed by additional economic weakness, resulting in larger home price declines, higher mortgage delinquency rates and culminating in even tighter lending standards. We expect a much deeper and drawn out housing cycle with a bottom still a ways off. New and existing home sales are both expected to bottom by summer with housing starts to follow (Figure 8). Residential construction should bottom this year. The bottom, however, will now be significantly lower than

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Five Key Questions for Decision-Makers February 10, 2009

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previously thought, as tighter credit conditions for home buyers and builders will send activity well below recent lows. Figure 7

Figure 8 Home Prices

Housing Starts

Year-over-Year Percentage Change

24%

24%

20%

20%

16%

16%

12%

12%

8%

8%

4%

4%

0%

0%

-4%

-4%

-8%

-8%

-12%

-12%

Median Sale Price: Dec @ $174,700 Median Sales Price 3-Month Mov. Avg.: Dec @ -12.4 % FHFA (OFHEO) Purchase Only Index: Nov @ -8.7 % S&P Case-Shiller Composite 10: Nov @ -19.1 %

-16% -20% -24% 97

99

01

03

05

-16%

Millions of Units

2.4

2.4

Dashed Line is Underlying Demographic Trend 2.1

2.1

1.8

1.8

1.5

1.5

1.2

1.2

0.9

0.9

0.6

0.6

0.3

0.3

-20% -24% 07

0.0

0.0 80

82

84

86

88

90

92

94

96

98

00

02

04

06

08

10

Source: National Association of Realtors, FHFA, S&P Corp. , U.S. Dept. of Commerce and Wachovia

Understanding where we are in the housing correction is critical in developing a coherent outlook for the broader economy. The current housing cycle is largely without precedent in timing, depth and breadth. Past housing slumps tended to follow the business cycle. The construction slump preceded the broader economic slump by about two years, with sales tumbling once easy and inexpensive mortgage credit disappeared. The initial tightening of credit followed a dramatic increase in delinquency rates on most subprime mortgages, which were poorly underwritten and thinly collateralized. As a result, delinquency rates soared well ahead of any noticeable slowing in the broader economy, which is something never seen before. By contrast, the more recent rise in mortgage delinquency rates and defaults is the result of the deteriorating economic environment. Unfortunately, the continuing rise in the unemployment rate will send delinquency rates still higher. Unusual Breadth: Regional Impact The breadth of this housing slump is also unusual, but the bulk of the housing boom and bust took place in just a handful of states—Florida, California, Arizona, and Nevada, which accounted for the greatest amount of speculative home-buying and also saw the largest price gains and declines in the country. Other notable hot spots that turned brutally cold include the outer suburbs of Washington, D.C., the greater New York area, the greater Boston area and some of the coastal metropolitan areas in the Carolinas and Georgia. There are also a few places where prices have slumped even though they never enjoyed a housing boom. Most of these areas are in the Midwest, and include the areas in and around Detroit and Cleveland. Housing prices have fallen precipitously in these areas largely due to extremely depressed economic conditions, a disproportionate amount of subprime lending and deteriorating demographics.

Understanding where we are in the housing correction is critical in developing a coherent outlook for the broader economy.

The breadth of this housing slump is also unusual, but the bulk of the housing boom and bust took place in just a handful of states.

III. Credit Markets We have seen the patterns of credit move toward a deleveraging of the economy against the prevailing pattern of the past 25 years. What forces account for this momentum shift in the credit cycle and what does it mean for 2009? Credit expansion has characterized economic growth over the past few decades especially during the recent economic upturn that lasted from 2001 to 2007 (Figure 9). Innovation in the credit markets resulted in an apparent solution for every situation. A vast number of credit instruments were developed during the expansion to fill in 5

Five Key Questions for Decision-Makers February 10, 2009

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the gaps of creditor and borrower needs. In many ways, it appeared that credit markets were becoming more complete. They could meet the credit needs of both borrowers and creditors across the spectrum. In addition to a long period of low, short-term interest rates, credit expansion was also enhanced by easier credit standards, which effectively meant a greater supply of credit at any interest rate across the risk spectrum. Figure 10

Figure 9 Domestic Nonfinancial Debt

U.S. Household Debt

As Percent Of GDP

250%

250%

U.S. Household Liabilities to Net Worth

28%

Nonfinancial Debt: Q3 @ 228.4%

28%

Liabilities to Net Worth: Q3 @ 25.8%

225%

26%

26%

24%

24%

22%

22%

20%

20%

18%

18%

16%

16%

225%

200%

200%

175%

175%

150%

150%

125%

125% 82

84

86

88

90

92

94

96

98

00

02

04

06

14%

08

14% 82

84

86

88

90

92

94

96

98

00

02

04

06

08

Source: Federal Reserve Board, U.S. Department of Commerce and Wachovia

Near the end of the past economic expansion, excesses in credit markets were rampant and were characterized by easy lending standards. Consumers benefited from this credit environment as housing finance became democratized and auto loans and credit cards were widely available (Figure 10). Businesses large and small benefited from this accommodative lending environment as well. Some borrowers overstated their income and some lenders never bothered to check. Over the past year and a half, however, we have witnessed significant backtracking which has led to a sharp curtailment of credit and to the current economic downturn. Credit markets are still searching for a new balance between risk and reward.

Credit markets are still searching for a new balance between risk and reward. There is also a trend toward a more conservative view of risk-taking in general. Over the past few months, we have already witnessed significant declines in the federal funds rate and Treasury yields, but private-sector borrowing rates have not yet receded, especially those farther out on the yield and credit curves. Figure 12

Figure 11 LIBOR to Federal Funds Effective Rate Spread

TED Spread

Basis Points

400

400

Basis Points

450

LIBOR to Federal Funds: Jan @ 94 bps

450

TED: Jan @ 103 bps

350

350

400

400

300

300

350

350

250

250

300

300

200

200

250

250

150

150

200

200

100

100

150

150

50

50

100

100

0

0

50

50

-50 2004

-50 2005

2006

2007

2008

2009

0 2004

0 2005

2006

2007

2008

2009

Source: Federal Reserve Board, British Bankers Association and Wachovia

At the short end of the curve, rates are still driven by the Federal Reserve. Our expectation that the recession will continue and that consumer spending and housing

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Five Key Questions for Decision-Makers February 10, 2009

SPECIAL COMMENTARY

will continue to struggle lead us to believe that the Fed will continue on its liquidity provision path until next year. Short-term interest rates in general will remain low for an extended period of time. Moreover, we have seen in recent weeks an improvement in private market spreads such as the LIBOR-to-Federal funds and the TED spread (Figure 11 & Figure 12). This suggests that credit supply may be coming back into the market and that the worst of the credit problem may have passed—at least at the short end of the curve. The Other End of the Maturity Street Financial markets have evidenced only modest improvement in credit spreads and credit supply at the long end. In addition, the benchmark 10-year Treasury yield has drifted upward since the start of this year. In the credit sphere, the recession and poor earnings continue to limit issuance in the face of a skeptical market buyer. As a result, we have seen very little improvement in bond spreads over Treasuries (Figure 13). Over the next three months we expect very little improvement. The Fed has certainly been helpful in areas such as mortgage backed securities, where it has been a direct buyer, but such help has not spread much wider.

Financial markets have evidenced only modest improvement in credit spreads and credit supply at the long end.

We remain concerned about the middle to long end of the Treasury curve. For now, the safe haven trade appears to be working. Longer term, we are concerned that fiscal deficits, inflation expectations and anti-China/trade rhetoric will dictate rising rates. We also have concerns that yields on longer-dated debt instruments will drift upward as inflation expectations rise and the flight-to-safety trade falls away. In addition, dollar weakness may reappear as this year ages and this would add to our inflation concerns as well as introduce currency risk into the mix. Figure 14

Figure 13

Consumer Loan Delinquency Rate

Aaa and Baa Corporate Bond Spreads Over 10-Year Treasury, Basis Points

700

700

Aaa Spread: Jan @ 253 bps Baa Spread: Jan @ 563 bps

600

500

400

400

300

300

200

200

100

100

0

0 92

94

96

98

4.5%

Consumer Loans: Q3 @ 3.7%

600

500

90

Seasonally Adjusted

4.5%

00

02

04

06

08

4.0%

4.0%

3.5%

3.5%

3.0%

3.0%

2.5% 1991

2.5% 1994

1997

2000

2003

2006

Source: Federal Reserve Board and Wachovia

On net, the changes in risk versus reward calculations by both borrower and lender dictate that the growth in consumer spending over the outlook period will be sluggish relative to the trend of prior expansions. Residential construction and business equipment spending will exhibit sub-par growth in the period ahead, in our opinion. Consumer delinquencies are expected to continue to rise (Figure 14). Moreover, if taxes are raised (windfall profit taxes, corporate taxes, dividend and capital gains taxes, for example), then the after-tax reward for risk-taking would be further diminished. The net result is that the demand for credit would be limited. Weak U.S. and foreign growth suggests that the supply of credit through savings and profits would also be very limited relative to prior recoveries.

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Five Key Questions for Decision-Makers February 10, 2009

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IV. Fiscal Stimulus: Help Today but Burden Tomorrow? In an effort to revive the ailing economy, various policy measures will be considered. A second stimulus program, which should provide a boost to growth at least in the short run, is likely to be passed in coming weeks. However, unintended consequences of the policy mix could offset much of the stimulus. Higher taxes on dividends and capital gains as well as increased income taxes for higher-income individuals could provide a disincentive to work. A more interventionist government could alter private risk/reward calculations, which could be negative for long-run growth prospects. What little economic growth we had in 2008 was made possible by strong global growth. With housing and consumer spending struggling, we project that the severity of the current recession will be somewhere between the 1973-75 downturn and 1980-82 twin recession periods. Unemployment is likely to rise to 9.5 percent by late 2010. Given this economic background, we have seen a rapid rise in federal spending and a rapid rise in the federal deficit since the recession began (Figure 15 & Figure 16). Figure 15

Figure 16

Federal Government Spending Ex. Interest Payments

Federal Budget Surplus or Deficit

Year-over-Year Percent Change, 12-Month Moving Average 30%

30%

As a Percent of GDP, 12-Month Moving Average

4.0%

Spending Ex. Interest Payments: Dec @ 20.3% 25%

25%

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5% 1970

-5% 1975

1980

1985

1990

1995

2000

2005

4.0%

Surplus or Deficit as a Percent of GDP: Dec @ -5.9% 2.0%

2.0%

0.0%

0.0%

-2.0%

-2.0%

-4.0%

-4.0%

-6.0%

-6.0% 70

75

80

85

90

95

00

05

Source: U.S Department of the Treasury, U.S. Department of Commerce and Wachovia

Attempting to ascertain the implications of a change in economic policy solely on the basis of relationships observed in historical data, which tends to be highly aggregated, is unadvisable.

Unfortunately, the use of policy stimulus in the past (such as the 1970s) did not have the desired result, but rather stagflation was the reality of the day. Attempting to ascertain the implications of a change in economic policy solely on the basis of relationships observed in historical data which tends to be highly aggregated, is unadvisable. 4 Individual behavior can change in reaction to policy initiatives, which could render those initiatives ineffective. We had a real-life example of this last year with the Economic Stimulus Act of 2008. While the stimulus did lead to a brief pickup in retail spending, it did not generate an ongoing economic recovery. Certainly there were other factors involved, but the basic lesson was that such “rebates” were simply handouts that did not alter individual incentives to work, save or invest. In the short run, policy endeavors may appear effective at the macro level, but without any change in individual incentives, there is no long term stimulus to the economy. Debt/GDP: Flexibility or Trap Door? One argument for the flexibility of fiscal policy to adopt a large stimulus with associated large fiscal deficits is that the current U.S. federal debt to GDP ratio is modest compared to nations such as Japan (Figure 17). We are not convinced that this is effective reassurance primarily for two reasons. First, we depend on foreign 4 Lucas, Robert (1976). “Econometric Policy Evaluation: A Critique.” Carnegie-Rochester Conference Series on Public Policy 1:19-46.

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Five Key Questions for Decision-Makers February 10, 2009

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investors for much of the financing; nearly 60 percent of marketable debt is currently held by foreigners. Despite a recent up-tick in domestic savings we will need foreigners to foot a considerable portion of the coming bill. Second, future deficits/debts are expected to rise quickly due to the entitlement spending boom associated with the retirement of the baby boom generation. In our opinion, the current low ratio of debt to GDP is a trap door which could lead to a much heavier burden on future generations. Figure 17

Government Debt As Percent of Nominal GDP

175%

175%

United States: 2008 @ 68.6% Japan: 2008 @ 166.5% Germany: 2007 @ 65.0%

155%

155%

135%

135%

115%

115%

95%

95%

75%

75%

55%

55%

35%

35% 1991

1993

1995

1997

1999

2001

2003

2005

2007

Source: Global Insight and Wachovia

V. International Implications: Global Economy, Dollar, and Capital Flows Net exports helped prop up U.S. GDP growth in 2008 despite weakness in domestic demand. However, that support is winding down. Every major foreign economy is either already in recession or about to slip into one, due in large part to the pernicious effects of the global credit crunch. Economic growth in the developing world has also slowed this year. Global GDP will likely expand an abysmally slow one percent in 2009, the slowest year for global growth since records at the IMF began in the 1970s.

Every major foreign economy is either already in recession or about to slip into one, due in large part to the pernicious effects of the global credit crunch.

Outlook for the Dollar: Best Among a Weak Bunch The U.S. dollar followed a downward trend against most major currencies between early 2002 and mid-2008 (Figure 18). There are a number of reasons for the dollar’s decline. For starters, the large U.S. current account deficit exerted downward pressure on the greenback. Interest rate differentials moved against the United States, which reduced the relative attractiveness of U.S. assets to foreign investors. In addition, dislocations in credit markets caused new issuance of structured fixed

9

Five Key Questions for Decision-Makers February 10, 2009

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income products, which foreign investors had purchased in droves, to plummet starting in the autumn of 2007. Figure 18

Trade Weighted Dollar Major Curency Index, 1973 = 100

115.0

115.0

110.0

110.0

105.0

105.0 Forecast

100.0

100.0

95.0

95.0

90.0

90.0

85.0

85.0

80.0

80.0

75.0

75.0

70.0

70.0

Trade Weighted Dollar : Q4 @ 79.41

65.0

65.0 2000

2002

2004

2006

2008

2010

Source: Federal Reserve Board and Wachovia

We project that the dollar will continue to trend higher against most major currencies in the coming year, before turning in 2010. The current account deficit is about to get significantly smaller, which will exert fewer headwinds on the greenback. The underlying trade deficit has narrowed markedly as real exports have grown much faster than real imports. Now that oil prices have collapsed, the nominal trade deficit should decline rapidly. In addition, foreign central banks probably will be cutting rates more than the Federal Reserve in the months ahead. As interest rate differentials narrow, foreign capital inflows should strengthen, which should lead to dollar appreciation. The value of emerging market currencies has depreciated over the past three months as risk aversion has spiked and deleveraging has soared. As risk aversion retreats from extreme levels, many emerging market currencies could recoup some of their losses. That said, we project that the dollar will grind higher next year versus most emerging currencies as central banks in developing countries cut rates due to slowing economic growth and receding inflation. Capital Flows Favor Only the Safest Assets: Risks, Regulation and Taxes The latest Treasury International Capital System data indicate that not only did foreign investors continue to eschew (Figure 19) riskier U.S. assets such as corporate bonds and agency securities, but investors were net sellers of U.S. securities in November (Figure 20). Strong foreign purchases of very safe Treasury bills kept total capital inflows positive in November. Net purchases of long-term securities declined

10

Five Key Questions for Decision-Makers February 10, 2009

SPECIAL COMMENTARY

for the second consecutive month. The $56.0 billion decline in foreign purchases of U.S. securities was offset by the $34.3 billion drop in U.S. purchases of foreign securities. Foreign investors continued to eschew agency securities and corporate bonds in November. Purchases of short-term securities, especially Treasury bills, remained strong. In the current environment, investors are flocking to the safest assets. Figure 19

Figure 20

Foreign Private Purchases of U.S. Securities 12-Month Moving Sum, Billions of Dollars

$600

Treasury: Nov @ $221 Billion Corporate: Nov @ $50 Billion Equity: Nov @ $37 Billion Agency: Nov @ $12 Billion

$500

Monthly Net Securities Purchases $600 $500

$400

$400

$300

$300

$200

$200

$100

$100

$0

$0

-$100

-$100 98

99

00

01

02

03

04

05

06

07

Billions of Dollars

$160

$160

$120

$120

$80

$80

$40

$40

$0

$0

-$40

-$40

-$80

08

2004

Net Securities Purchases: Nov @ -$22 Billion 3-Month Moving Average: Nov @ $14 Billion 2005

2006

2007

-$80 2008

Source: U.S Department of the Treasury and Wachovia

Looking ahead, the risk avoidance trade will have a lasting impact on keeping foreign investors away from many corporate issues. In addition, the threat of greater regulation and higher taxes on capital gains and dividends suggest that capital flows will likely decline relative to earlier this decade. After the flight-to-safety trade evaporates, the cost of credit to the U.S. is likely to rise. This will be evident in higher interest rates, lower price-earnings ratios or depreciation in the dollar relative to earlier this decade.

In the current environment, investors are flocking to the safest assets. After the flight-to-safety trade evaporates, the cost of credit to the U.S. is likely to rise.

Conclusion In sum, further declines in consumer spending, business fixed investment and residential construction translate into continued contraction in real economic activity. By the time the economy hits bottom in late 2009, real GDP will probably have contracted more than three percent, the worst downturn since 1981-82. Employment may post the worst performance in 50 years, with declines topping five million jobs, or more than four percent of total employment. Underlying our forecast, however, is the assumption that policymakers will take the necessary steps to prevent the global financial system from locking up again. Should that assumption prove overly optimistic, global economic growth would end up even weaker than our already bleak outlook projects.

11

Wachovia Economics Group

John E. Silvia, Ph.D.

Chief Economist

(704) 374-7034

[email protected]

Mark Vitner

Senior Economist

(704) 383-5635

[email protected]

Jay H. Bryson, Ph.D.

Global Economist

(704) 383-3518

[email protected]

Sam Bullard

Economist

(704) 383-7372

[email protected]

Anika Khan

Economist

(704) 715-0575

[email protected]

Azhar Iqbal

Econometrician

(704) 383-6805

[email protected]

Adam G. York

Economic Analyst

(704) 715-9660

[email protected]

Tim Quinlan

Economic Analyst

(704) 374-4407

[email protected]

Kim Whelan

Economic Analyst

(704) 715-8457

[email protected]

Yasmine Kamaruddin

Economic Analyst

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