Student Loan Debt: How Serious is it and Where Will it Lead? (Part 2)

by Mark Schniepp
July 2018

Is the Student Loan Debacle a Bubble, and will it Burst?

In a word, and despite what Mark Cuban says: No.

However, student loan debt is still a problem due entirely to its enormity. It’s already having an impact on the economy, and this will continue for many years to come.

Why it’s a Problem

This particular debt issue is not a repeat of the financial crisis of 2007 that occurred when the housing bubble exploded. Student loan debt is not really a bubble that will pop. It’s more akin to a balloon that will slowly leak.

Most of the debt is carried by Millennials, who were born between 1980 and 2000 and are now roughly 18 to 39 years old. They are now the largest generation in the nation and represent the largest age cohort in the workforce today. Student loan debt is the largest debt load they carry and it will persist for many years hence.1

Debt is hampering overall spending by Millennials in the economy. This is especially evident for the existing housing market and the consumption that goes with it. There is decidedly less home buying during this economic expansion, and that means less homeownership. With lower homeownership, there is less spending on furniture, fixtures, and furnishings. There is less home building, and fewer architectural, engineering and construction services needed.

And other expenditures are being replaced by debt repayment, which produces less economic stimulus than expenditure on private sector goods and services.

Since you can’t get rid of these loans via bankruptcy (like you could with any other debt) borrowers are on the hook for them until they are ultimately paid. The only way borrowers can avert the debt is to flee the country or die.

Default is more likely to have a slow motion impact, in line with the notion of a leaky balloon.

Why there’s no Bubble

Most of the debt will be repaid over time, and both banks and the federal government could well make a profit from these loans. But if delinquency and default rates continue to rise, then the public sector loses.

Federal student loans constitute 85 percent of all outstanding student loans, and most of these loans are backed by guarantee, which means that banks making these loans through 2010 are not on the hook for payment default.2 The federal government is. Back in 2008 when the housing bubble popped, it was the financial institutions that took the loss. This time, it will be the federal government. We don’t expect to see a financial crisis spreading through the private financial sector.

But who really loses? You do. It’s your loss, the taxpayer, since you provide the government with most of its revenues for running government programs like federally insured student loans.

Bubbles burst when asset pricing in markets does not make sense. So a correction occurs. But the price mechanism that corrects does not exist for loans held or guaranteed by the federal government. So what happens?

Consequences Ahead

Taxpayers will be on the hook for providing the federal government with increased revenues to offset the losses. We already have large federal deficits and they are rising. This will only increase the size of the deficit until the public pays for it through taxation.

Education costs will be driven higher as students obtain loans and inundate colleges and universities. This notion was advanced by former Education Secretary William Bennett and is known as the Bennett Hypothesis. Students have relatively easy access to uncollateralized loans and this has led higher educational institutions to raise prices (increase tuition). Consequently, federal student aid has not necessarily made higher education more accessible or more affordable. The resulting education may ultimately not return an income stream that justifies the cost of that education. When this happens, the demand for education will decline.

Colleges and universities that did not contain their costs might become insolvent.

The federal government will continue to change its policies regarding student loans. Right now, it does offer loans to students that need assistance. Everyone else must obtain loans from private institutions. And interest rates on these loans are not always designed to hedge the overall risk factors that could lead to delinquency and default. There will be changes in how we finance higher education.

Look for student loan caps, higher interest rates, and the removal of loan forgiveness options for any borrower.

Finally, we might already be seeing a shift in Generation Z, currently the youngest generation who are just now entering 4 year colleges and universities. They appear to be much more calculating when it comes to higher education and are more apt to factor in college affordability and community college than Millennials were.

 

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1 The standard repayment plan for federal student loans puts borrowers on a 10-year track to pay off their debt, but the average bachelor’s degree holder now takes 21 years to pay off his or her loans. Under federal income-based repayment options, remaining debt is forgiven after 20 years.

2 Under the guaranteed student loan program, private lenders including Sallie Mae and commercial banks issued student loans that were guaranteed by the federal government. The program ended by Congressional mandate on June 30, 2010. Loans made since that date no longer have a government guarantee (unless they are direct government loans, or FFEL). Loans that default by student borrowers are taken over by the federal government and a contracting “guarantee agency” then services the loan. Banks are paid off by the guarantee agency and the latter attempts to collect on the loan.

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

 

Student Loan Debt: How Serious is it and Where Will it Lead? (Part 1)

by Mark Schniepp
June 2018

Student Loan Debt has Soared

With over $1.5 trillion in loans outstanding, student debt is now the second-largest source of household debt (after mortgage debt) and is the only form of consumer debt that continued to grow during the aftermath of the Great Recession.

The principal concern over the last few years has been the shear volume of student loan debt and the speed at which it is rising over time.

Per graduating student, debt loads are non trivial, and are now at their highest levels ever measured. The average student loan burden for Class of 2017 graduates was $39,400, up 6 percent from the previous year. More than 44 million Americans today carry some student loan debt.

Tuition costs have soared at colleges and universities. Between 1997 and 2017, in-state tuition at public universities jumped nearly 240 percent. During this same period, consumer price inflation increased 53 percent. Consequently, the cost of college and university tuition outpaced the general price level by 5 times.

And relative to expected income, tuition has increased to between 25 and 40 percent of an adult’s median household income. Back in 1970, annual tuition represented between 7 and 20 percent of the annual median household income. The result is that student graduates owe a far greater amount today relative to their current and future incomes than the baby boomer generation who graduated from colleges in the 1970s and 1980s.

Student loan payments average $351 per month for those who carry debt. If your starting salary after graduating from a 4 year university is $60,000 per year, those debt payments represent 9 percent of your monthly take-home income. Clearly, graduates earning less have a higher loan payback percentage of income, and this diverts household spending from private sector goods and services to federal loan repayment, an area of expenditure with a much lower, if any, economic multiplier.

Interest rates on new student loans currently range from 5.05 to 7.6 percent.1 This makes student loans more expensive than paying a mortgage. And this is especially true for graduate students (and parents) who face the highest rates from Sallie Mae. Freshly minted lawyers and doctors can have student loan debt of $200,000 to $500,000, which is often larger than a mortgage.

National University Rankings by Cost of Annual Tuition


School 2018 Tuition 2018 Enrollment 2017-2018 Acceptance Rate
Columbia University (New York) $57,208 25,084 5%
University of Chicago (Chicago) $54,825 13,322 8%
Tufts University (Medford, MA) $54,318 11,489 14%
USC (Los Angeles) $54,259 43,871 17%
Carnegie Mellon (Pittsburgh) $53,910 13,391 22%
Duke (Durham, NC) $53,744 15,928 11%
UPenn (Philadelphia) $53,534 21,826 9%
Boston College (Chestnut Hill, MA) $53,346 13,851 31%
Cornell (Ithaca, NY) $52,853 22,319 14%
Georgetown (DC) $52,300 18,525 17%
Source: US News, Best Colleges, 2018 National Rankings

The size of student loan debt and its growth over time has previously been the focus of attention, but now a growing concern is the default rate among borrowers.

Delinquency

New data show that delinquency rates on student loans may be going as high as 40 percent of borrowers by the year 2023. The default rate is already higher than anticipated for the particular student cohorts studied, so the federal government should be bracing for substantial non payment of debt.

Currently 58.5 percent of all direct student loans are in repayment, and 41.5 percent are not. Regarding those that are not, 23 percent are in deferment or forbearance, meaning the repayment is temporarily suspended with or without interest, on the request of the borrower. Five percent are still in the grace period and 15 percent are in default.

When a borrower defaults, he or she simply fails to pay interest or principal on a loan when due. So if the loan is federally insured, as most loans were up to mid-2010, then the Federal Government is on the hook. It’s the same thing as when the U.S. loans a few billion dollars to the Cayman Islands and they don’t pay it back. In fact, as of 2017, the Caymans owed the U.S. $302 billion. Canada owes the U.S. $380 billion. Neither of these countries is likely to default however, but countries have in the past like Mexico in 1994 and Argentina in 2001. And we can’t trace these defaults to an impact on our economy.

Can students merely declare bankruptcy to avert paying back the loan? No. Student loan debt is virtually inescapable and is precluded from debts that are dischargeable in the U.S. bankruptcy code.

Consequently, there are increasing stories online reporting how debt strapped former students are fleeing the country and hiding out from Sallie Mae and collection agencies.

Sallie Mae is the nation’s largest originator of federally insured student loans. It was formerly a GSE, but it is now entirely independent from the federal government.2

Is the Potential Flood of Defaulting Student Loans Another Looming Financial Crisis?

1. First, the Basics

Our lending systems generally work efficiently and borrowers don’t default on debt because lenders won’t make too many high risk loans. System risk rises when lenders extend unwarranted credit. This occurred during the housing bubble days of 2004-2007 when easy credit gave rise to massive home buying pushing selling values to record levels.

A bubble “pops” when prices correct to more accurately represent the intrinsic value of the asset. Clearly, home prices towards and at the peak exceeded the true value of those homes. Prices corrected, borrowers owed more than the home was worth, and there were unprecedented numbers of defaults and lender bankruptcies. Loans ultimately became restricted and this slowed down the economy because businesses had difficulty obtaining capital needed to grow, invest, and hire.

2. Student Loans

Is the current student loan debacle a bubble? And if so, when will it burst?

I’ll address this in the upcoming July newsletter.

 

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1 https://www.credible.com/blog/refinance-student-loans/what-are-average-student-loan-interest-rates/

2 A GSE is a government-sponsored enterprise, or a financial services corporation created by Congress to enhance the flow of credit to particular economic activities such as agriculture, home finance, and education.

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

 

An Update on the Recent Economic Evidence

by Mark Schniepp
May 2018

No Suprises

The employment report for April produced no surprises. Job gains remain relatively strong, the unemployment rate continues to tighten, and wage growth is ahead of inflation. It is curious that wages and salaries are not rising faster given the tightness of the labor market. This is disappointing for workers but it will keep the Fed on track for three rate hikes this year because inflation remains predictably in check. It’s likely that stock market volatility will also subside, at least for the meantime.

Why the Probability of Recession is So Low

The probability of recession rose in March but still remains low. The odds of a recession this year should be low because recessions occur when imbalances develop in the economy, and no glaring potential macroeconomic imbalances are forming.

The labor markets continue to create more jobs, and the financial markets, while exhibiting more volatility since January, still remain buoyant. A fully employed economy, rising housing values, improved access to credit, and low household debt are driving both the consumer and business investment engines of economic growth.

Consumer confidence remains near its highest level in a generation. The present economic climate is rated consistently more favorably while economic expectations remain strong.

Consumer confidence at these stratospheric levels is consistent with a fully employed economy, households with rising real wealth and low debt, and low inflation.

Further tightening in the labor markets is likely this year, even as the pace of job growth continues to moderate. Employment growth has gradually declined toward 150,000 jobs a month in the U.S. and 20,000 jobs per month in California. This moderation is expected to continue through the rest of 2018.

A decrease in job growth is not abnormal at this stage of the business cycle and should not be mistaken for an economic slowdown. However, as long as job creation continues to exceed the flow of entrants to the labor market (80,000 to 100,000 a month), the unemployment rate is very likely to fall to 3.5 this year. Currently, the rate is at 3.9 percent.

Slower population growth and aging of the population will continue to exert downward pressure on labor force participation rates which will restrain labor force growth.

Growth in the economy in 2018 and 2019 will have to be accommodated with fewer additions to the workforce, due to slow growth in the labor force and a labor market that has very little slack. Consequently, look for much greater investment in automating business processes and functions. This has been the subject of my March and April newsletters.1

The environment in California is even more austere regarding labor market capacity. The unemployment rate has now reached a level that it has not achieved since the late 1960s. And predictably, wages have been rising more sharply here than in the rest of the nation over the last 18 months.

This year employee compensation is forecast to rise 4.0 percent compared to a 2 percent increase in 2017.2 Average salaries are forecast to rise 3.0 percent in California this year, after relatively hefty gains of more than 3.0 percent in the Bay Area economy during 2017.

The Updated Forecast

Even though the stock market has been under pressure since January (largely because of rising interest rates), the rest of the economy has remained more steady. This includes consumer spending, business investment, manufacturing, and surprisingly, inflation.

I believe that economists are much more focused on inflation than previously, because the labor markets should be producing faster wage growth now.

We are watching for any unexpected movements in inflation because that would pose one of the bigger risks to interest rates and the economy this year.

That said, nothing seriously out of the ordinary is within view. At our vantage point right now, it appears that the economic indicators for 2018 will remain auspicious.

The consensus forecast has real GDP still on track to expand at a pace of close to 3.0 percent this year with a slowdown strongly projected for 2019 and 2020.

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1 For all of the monthly newsletters of the California Economic Forecast for the 2018 calendar year, please go here: http://californiaforecast.com/monthly-newsletter/

2 UCLA Anderson Forecast for the State and Nation, March 2018, page Nation-15.

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

 

Full Employment and Robots, Part 2

by Mark Schniepp
April 2018

In this part 2 of my monthly newsletter blog on robots, I’ll mention how our fully employed economy is rapidly accelerating investment in and implementation of a robot workforce.

Are We Actually Experiencing an AI Explosion?

The world of artificial intelligence is advancing so rapidly and in so many industries, countries, and applications, that to many it feels like the automated evolution is rising exponentially. Here is tech writer Tim Urban’s (waitbutwhy.com) illustration of just where we are on the timeline of human progress and the explosion that is allegedly right in front of us.

There is this notion that rapid growth in AI (or rather, explosive exponential growth) is here now or just in front of us. Tom Friedman’s best selling book, Thank You for Being Late, also supports this premise.

However, I don’t believe we are this far along the S-cure of progress, because implementation of robotic technologies is not evolving at light speed. AI trends such as virtual assistants, smart robots, and human voice adapting are still in their relative infancy and taking more time than initially thought to be really useful. While I think the future is soon, it’s not that soon.

Consequently there is time to prepare your company and your workforce for the robot economy. And it’s a good idea to start soon because there is no doubt that the robots are coming.

In last month’s newsletter I mentioned a couple of AI applications fully operational now. Aside from Flippy at Caliburger in Pasadena, there are many examples just in the past 18 months of robots successfully performing repetitive or mundane tasks in a variety of industries.

Robots are quickly expanding in the food industry mostly in China and Japan, but also here in California. The robot restaurants in China have replaced greeters, waiters and some cooks. They are growing more popular, even if only as a curiosity for visitors to experience being served by robot waiters.

For a number of years robots have largely worked in industrial capacities, bolted to an assembly line. Industrial robots are automated, programmable and capable of welding, painting, product inspection and testing, all with precision, consistency and speed. A study by MIT economists found that robots were responsible for the loss of up to 670,000 manufacturing jobs between 1990 and 2007 in the U.S.

Amazon and Walmart employ hundreds of thousands of machines within their warehouses and fulfillment centers that do much of the heavy lifting of goods, and filling and organizing shelves with the help of directing human workers.

The warehouse robots have replaced some humans and the growth of Amazon has created thousands of new human labor positions, but the massive growth of e-commerce including the numbers of new warehouse hires do not mitigate the overall retail jobs losses that have been the consequence of this growth.

Sea Change in the Use of Robots?

Now, a new generation of robots is here, capable of moving among people and therefore finding a wider range of work in stores, hospitals, hotels, and offices. And this has become a major cause of concern because the McKinsey Global Institute reported that 30 percent of the global workforce could be displaced by robots by 2030.

While robots employed now are not displacing too many workers, they will in the future as they become more dexterous and smarter, and as human workers performing repetitive tasks become too expensive. Robots don’t need to be paid the minimum wage (or any wage at all) and they don’t need healthcare, family leave, sick leave, “a change in perspective,” vacations, or worker’s compensation insurance.

There would likely not be massive unemployment because millions of new jobs would ultimately be created. Robots need repairmen, software programmers, circuit board designers, ergonomic specialists, etc. Consequently, robots do pose a disruptive force that will push us to seriously reevaluate our occupational training and skill set more carefully than ever.

This is a good thing because when human jobs are eliminated much of this can take place mainly through attrition, particularly as the baby boomer industry continues to progress into retirement.

Wages are now rising more rapidly in the fully employed economy, and this trend is likely to reverse as automation increases. Consequently, it is more important than ever before in human history to own skills that are deemed necessary for a rapidly evolving techno-economy.

Furthermore, companies must adopt coming trends in AI that can create competitive advantage and generate value. This is what Amazon has successfully done, (and not without major criticism for being one of the early and successful pioneers).

At a minimum, you can at least own assets that will rise in value as a result of AI growth. To me, this means owning shares of companies like IRobot, Nvidia, Google, Bosch, Ekso Bionics, Northrop Grumman, Honda, Boston Dynamics or Waymo. There are many others so now is a good time to conduct your own research.

 

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

The 2017 California Labor Market and How Today’s Full Employment is Accelerating Worker Robots

by Mark Schniepp
March 2018

We’ve been reporting for years that the labor markets in California and the nation are as healthy as they can possibly get, that anyone who wants a job can get one, and that technology has been the engine of growth during this expansion.

The state just revised the jobs numbers for 2016 and 2017 that affirm all of this, and then some.

The unemployment rate in California is the lowest since reliable records have been kept. My data for the state go back 50 years to 1968.

Technology employment, though slowing down, is still the engine of growth in California and remains the fastest growing sector of the Bay Area economy.

California created another 333,000 jobs in 2017, about 40,000 more than previously reported. My continued question about this is how can the state and its regions continue to produce more jobs when the unemployment rate says that the labor force is fully employed?

The only way to create new jobs is for the labor force to expand. Now the labor force is merely the population, 16 years or older, that wants to and is able to work. The labor force expands when seniors graduate from high school or college and enter the job market, and when graduates complete graduate school.

The labor force can also expand when people move to California from other states or countries, legally or illegally.

So 126,000 people that were previously unemployed found work last year and another 218,000 new people entered the labor force and were employed.

But this kind of scenario cannot continue much longer. At some point, the low unemployment rate will constrain employment growth and not just marginally like it has to date.

The Robots are Coming. No They’re Actually Here Now.

The tightness of California’s labor market is and will continue to manifest in onerous conditions for firms in recruiting new workers, higher wages and salaries, and more demands by workers for additional benefits, such as more paid time off, a better healthcare plan, or an office with a window.

Rare conditions like these accelerate the incentives by firms to pursue substitutions for human labor with more capital intensive investments. And with the new tax bill, there are additional incentives to explore labor saving automation. You see, there is full and immediate depreciation of capital spending, including investments in technology and equipment (like robots) that could soon or ultimately replace workers.

Consequently, with a fully employed and healthy economy in 2018, look for more news about the implementation of workplace robots, especially in the service industries.

Take Flippy for example, who just this month started working at CaliBurger in Pasadena. The robot combines thermal vision, 3D vision and computer vision. Flippy can cook 150 burgers an hour, flipping them at the right time and removing them from the grill perfectly cooked. CaliBurger says more “Flippies” will be flipping burgers at multiple locations this year.

In late January, the first Amazon Go opened in Seattle. The convenience food store allows shoppers to scan their phone upon entrance, grab whatever items they want off the store shelves, and automatically get charged after exiting the store without needing to stop at a register. In fact, there are no registers and the only employees in the store are those that prepare fresh food, check IDs for beer and wine, and stock the shelves with merchandise.

Not only does the new technology replace human cashiers, it eliminates the wait to check out which can often be as long or longer than the shopping time. Moreover, this new technology also renders shoplifting obsolete.

Another Amazon Go is apparently being planned for a location in the Grove in Los Angeles later this year, with another 5 stores to open elsewhere.

Since Amazon now owns Whole Foods, the “Go” technology might be headed that way in the not-to-distant future.

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

The Golden Age / Another Reminder

by Mark Schniepp
February 2018

GDP growth in the 4th quarter was 2.6 percent, which is in line with expectations. This amount of economic growth is not too hot and not too cold, and at this point in the economic expansion, it’s actually a decent number. Though most of the GDP reports during the current expansion are considered disappointing, the economy continues to hum along producing new highs in many key indicators along the way.

I wrote about this last year and conditions have only improved since. We are at fuller employment, a much higher stock market, higher consumer confidence, higher industrial production, and a faster than expected pace of consumer spending.

Why? Everyone has a job, business confidence and investment are strong, and the world economies are growing including the troubled ones like Spain, Greece, Ireland and Italy.

Last year I called it another Golden Age of the American Economy. These don’t come around often so enjoy it while it lasts. But that begs the question: How long will these times last?

The financial markets sold off sharply on February 2, and again on February 5. What does this mean? Is this a timely omen? Are we now in the midst of an inevitable fall?

As an economic forecaster, I’m always on recession watch, but admittedly I’ve been able to nap a bit at my post because the economy shows no tell tale signs of weakness.

A 2,000 point contraction in the Dow Jones Industrial Average (or a 200 point decline in the S&P 500 index) is actually a healthy sign for this market. The indices have simply risen too far, too fast and for too long without a pull back. We have been expecting some sort of correction for quite some time. Profit taking is inevitable and arguably, the price-to-earnings ratio is on the higher side of history and needs some adjustment.

Fundamentally however, corporate profits are higher and should continue to rise this year because of the new tax policy and a growing world economy. I look for the financial markets to stabilize and resume their upward march this year, albeit with a little more volatility than we’ve seen the last two years.

The probability of recession is unbelievably low and business confidence around the world remains surprisingly strong. Just because the financial markets are going through a correction doesn’t mean that economic momentum has changed.

 

The recent fire and flood disasters in California will only act as a further economic stimulus providing more opportunities for business expansion this year and next.

So don’t let a few hundred points in the S&P get you down…. not just yet anyway. The economy remains fundamentally strong and economists are generally looking for a stronger growth year in 2018 than we experienced in 2017.

Your List for 2018

  • Learn the basics about the new tax reform act and take advantage of it. Speak to a seasoned accountant this year because tax reform rules now apply. Part of this may ultimately be investing in your business with new capital and equipment.
  • Technology is changing at an accelerating pace so have your IT up to date and ready to change going forward.
  • Automate what you can. Hiring is more expensive and it’s so tough to recruit.
  • Business conditions are unlikely to change much this year. There will be more income and more spending because more people are working and earning a higher salary.
  • Interest rates will go higher. All forecasts have the 30 year mortgage rate moving higher through the year.
  • Nevertheless, home prices will still move higher. If you are waiting for a pullback in prices, it won’t be this year.

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

Welcome Higher Growth in 2018

by Mark Schniepp
January 2018

The Expansion Continues Through the Year

We are now in month 102 of the economic expansion, eclipsed only in recent times by the March 1991 to March 2001 expansion lasting 120 months. From what we can see at this vantage point in early 2018, the current expansion will at least challenge that record.

The Tax reform bill will result in a net gain in economic growth in 2018, despite all the wrangling commentary you’ve heard over the last 30 days. Tax reform will certainly have a positive effect on corporate profitability. And higher expected profits will drive stock market valuations.

So while it’s hard to see the 2017 stock market returns eclipsed in 2018, barring any episodic change in the world’s economy, the stock market advance is likely to continue. An expanding economy supported by low interest rates, low inflation and improving corporate profits all provide a favorable environment for stocks. The second half of 2018 is less certain, and cracks in the economy that are invisible now may begin to show. Hence more volatility in the market is likely.

Admittedly, tax reform could be modestly negative for housing, especially as the mortgage-interest and property-tax deductions will be scaled back some.

However, real estate is more highly dependent on local factors. Creation of higher paying jobs, for example, are lacking in certain parts of the nation. And though homes are much less affordable in California and other coastal hotbeds, there remains strong demand for higher paying positions, particularly in the technology sectors. The state continues to attract population from other states and abroad. Furthermore, there’s all those millennials living with parents. Are they ready to move out yet?

 

And incidentally, whichever city lands Amazon’s coveted second headquarters this year could become a sizzling housing market practically overnight, for better or worse.

The global economic outlook continues to improve. The expansion has been underway since 2010 but now almost all affluent nations are growing again. World GDP is forecast to rise 4 percent this year. Global growth will only heighten the demand for U.S. products and services.

What You Should Expect in 2018

Increased profitability and continued job creation

  • Due to lower corporate tax rates and a rising global economy

Rising interest rates

  • The fed is committed to higher rates, especially in an expanding economy

Rising wages

  • We are at full employment and rising wages are a natural outfall of this
  • If you need workers this year, recruiting will be difficult

More stock market volatility

  • Valuations are high and we are overdue for a correction

An increase in consumer spending

  • This is a no-brainer based on higher wages in a fully employed economy. Furthermore, stock market valuations are at record levels, household net worth is at record levels, and average real estate equity per household is just shy of the 2005 record level

A modest increase in inflation

  • A symptom of an expanding economy at full employment
  • The rate of inflation will be higher in California due to housing

More new homebuilding

  • Especially more affordable homes

A Note on Bitcoin

I mentioned it last month but said little. Why? Because there’s really not much to say. The meteoric rise in price has corrected some in recent weeks. Valuations for Bitcoin and other cryptos will ultimately head further south. The question is not if but when because the digital asset has no protection, no intrinsic value, plenty of substitutes, and its price behavior is indicative of a textbook bubble, driven by speculation. If you own bitcoin, you’d better be thinking carefully about an exit strategy. However, I do believe that the general class of cryptocurrencies is here to stay as a modern method of asset exchange.

 

 

 

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

It’s the Stupid Economy

by Mark Schniepp
December 2017

Well the title should actually read: “It’s the Economy Stupid.” I hope that got your attention because you’re gonna want to read this final feel good edition of the newsletter for 2017.

If you will recall, that was the old campaign slogan of Bill Clinton in 1992. And it’s still true today because it’s the answer to the question of why American households feel so optimistic about their economic futures. Except this time, conditions are stellar rather than lackluster as they were for much of 1992, prompting the regime change from Bush to Clinton.

Despite record numbers of retail closures this year, horrific fires, hurricanes, Kim Jong Un and an ugly World Series game 7 (for the Dodgers), the consumer confidence index rose another 3.3 points in November to the highest monthly reading in a generation, or since December 2000. Americans view their current and future job prospects very favorably; ditto their income growth and their spending levels. Consumers have been the strongest and most consistent source of growth in the current economic expansion.

The increase in household wealth has been stunning as wages are rising and stock and house prices have surged.

Last week’s Gallup U.S. Economic Confidence Index rose sharply, at more than twice the rate as the average weekly gain observed over the past year. Like the Consumer Confidence Index, the Gallup pole measures American sentiment regarding both current and future economic conditions. The Gallup current condition component of the index rose to its highest level since Gallup began tracking economic confidence in 2008.

The confidence indices are now at some of the highest levels ever recorded. Why? Because economic growth is accelerating, everyone has a job, incomes are rising, homes are selling, and the new Star Wars movie is about to be released.

Speaking strictly in terms of the economy, 2017 has been a good year and perhaps the best year during this up phase in the economic cycle, which began in July of 2009.

We are now in year 8 of the economic expansion and by next summer, we will be in year 9. Economic expansions rarely go for 9 years but this one is clearly headed that way. We have no indications at this time that the economy is vulnerable. And fortunately, there are no bubbles, except for Bitcoin.

The economic expansion continues to power forward. Recent economic data have exceeded expectations and in some cases by a wide margin. Along with strong confidence in the economy, the unemployment rate is the lowest since 2001 and October existing home sales rose to their highest level since 2007.

Furthermore, third quarter 2017 gross domestic product growth was revised higher, from 3.0 percent to 3.3 percent. The nation is now growing at the fastest pace since 2014. We are likely to see approximately 2.7 percent growth in the current quarter of 2017 with consumer spending leading the charge. Remember, hundreds of thousands of vehicles need to be replaced in Texas and Florida. And tens of thousands of homes need major repair.

The likelihood of recession over the next six months is now at the lowest level since the risk of recession index was invented, back in 1996. If there is a chance that the economy will change over the next six months, it’s likely going to be faster growth because of impending tax cuts, fire and hurricane rebuilds, infrastructure spending, and a rising stock market which is already at record levels.

The Senate Finance Committee passed its tax reform plan. The full Senate will now consider the bill. The potential for tax reform is a further contributing factor for high consumer confidence and record stock valuations.

OK, Conditions Appear Safe for Now but What are the Seeds for the Next Recession?

A myriad of conditions can produce a recession, but the ones that we can identify in the current environment are these:

  • Overly tight monetary policy
  • A supply shock
  • Another financial crisis

The Federal Reserve is expected to hike interest rates in December and several times in 2018. Despite low inflation of 1.3 percent in the core consumer price index, the Fed will decide that GDP growth is strong enough to boost the short-term federal funds rate to 3 percent by 2020 from 1.25 percent today.

Long-term rates that affect mortgages are likely to stay low if inflation remains contained, which we expect to be the case for a while.

So while the fed is trying to tighten monetary policy, their prescription for raising (normalizing) interest rates is very conservative and cannot be interpreted as “overly” in any sense of the word.

A supply shock is just that, a jolt to the domestic or world economy that is a shock, or unanticipated. We can’t predict one and it’s unlikely to happen. We do see that geopolitical risks are rising especially between North Korea and the U.S., so we are watching this with particular interest. But we can’t otherwise predict a random event.

Another financial crisis is also very unlikely because of regulations put in place since the last financial crisis. Banks are quite healthy today. Nevertheless, international incidents including defaults by entire countries (like Greece or Spain) might always occur, especially in the very slow growth environment of Europe. We don’t see this as a major risk, nor even a minor one. The European economy is actually strengthening, as is much of the rest of the world.

At this writing (December 2017), it appears that we will avert recession for another year. So plan accordingly.


The new 2018 Edition of the New Development in California report is now ready for purchase.

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The report documents the principal new non-residential and residential building projects under construction or in the pipeline all over California. This is a must report for all construction and building material contractors, and anyone that needs to understand the new development environment by region in California.

 

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

The Proposed Tax Reform of 2017: How Will it Impact You?

by Mark Schniepp
November 3, 2017

Key Elements of the New Tax Reform Plan

So as of November 3, here are the key components of the House Ways and Means Committee’s tax reform proposal, before any further revisionist intervention from the full House or Senate:

The maximum corporate tax rate would be cut from 35 to 20 percent. Many business expenses would no longer be deductible, except expenses on R&D, low income housing, and some other miscellaneous expenses. Depreciable asset expenses can be deducted entirely.

There are 3 proposed tax brackets for individuals: 12, 25 and 35 percent instead of the seven that now exist.

The AMT (alternative minimum tax) would be eliminated. The standard deduction for middle class families would be doubled.

The estate tax would be gradually reduced and entirely repealed in 6 years.

The inherited wealth exemption would double from $5.5 million to $11 million.

Tax credits for children will increase from $1,000 to $1,600.

Itemized deductions would be eliminated, except for charitable expenses and the mortgage interest deduction which would be capped for newly purchased homes up to $500K.

Also property tax deductions would be retained but only up to a maximum of $10,000.

State and local taxes would no longer be deductible.

There would be no changes to pre-tax 401(k) contributions.

There is a new 25 percent tax rate for sole proprietorships, partnerships, and S corporations that currently pay taxes at the individual rate of their owners. These type of businesses represent about 95 percent of all businesses in the U.S. and produce most of the corporate tax revenue for the U.S. government.

How Will this Impact You?

If you own a home in coastal California and you’ve purchased it in the last 4 years or so, your property taxes are likely in excess of $10,000 annually. So you will not receive the full benefit of the property tax deduction. However, the standard deduction roughly doubles from $6,350 to $12,000 for individuals and $12,700 to $24,000 for married couples.

If you are a business owner, you are very likely to see a smaller tax obligation. And if a large part of your business expenditure is for research and development of the business, or equipment, software or the purchase of a building, then your tax liability will go even lower because those expenditures will be deductible on top of the low 20 percent maximum rate.

Do We Need Tax Reform?

The hieroglyphical tax code that we all have to navigate through each year to determine both our personal and our business’ tax obligation is constantly changing and seemingly growing more complex. For anyone that has filed a tax return beyond the standard 1040 form, their answer is a very likely yes. We desperately need tax code simplification.

Does the economy need a tax cut? Well, growth has remained strong even as the administration and the Republican-led Congress have struggled to enact economic programs. And despite all the campaign rhetoric about jobs and businesses going overseas because of high corporate taxes, the economy has remained ruggedly resilient, the unemployment rate is the lowest in 17 years, real wages are rising, and GDP growth is accelerating.

Tax reform is always welcome, but do we need a tax cut to stimulate economic growth? No, not right now.

Conclusion

For me, any tax reform that is an actual reduction in my taxes is a good thing. I would much rather control the expenditure of my own income than I trust the federal or state government to do. So any tax cut is welcomed, providing it actually does reduce my taxes.

As Californians, some of us will face a higher tax bill due to the fact that we won’t be able to deduct all our property tax payments. This is especially true if you purchased a home recently in the Bay Area, or coastal Southern California. Moreover, the state income tax payment is non-deductible and California income taxes are higher than anywhere else.

Also, the home mortgage deduction on new purchases will be capped for many new home owners in the higher housing cost areas of the state. This includes Santa Barbara and Goleta, coastal Ventura and Oxnard, the Conejo Valley, most of LA and Orange County, and coastal San Luis Obispo County. A reduced mortgage rate deduction will impact the decision to buy a home in California, so fewer home sales next year are likely. Realtors are naturally against this.

If you already own your home, you’re not going to be affected by the limits on the mortgage deduction. If your household income is above $250,000, then the elimination of the state income tax deduction will hurt you, but as an offset, you’re likely to benefit from the business tax reforms.

The Tax Foundation in Washington D.C. has evaluated the plan and according to them, households from the full range of incomes would benefit with at least a modest tax reduction.

Critics say this plan will hurt the poor. This is nonsense simply because the poor do not pay any state or federal income taxes. The bottom 35 percent of Americans will not get any extra benefits, because they already have a $0 federal tax liability.

Might this plan increase the deficit? Yes, it likely will. But I see the deficit as it’s own issue which does not have to be addressed when discussing tax reform. Why? Because there is always expenditure reform which many people erroneously assume is unreformable. The Senate must consider expenditure reform if they hope to pass tax reform with a 51 vote majority. Otherwise, the plan is dead.


Upcoming Presentation:

Santa Barbara Executive Roundtable
“Anticipating and Bracing for the Next Recession…”
Panel discussion with Mark Schniepp, Brian Johnson, Keith Berry, and Justin Anderson
November 9, 2017
University Club, Santa Barbara, 8 AM

 

Register Now

 

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.

Irma and Harvey and Their Effect on the Economy

by Mark Schniepp
October 2017

First Half GDP Growth

Second quarter real GDP rose 3.1% at an annual rate, up from 1.2% in the first quarter. That’s a decent economic growth rate for the U.S. at this stage in the expansion, but not a great one. The third quarter of 2017 is now in the books. How did the economy do and what does that mean for the final quarter of the year?

We can’t forget that Irma and Harvey struck in the third quarter of the year. They destroyed nearly 1 million cars and damaged over 200,000 homes in Texas, and nearly every home in the Florida Keys. More than 20,000 homes were completely destroyed by both hurricanes.

Damage Valuation

The carnage is still being assessed and will change with more information, but at the end of September, the latest estimates for the cost of Hurricane Harvey’s damage range from $65 billion to $190 billion. In the event the actual cost falls on the higher end of that range, it could become the most expensive disaster in the history of the U.S.

Meanwhile, Hurricane Irma damage could end up costing between $50 billion and $100 billion. Irma was the bigger storm but the property damage due to flooding was much greater with Harvey.

The storm and floods have interrupted 20% to 40% of U.S. refining capacity. The damage to refineries was serious and caused gasoline inventories to sharply decline, affecting gasoline prices. Consequently, the Department of Energy released 5 million barrels of oil from the Strategic Petroleum Reserve to bolster supply.

Despite all the carnage and tragedy, the hurricanes hardly affected consumer optimism; the assessment of present economic conditions hiccupped in September, while expectations of future business conditions moved higher. Consumers still believe jobs are plentiful and they expect their incomes to increase over the next 6 months. Their buying plans have slightly declined for homes and cars but have increased for major appliances.

It does appear that Harvey impacted new home sales in August because that metric was off 3.4 percent during the month. We know that the September numbers will be more negative when they come in next week. However, new home sales have slackened elsewhere as well and not just in Texas and Florida. So the hurricanes are only partially responsible for tepid U.S. home sales.

Spending during August was also affected slightly, with less retail sales of general merchandise and less consumption of utilities (because of power outages). Nearly 6.9 million homes were left without power in Florida, Georgia, North Carolina, South Carolina and Alabama.

The damage and closure of Gulf located refineries notably pushed gasoline prices higher following Harvey in Texas. However, average U.S. prices are now falling precipitously again. In California, the price spike was much less significant.

 

Who Loses and Who Wins

An estimated $20 to $30 billion in economic losses are the immediate impacts resulting from business interruptions, such as idle hotels, closed stores, shutdown refineries, workplaces closed and people unable to go to work, Disneyland, SeaWorld, and Universal Studios—all closed. Spending was therefore curtailed on energy, home buying, car buying, and tourism. There is an estimated 50% to 70% loss of Florida’s citrus crop, valued at $1 billion. The estimate for third quarter GDP is predicted to be ½ percent lower because of the hurricanes. So perhaps a rate of between 1.8% and 2.3% is anticipated.

But we fully expect that total economic activity linked to rebuilding and replacement spending will compensate for any short-term economic losses. Already, Congress has allocated more than $15.3 billion in hurricane relief funds to the more than 1 million applicants for federal aid so far.

This means the economy, as a whole, will not only be okay, but will likely see a surge in GDP growth during the first half of 2018. Stay tuned for more updates in future newsletters.

 

The California Economic Forecast is an economic consulting firm that produces commentary and analysis on the U.S. and California economies. The firm specializes in economic forecasts and economic impact studies, and is available to make timely, compelling, informative and entertaining economic presentations to large or small groups.