A look at 2003.

Author:Duncan, Douglas G.
Position:Cover Report: Business Outlook - Industry Overview

Compared with record production last year, the 2003 Mortgage Bankers Association forecast calls for $1.77 trillion in residential production. Rising rates and a falloff in refinancing spell the difference. The economy is the more intriguing topic. Here, the outlook calls for an improvement in unemployment and genuine signs of recovery despite uncertainty over Iraq.

THE MORTGAGE MARKET SHOULD EXPERIENCE A THIRD CONSECUTIVE YEAR OF STRONG PRODUCTION IN 2003--BUT NOT AT THE TSUNAMI LEVEL OF 2002. In fact, 2003 should be the third strongest origination year on record, following 2002 and 2001. The economy--in slow motion for much of 2002--Should be in a healthy recovery by the second half of 2003.

The rebounding economy should lead interest rates slightly higher and slow refinancing but keep the purchase market strong as employment picks up. Still, our economic recovery faces major risks.

The economy in 2003

The elements appear to be in place for a self-sustaining recovery. We expect the economic recovery to gain broader footing in 2003, and in the second half to have significant momentum.

Our view is that gross domestic product (GDP) growth should accelerate through the year, with growth in the second half of 2003 at 3.4 percent in real terms or near its long-term capacity in a noninflationary manner (see Figure 1). If this scenario plays out, we expect the Fed to reverse course around midyear and begin raising short-term rates. This will be evidence that the recovery has legs, and the longer-term Treasury market probably will already reflect that fact with gently rising rates.

First, the bad news

As we close 2002, the manufacturing sector is still struggling to get back on its feet. The Institute for Supply Management's PMI, an index of manufacturing activity, shows that earlier in 2002 the manufacturing sector was recovering from the recession but then it stalled again beginning in September (see Figure 2). An index exceeding 50 percent connotes an expansion, while below that indicates a contraction for the manufacturing sector.

A recovery in manufacturing awaits the re-emergence of corporate profits. Growth in corporate profits proved disappointing in 2002. Before-tax profits rose 1.6 percent in the third quarter of 2002, after a rise of 2.9 percent in the second quarter and 6.7 percent in the first quarter. Taking into account depreciation and inventory valuation, however, profits fell in each of those quarters.

For example, a significant share of recent durable goods purchases by consumers has been encouraged by zero-percent financing and other price concessions being offered by the auto industry. Unless these concessions are replaced by higher profits, we will not see new investment pick up.

Surveys of corporate executives indicate a concern about the impact on economic activity of an impending war with Iraq. Such concern seems to be leading to postponement of investment--a fact reflected in the low level of business fixed investment. Nonresidential construction, in serious recession, probably also has been adversely affected by the absence of terrorism insurance until recently when the problem was addressed by legislation passed by Congress and signed by President George W Bush.

Investor uncertainty over the accuracy of corporate financial reporting is another major factor contributing to economic weakness. A number of high-profile cases of restatement of past profits shook investor confidence. While legislation was passed and signed to address corporate accounting accuracy, there remains additional need for clarity of financial reporting to fully restore investor confidence. This, combined with the effects of the recession, caused a significant decline in the stock market, simultaneously raising the equity cost of capital and widening the risk premiums in the high-yield bond market. In both cases, this made the cost of fixed investment very high and impeded its recovery.

Finally, the unemployment rate rose to 6 percent in November and raised the specter of a jobless economic recovery (see Figure 3). While unemployment is typically a lagging indicator, as it is costly for firms to release and rehire employees, the choppy nature of the recovery has thus far not encouraged business to start adding employees.

Then, the good news

The emergence from the recession of 2001 has been pretty uneven, and it might seem as though a double dip is in the offing...

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