Strategic Exchange - August/September 2009

By Kemp Harr

If you’re looking for good news on the economic front, we’re starting to see a little. Unemployment numbers for July actually dropped for the first time in 15 months, taking the total from 9.6% to 9.4%. Analysts have revised the third quarter GDP estimate to a healthier growth of 3% to 4%, indicating that the second quarter might mark the end of this unprecedented era where five of the last six quarters showed GDP contraction.

It’s true that consumer confidence dropped in July, which would indicate that consumers could continue to be frugal for a while longer. But on the housing front, pending sales of existing homes have risen for the last five months and new home construction has risen to a 563,000 annual pace—the best performance since early 2008. And let’s not forget that the $3 billion invested in the cash for clunkers program has helped clean out the auto industry’s inventory glut.

But as Warren Buffett says, it takes a while to wring out the excess and reset the economy to a more sustainable level of growth. And before we lift our glasses too high and toast the inevitable recovery, let’s remember that some more conservative analysts warn of a potential “L” or even worse “W” shaped recovery, which could be brought about by a combination of several factors. Loan defaults in the commercial real estate market could put undue stress on the volatile credit market, the cap and trade and healthcare reform movements could backfire, and there’s always that chance that the swine flu virus could cause major work outages this fall during the flu season. On the other hand, the recovery could just as well be “V” shaped (like they’ve been for the last 30 years), the real estate/credit market could stabilize, our political reforms could stall, and we could avoid a flu outbreak.

However, it seems that the most grim scenario has been averted—a global financial collapse. The rapid intervention both in the U.S. and in major international markets seems to have worked. Banks are starting to lend, though they’re certainly being more conservative. But many in the commercial market remain frustrated at the continued reluctance of banks to open up their coffers. Thousands of projects are on hold or have even been canceled because of funding problems.

Most experts agree that while the while the decline in the residential market has started to ease, the commercial market is in a lagging cycle and will continue to decline well into next year. The chief economist for the Associated General Contractors of America predicts that nonresidential construction will decline 9% this year and another 5% in 2010. Moody’s Investor Service reports that commercial property values have fallen 35% since October of 2007, which will make it difficult for owners to refinance their commercial mortgages. While the office market has been hit the worst, there continues to be some investment in the healthcare, education and institutional sectors.

Wood prices may move higher soon
With much of the furniture industry moving to Asia, and the slump in housing construction reducing the demand for cabinets, millwork and hardwood flooring, it’s no surprise that the demand for hardwood in the U.S. has been down. As hardwood lumber prices have continued to decline, private landowners are holding on to their trees, hoping for better pricing. Logging companies have converted their operations over to coal and natural gas businesses, and over 30% of the family run sawmills have shut down. According to the 2009 Hardwood Market Report, the U.S. harvest numbers have dropped more than 50% in ten years, from 12.6 billion board feet in 1999 to an estimated 6.1 billion board feet in 2009.

Our latest consumer survey put hardwood flooring as the number one most desired flooring surface for homeowners. But during this recession, the wholesale value of hardwood flooring sales has dropped from $2.9 billion in 2006 to probably under $2 billion this year. But as the market starts to recover, the raw material infrastructure no longer exists to sustain an even marginal increase in demand for the three biggest consumers of hardwood—cabinets, millwork and flooring. As a result, Neil Poland, the president of Mullican Hardwood, predicts a supply shortage will cause hardwood flooring prices to climb as early as next January.

Raw materials are also rising for other flooring manufacturers. If you monitor our Floordaily.net news site, you’ve seen that raw material prices on the carpet side have already started to kick in. Dow, BASF, and Propex have all announced recent price increases for their petroleum derivative products like nylon, latex and polypropylene backing. We’ve watched oil prices go from a high of $147 in July of 2008 to a low of $33 in January this year to its current price of just over $70. Most energy pundits say that as the economy starts to show signs of recovery, oil prices will continue to rise and we can only assume plastic pricing will rise with it. However, with the Federal Trade Commission’s recent announcement that it will start to police oil price manipulation, perhaps these severe price swings will be a thing of the past and flooring manufacturers can operate with more price certainty.

Housing as equity
One very interesting hangover from this recession, along with the rising costs of energy and an aging baby boom generation, is a decline in the average size of new homes in the U.S. In 1950, the average American new home was 983 square feet. By 2007, that number peaked at 2,479 square feet—an increase of 152%. But in the third quarter of 2008, the number dropped to 2,438. The growth pace has always dropped a bit following a recession and it will be interesting to see if the McMansion era is over for good.

As consumers become more sustainably minded and recognize the amount of wasted energy consumed to heat and cool media rooms, his and her walk-in closets, food pantries, wine cellars, vaulted ceilings, exercise rooms, home offices and guest powder rooms, these excessive luxuries could become a thing of the past. The generations that follow might be just as happy spending time outdoors or in a small urban flat and might not be as prone to collect mountains of stuff that require bigger structures to warehouse it all.

John Baugh, a market analyst with Stifel Nicolaus who closely monitors the interior furnishings business, recently commented on where the new housing norm might be as the residential market starts to recover. Savings rates have jumped from zero to 7% as Americans have discovered that the home may not be the best place to store equity needed for retirement. For many years, homeowners grew accustomed to jamming disposable income into their residence because it served two purposes. Initially it served to immediately improve their comfort and desire to be stylish, but in addition homeowners felt secure that they could recoup their investment down the road whenever they needed the money. But with foreclosures and abundant supply issues, housing values have rapidly declined. According to the U.S. National Home Price Index, housing values peaked in 2006 and in the first quarter of ’09 had dropped to 2003 levels—not exactly the type of return you want to get in your retirement account.

If you are asking yourself when the housing market will fully recover, remember that pushing home ownership is part of what got us where we are today. Some pundits would say that only 63% of American households can afford to own their own home. But through government subsidies and ridiculous lending habits, that number approached 70% in 2006. So, during this recession, as American home ownership recedes to the normal level, there is an abundant number of homes to be absorbed by the estimated 115 million U.S. households. And with the current U.S. birthrate of 2.2% coupled with current immigration rates of growth, the number of households in the U.S. increases 1.1 million per year. But even at that rate, it may take several years for demand to absorb the supply.

The Future of Extravagance
With 70% of the U.S. economy based on consumerism, no one can accurately predict when this economic recession will end. Americans don’t buy cars or other disposable items when they need them; they buy them when they feel comfortable enough to afford them. This optimistic outlook comes from feeling secure and feeling like they are in control of their own destiny. The fact that Ferrari sales are down 60% and Neiman Marcus revenue is way off tells me that even the affluent are being cautious. I guess that would be the same people who make over 250,000 a year and know their taxes are going up but don’t know by how much. The same bodes true among the masses. Americans will only open their wallets when they know their job is secure because their employer is starting to make money again.

There’s compelling evidence that we’re a few economic indicators away from an end to this recession, and with so much of the economy based on consumerism, the big question is how U.S. consumers will react once they feel secure again. Optimism and relief that the danger is largely behind us may lead to a burst of spending, sending some economic indicators skyward, but many experts say that’s not what they want to see, citing premature optimism following the 1929 depression that led to another dip (the W scenario). They believe that the long term health of the economy will be better served by a conservative response to the rebound, at least initially.

Many also believe that even long term the answer is not for consumers to spend as much as they can afford or for the economy to grow at the fastest rate possible. They believe that slower growth is steadier growth, minimal debt is healthier and safer, and the age of extravagance is best relegated to history books.

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