A Mid-Year Economic Report

With Pat Becker Jr., Bill Conerly and Tim Duy

Twice yearly, BrainstormNW invites the regionís expert economic voices to give readers an in-depth evaluation of the current financial situation and their predictions for the future. This mid-year roundtable included Pat Becker Jr., portfolio manager and analyst at Becker Capital Management and frequent contributor to Bloomberg News; Bill Conerly of Conerly Consulting, a founder of Cascade Policy Institute and author of ďBusinomics: From the Headlines to Your Bottom LineĒ; and Tim Duy, University of Oregon economics professor, author of the Index of Economic Indicators for Oregon and former economist for the U.S. Treasury Department during the Clinton administration.

BrainstormNW: Were you expecting GDP growth in the first quarter to be positive or negative?

Bill Conerly: I had a negative number for my forecast for the first quarter.

Tim Duy: I had it flat. The number was better than I anticipated. I donít know if that fundamentally alters my world view. The basic story, that the economy did slow, and did so significantly, and that the consumer feels that there is a significant negative downturn, still holds.

Pat Becker Jr.: There are silos within the economy that are in recession and silos within the economy that are not. When you look at areas of the economy, such as exports, or regions, such as Wyoming and Montana, these areas are not in recession. Jobs have been fairly resistant.

BNW: Whatís going to happen to commodity prices, with the pressure of the newly emerging middle classes in Asia wanting or demanding Western lifestyles?

Becker: What needs to be addressed is the amount of speculation that is going into this. Not only energy, but commodities in general. I see clients being told all the time, ďHey, you need to have energy or commodities as a significant part of your portfolio.Ē The next bubble will be commodities.

Duy: If this is the next bubble, we are still in the early stage of that process. There is an increase in demand that has been faster than you could bring new reserves on line. We know there is going to be a lag time until we get new reserves. If we talk about the deep water drilling in Brazil, that suggests a significant amount of time to get reserves. Any good bubble has a story that is honest. There is truth underneath it. That is how you keep it going. The same thing goes for food. There is something to that story. We are going to have a huge middle class in China and Asia that wasnít there before. That is going to have an impact. It is not clear to me that we are in the early or late stages of this bubble. I tend to think the early stages.

Becker: Concerning open option contracts on the Chicago Board, we are up four times in energy. So there is a ton of speculation in those markets. It is not like Federal Express or Alaska Airlines are trying to hedge; you have speculators in the market buying oil futures. Part of it is supply and demand, and part of it is speculation within the investment class.

BNW: Are we in for a long period of slow growth?

Becker. Yes, a period of nominal growth.

Duy: That is my view, too.

Conerly: I am more optimistic. We will see less than 1 percent in the first half of 2008 and then in the 3 percent range in the third and fourth quarters, and better than that in 2009.

BNW: When are layoffs going to start?

Duy: If you look at initial unemployment claims, I donít believe they are going to spike the way they did in the last few recessions. They are going on at an accelerated pace, but not like we saw in 2001. That is the nature of this downturn. It is not the technology investment downturn that we had the last time. The recovery from that last downturn was not impressive. This downturn is driven by housing/consumer spending and that is a little bit different than an investment technology downturn.

Becker: It will be more like a 1990-91.

Duy: We saw a subpar period of job growth following 2001. I expect another period of subpar job growth. Especially if we get the story that the housing market is slow to boom. There are a lot of excess employees in those industries. Between mortgage and construction, they have to find somewhere else to go.

BNW: Will it affect state revenue?

Conerly: Right now the state revenue is holding up well. I am concerned that the state is not doing contingency planning. We are halfway through the biennium. This would be a good time to defer things that can be deferred. Slow down hiring when possible so that if you do get bad news you donít have to hit the wall. This state administration will not do that kind of contingency planning.

BNW: Gov. Vic Atiyeh cut the budget by 25 percent, and Kulongoski had to cut the budget by $2 billion in 2003. Will this be like that situation?

Duy: No. It is where you go from here. The difficulty is creating rapid growth. If you have a slow growth environment going forward, you will have slower revenue growth.

BNW: So the economy is basically sound?

Duy: Some sectors are doing very well. Some sectors are doing poorly.

Conerly: What we think of as a recession is when the problems in one or two silos of the economy spread. We are seeing some of that in consumer behavior. But it is not severe. We are seeing some of it in business capital spending, which has been flat for nine months. We have had it spread enough that on the breadth of criteria, we qualify for a recession. We just havenít see it go down enough. We have got the breadth, but not the depth.

Duy: Some say their industries are in recession, but in aggregate you donít have the depth. When you look at business capital investing, the ISM index, for example, things that would normally point to a recession or not, are saying no.

BNW: Is the investment banking crisis over?

Duy: I would say probably not. The attitude on Wall Street seems to be that the Fed and the government have decided to do anything they can to make sure it doesnít go further.

Becker: Jamie Dimon, CEO of JPMorgan, spoke last month, and what makes him a pretty good CEO is that he is forthright. He thought most of it was over.

Conerly: That is plausible. But with securitization we developed some complex securities, mortgage-backed securities, collateralized debt obligations, that you need to run 10,000 well-crafted simulations to get a sense of how to value them. People are not running those simulations; they are relying on shorthand results of somebody elseís simulation. As a result, a lot of investors, not just Wall Street houses, but mutual funds, the private managers, the hedge funds, they are holding assets and they donít know what they are worth. They donít know what their underlying value is. So it wouldnít surprise me if somebody else suddenly wakes up and looks in a box and says, ďOh God, I didnít know how stinky this was until I opened the box.Ē

BNW: How come housing prices fell 20 percent and the economy still grows?

Conerly: Most spending is driven by income. If people still have jobs, are getting dividends, interest, and rent, they spend the money.

Duy: There is no doubt that a certain amount is driven by housing growth, and weíve taken that away on the consumer side.

BNW: Business Week said that half the expansion in the years from 2002 to 2007 was driven by the housing market.

Duy: One and half percent per year would be half the expansion. That is an issue going forward. Where do you get that next source of money? That is why I have a cautious outlook.

Becker: That is why I am on the slower growth side as well.

Duy: I am pessimistic about where the next burst of spending power comes from.

Conerly: You donít think garden variety disposable income does it?

Duy: I would love to see that, but we havenít seen that organic growth. We would like to see wages start to rise more quickly to compensate, but medium household wages have been pretty stagnant for six years.

BNW: Comment on the condition of the credit market. Do you worry about D.C. regulatory efforts?

Conerly: Yes. We will get regulatory overkill. The fact is that the players on Wall Street made a couple of mistakes. They misjudged the cyclicality of housing, which is understandable. Weíve had 25 relatively stable years, and the last recession was mild for housing. They forgot that housing has downturns, and then they created these mortgage- backed securities that were too complex too understand. It blew up on them. They will make future decisions with an understanding that housing markets can go down, and they will be cautious about overly complex securities.

Becker: They went to all these institutions and said we have this Triple A-enhanced investment. You will get equity-like returns with bond-like risk. That product was sold everywhere. And all these guys bought it ó hedge funds used it. Where did that money come from? In investment pools most people have been saying you donít want to be in large U.S. stocks. You look at the S&P returns for the past 10 years, and you are looking at 3 percent or less. You would have done better in a money market than the S&P, even though earnings have grown at the time at a nice clip. That reallocation shift, within these large pools of money, away from large U.S. equities, into international markets, into these types of securities, we think now goes the other way. If you are a trustee of a state pension, you say, ďYou told me it was Triple A. You told me I would get equity like returns. Iím not getting it. Iím not going to take the risk anymore.Ē So you go through the risk avoidance cycle. We think large U.S. equities are fairly cheap. We will see a tailwind. You are talking about allocation shifts. It takes awhile.

BNW: So there is enough liquidity in the economy?

Conerly: Yes. I keep my fingers crossed. Risk is more expensive. There is still the potential for some collateral damage, where one sector of the finance world gets very scared and nervous and closes down for three to six months. Maybe it will be commercial mortgage-backed securities.

Duy: It is not clear outside of housing that there is a huge credit problem.

Becker: I just had a specialty food company that did a commercial building. It was tougher for them. They have $8 million in sales. It is a food business, so it is fairly stable, and has been growing.

Duy: But they got it.

Becker: Yes, they got it. But it was tougher.

Duy: That is what I am hearing ó people who used to get approved one day later are getting approved two weeks later and going through hoops that they wouldnít have been asked to go through.

BNW: How long will the housing slump last?

Conerly: Through í09.

Duy: Who is going to make the loans? What kind of conditions? If you have an area where the median income is $60,000, what house does that afford? A house for $200,000.

Becker: If you were able to convert farmland quickly to construction, you are hosed for a long time ó even a place like Boise that has great inflow. We are going to be okay because for the most part UGB keeps supply somewhat tight.

BNW: We reported last month that supply isnít tight in Multnomah Country ó that there are 7,500 unsold condominiums, a decadeís worth of inventory.

Duy: You can get problems building up, as much as building out. The argument is that Portland is getting into some problems building up, rather than building out.

Becker: Bend was the market that was the weakest for home sales. Behind that was Medford. In Bend, they reverted back to something that is not inconsistent with the 1990s, which might be consistent with their fundamental inflow. There are 7,000 excess homes, and there are 5,000 bare lots of land in Bend. Given the amount of farmland you could plow under, these are not crazy numbers.

Conerly: A lot of folks in the housing boom were looking at second homes as an investment. Stocks were down in 2002, so they bought a second home. But the house doesnít cash flow off of rentals. The market turns, and they are still up over the price they paid in 2003. So they say, letís liquidate.

Becker: Where the pools of money go is important. In 1999, they got burned in the market. Then 2000 to 2002 were bad years, and everybody said real estate Ė and you had the big bubble.

Duy: Housing will not bounce back in any significant way soon. You are going to have to return to something more conventionally financed based, which is that roughly 30 percent to 33 percent of income is acceptable to spend on housing. That would translate to something more like three times the median income. Other things have gone down in price. How do you put a higher percentage of your household finance at stake in housing?

BNW: Has the psychology of housing changed?

Duy: It used to be that a house provided a service, and that it happened to have a secondary benefit as a decent investment, too. When it shifted to being an investment, having this secondary benefit of a home, your psychology about it changed. We shifted the psychology and we were willing to take more risk on the house because it always goes up. We ended up buying more house than we could afford.

Conerly: Donít forget the role of falling interest rates. Two times income is unreasonably conservative in a world with a 6 percent mortgage rate.

Duy: Three times income is closer. It comes down to how much people worry about their futures. Pat, what do you think of the national savings rate?

Becker: Too low.

BNW: The Oregonian reported 1,300 high-end unsold condominiums in Multnomah County. We reported that leading bankers thought the number was 7,500. Jerry Johnson of Gardner Johnson corroborated our reporting.

Duy: I wouldnít be surprised if it was high. Who knows how many of these are investment properties that people are going to want to sell as soon as they go up in value?

Conerly: The number is big if you include people who would sell if they thought there was a market.

Duy: Also, how many have been converted into apartment complexes? That suggests there is a significant glut.

BNW: If you end up with close to a decadeís worth of inventory, and you publicly funded part of it, then you might think about the broader agenda and why it goes under- reported.

Duy: Public policy here is to encourage urban growth. If you have a less desired place, for whatever reason, sometimes you need some public subsidy to get it running. Maybe it is just unfortunate policy during a housing crisis.

Becker: Time will tell, but the key to the success of the strategy will be the attraction of businesses. Fill those spaces up after the 10-year property tax abatement is over in the Pearl, and then youíve got something ó youíve got a vital core downtown.

Conerly: Are you just pushing peas on a plate? The real fallacy of tax increment financing, is that if you say we are going to gussy this up, and the increment of property value goes up, you move people from one part of the metropolitan region to the area. It is a zero sum game unless you are bringing in new jobs from out of the region.

Becker: I see a strategy of putting the infrastructure for the condos around it, but I donít see a plan to attract businesses in your downtown core.

Duy: The assumption is that if you get the people, their businesses will come. But it is not clear that is happening.

Conerly: We didnít need South Waterfront on top of the Pearl.

BNW: Gov. Atiyeh says that government doesnít create jobs; it creates the atmosphere for jobs. Mayor-elect Sam Adams told us that he needed data on the subject, and then he would know how to help create jobs. What is the role of city government in planning to create jobs?

Becker: Firms like ours pay 90 percent of the cityís Business License Fee. Standard Insurance across the street could pay a fraction of what we pay because they have a lobby. Where as an investment firm with 27 employees, we donít. We pay our employees extremely well. Our benefits are above average. We are the type of company that you want downtown. We gave $158,000 to charity last year.

Conerly: How about Kruse Way?

Becker: Yes, we are looking. It is quite possible. With us go the 400-plus companies that come downtown to visit us, have lunch at the Heathman, stay at the Hilton. The CEO for International Paper was in our office this morning, those guys walk in and say look at Portland, what a great place. Mt. Hood is out this window, Mt. St. Helens out the other. That will be gone ó they are going to see Kruse Way.

BNW: Mayor-elect Adams said that when he gets some new data, then he will be able to do something about the economy.

Duy: That is part of the problem right there ó thinking that you can do something about it, other than the infrastructure, creating the environment.

BNW: Adams said that 21 percent of residents in Portland are making poverty level income versus 9 percent in Seattle. He would like to have that studied.

Becker: City Hall believes business is bad, that we are a bad entity. Big Business is bad. Well, we donít have any big business in Portland.

Duy: Why is that?

Becker: Keep Portland weird. There is this mentality that business is bad, that business is just out to screw their employees, screw the world. Thatís not necessarily true; you need to have business or we donít have jobs. Nothing against Kruse Way, but Iíd rather be downtown. Rents were expensive on Kruse Way versus downtown. Now that is starting to come into equilibrium, you are looking at companies making a harder decision. By the time City Hall figures it out, looks at the data, it will be too late. There are some software companies that have revenues of $20-30 million, and you ask why are you downtown? They say they can attract talent. You have the law firms that have to be downtown.

BNW: Michigan is running a TV ad with the actor Jeff Daniels saying that Michigan is the green state. Mayor Richard Daley of Chicago says Chicago is the leading green city. Is there a possibility that there are 100 communities around the nation who are each telling themselves that they are the green city and they will attract green industries?

Conerly: Every company has the green product. We are all just lathering ourselves up with BS on the subject.

BNW: So there could be a lot of talking to ourselves without a lot of economic growth?

Conerly: Right. All of the communities that were going to be the center of biotechnology are now the centers of sustainable business.

Duy: Not everybody can be the greenest city. Iím not entirely sure what that means.

BNW: When you look at economic indicators three or four years down the road, will Oregon being the greenest state indicate growth?

Duy: If it does turn out that we have some special comparative advantage, it will show up. I am not convinced that because we say we have a comparative advantage that we actually have one. Everybody says they have a comparative advantage.

Becker: The only place I see as a possibility is on the semiconductor side, in solar energy. We already have a core competency with water and electricity.

Conerly: You use the same technology to make solar panels as you do to make computer chips.

Becker: Yes, it is a semiconductor that takes that power and converts it efficiently. The problem with solar power is that it hasnít been efficient. But if solar power gets improvement in the technology side and there is a ton of dough being thrown in that area, then it looks better.

BNW: So we might attract some of those companies?

Becker: Yes, if you were to make a case on leveraging some of our key strengths, then that would be an area. But you donít know if itís going to happen.

Duy: It is not bad to say that you want to be sustainable, if you can define what that means. Some of these opportunities might happen regardless of whether or not you say you are sustainable.

Becker: If I were going to bet on these technologies, I would bet on the solar. I think there has been a lot of work done in the 1970s, 1980s and 1990s. Mooreís Law can be applied to it. Applied Materials announced a billion dollar tool order for solar plants. Venture capitalist Ralph Shaw would say that the problem is that we fund these solar companies here in Oregon, but the money comes from San Francisco or someplace, and they will get successful and then move them out of here.

Duy: Which gets back to how few Fortune 500 companies we have here.

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