Economic update

The credit cycle is set to turn. After two years of steadily weakening loan growth and eroding credit quality, the worst is nearly over.

Commercial banks have struggled with an increasingly difficult environment since Y2K. Overall loan growth has come to a virtual standstill--the weakest lending growth since the credit crunch of the early 1990s. Commercial and industrial (C&I) lending has been especially difficult, as businesses' credit needs have weakened with their reluctance to expand and lenders have grown more circumspect in extending credit. Residential mortgage and auto lending have remained bright spots for lenders, although booming refinancing activity has knocked the wind out of credit card lending, and auto loans have expanded only because of unprecedented zero-percent financing deals.

Commercial loan quality has also deteriorated substantially since Y2K. Delinquency and charge-off rates on C&I loans are near record highs, as are personal bankruptcy filings and losses on credit card portfolios. Credit problems for residential mortgage loans have also risen measurably despite surging house prices and homeowners' equity.

Economic rebound. Despite lenders' current problems, the prospects for a turnaround in loan growth and credit quality are improving quickly. Continued low interest rates and somewhat tighter underwriting standards are important to this anticipated improvement, but most important is the firming economy. Last year's recession gave way to recovery early this year, as is evident from the robust near 6% first-quarter gain in real GDP, solid growth in retail sales and industrial production, booming home sales and house price gains, and most importantly, a resumption of job growth.

The economy's recent gains are most fundamentally due to surprisingly resilient productivity growth. The productivity of nonfinancial corporations exhibited no slowing in last year's recession and spurted substantively higher early in the recovery. Underlying growth appears rock-solid at just under 2.5%. This pace of growth has been enjoyed since the mid-1990s and is well above the less than 1.5% per annum experienced in the previous quarter century. That productivity growth simply remained positive last year stands in striking contrast to the productivity declines experienced in every other recession.

Supporting the stalwart productivity gains is the seemingly still rapid pace of technological change. All-important semiconductor technology appears to be advancing at an even more accelerated rate. Partially driving these advances is fierce competition between Intel and AMD. Heightened competition is also fueling productivity gains in other important industries such as retailing, where WalMart is quickly grabbing market share. The investment boom surrounding Y2K included some bad investment decisions and thus the overcapacity that is weighing on current investment plans, but much of that investment is only now being effectively utilized.

The benefits of the continued strong productivity growth have predominately accrued to workers in the form of solid compensation gains. Close to 1% of the nation's jobs were lost in the recession, but those workers who held onto their jobs were largely able to maintain their pay increases. When combined with lower energy and other goods prices and tax cuts, real disposable income gains have experienced little weakening. Consumers have thus remained willing and able spenders.

Strong and more recent accelerating productivity gains are also arresting the long-running erosion in corporate profit margins. Even though businesses continue to have difficulty raising their prices, inflation is now stronger than the growth in unit labor costs. With corporate interest payments declining and material costs low, profit margins have hit bottom, and corporate earnings will rebound quickly with any pickup in sales.

Businesses are expected to step up their investment spending as corporate earnings improve and businesses come under increasing pressure to upgrade their equipment and software to remain competitive.

Business hiring is also expected to improve steadily, and unemployment, which is expected to peak at just over its current 6% in coming months, will fall throughout much of next year. The economy's longer-term prospects also remain bright, as the resilient productivity gains throughout last year's recession augur well for productivity during the coming expansion.

Conclusion. The turnaround in credit conditions will become evident this summer and fall. C&I loan growth is expected to rebound in coming months as businesses' credit needs increase with greater hiring and investment. Credit card lending is also expected to pick up smartly, in part because mortgage refinancing activity is expected to fade with expectations of somewhat higher mortgage rates. Homeowners have been using part of the cash raised in cash-out refis to pay down their higher-cost credit card debt. Auto lending is also expected to soften as the vehicle makers eventually pull back on their aggressive financing deals.

Credit quality will also improve in coming months. Even if bankruptcy reform legislation is passed in coming weeks, the peak in personal bankruptcy filings is expected to be not much more than 1.6 million filings in the third quarter. C&I loan credit problems are also expected to peak soon, with delinquency and charge-off rates falling measurably by year's end.

Despite the sanguine near-term credit outlook, substantial downside risks still abound. The incipient economic recovery is still fragile and could easily be short-circuited. Energy prices could spike depending on events in the Middle East and this summer's weather. Consumers could also pull back on their still aggressive buying if businesses don't soon become more aggressive in their hiring. The recent weakening in the dollar could also turn into a rout if global investors decide the large and growing U.S. current account deficit is too significant to ignore.

Lenders also face significant longer-term risks. Most notable is that leverage remains high. Unlike in past recessions, many businesses and households did not reduce their debt loads in the just ended downturn. Lenders are also expected to soon resume lowering their underwriting standards in response to the anticipated improvement in credit quality. All of this suggests that any improvement in credit quality in the coming several years will be less substantial than in credit cycles past. Perhaps more worrisome, the next downturn in credit quality, sometime in mid-decade, may very well be unprecedented.

Contact Zandi by e-mail: mzandi@cconomy.com

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