The U.S. Department of Commerce Bureau of Economic Analysis just recently released its estimate of GDP growth for the first quarter of 2010.  This preliminary estimate came in at 3.2 percent.  This followed a growth in the fourth quarter of 5.6 percent and growth of 2.2 percent in the third quarter of 2009.

Following four cycles of sometimes severely negative GDP growth, the most recent quarters are a welcome respite (see Chart 1).  The question is, what does this growth really constitute?  Are we truly on the path to recovery, or is this just a lull in a deeper, more prolonged recession?  Most economists feel as though we have emerged from recession into recovery, with most citing the turning point as sometime last summer.

While many of us are beginning to breathe again, there are a couple of critical issues to which we should pay attention.  First, most recoveries are driven by investment in residential real estate and improvements in consumer spending.  This recovery is different.  The strong fourth-quarter GDP growth was driven heavily by businesses rebuilding inventories, which had been severely depleted.  This factor also played a significant role in first-quarter GDP growth.  Inventory rebuilding is not a sustainable contributor to GDP.  Once inventories are rebuilt, this factor ceases to play a major role in future GDP growth.

Second, investment in residential real estate is not likely to be a significant contributor to growth anytime soon.  Chart 2 illustrates housing starts in the U.S. since 1960.  2009 represents the lowest level of housing starts ever recorded.  Now the good news is that 2010 is significantly better than 2009 — up 17 percent over 2009 starts based on first-quarter data.  The bad news is that 2010 will nevertheless rank as the second worst year ever for housing starts.

Third, while consumer spending is up, it is not certain how sustainable this growth is.  One of the major categories of consumer spending is new vehicle sales.  Chart 3 shows that vehicle sales in 2009 were the lowest level recorded since the early 1980s.  Again, while auto sales in 2010 are up by more than 15 percent over 2009 levels, we are still projected to be at the lowest level of new vehicle sales since 1983.

Recent increases in consumer spending are not likely to be sustained unless unemployment declines, and if growth in GDP averages around the current 3 percent for 2010, we are not likely to see any significant reduction in unemployment.  Indeed, April unemployment actually increased to 9.9 percent, a reflection of more workers re-entering the work force and not enough new job opportunities to absorb them.

Finally, add the crisis that is emerging in Europe, currently in Greece.  This added uncertainty is impacting the stock market and this in turn will influence the behavior of consumers.  When investors see the Dow drop 1000 points in one day (although the market “recovered” to only a 350-point loss) due perhaps in part to what is happening in Greece, rest assured they are fearful.  Fear dampens spending, and reductions in spending will stall a recovery.

Amid all of this turmoil, there are some positive long-term developments.  First and foremost, consumers are saving more and reducing their debt loads.  In 2009, savings as a percent of disposable income grew to 4.3 percent — still below the historical norm of 7 percent but a significant improvement over 2.4 percent in 2006, 1.7 percent in 2007, and 2.6 percent in 2008 (see Chart 4).

Moreover, many markets have seen the beginning of a recovery in regard to real estate values.  While still substantially below their peaks, many of the major markets in the U.S. are now seeing the beginning of real estate appreciation.  However, many markets have not yet begun to see recovery in prices (see Chart 5).

The intent of this article is not to put us all into our own personal recession (depression?).  However, we do need to be realistic about how strongly our economy is likely to grow in 2010, and the impact of this on our own performance as well as that of our customers.  We are not moving into a V-shaped recovery typical of most deep recessions of the past.  We have a hangover effect stemming from too many houses built and too much debt incurred.  It will take a while before we work our way through these impediments.

What is clear is that “normal” has changed.  Even as this recovery progresses, we should not anticipate a return to what the economy was in the decade of the 2000s.  There will be less borrowing as consumers attempt to reduce debt and improve savings.  There is likely to be more of a focus on saving.  All this is good for the long-term health of our economic system, but in the short term will tend to slow the recovery.

What are the implications for how we manage our financial institutions and what should we be doing?

1. Lending growth will be difficult. Providers of credit products will need to be sharper in product design and marketing in order to generate growth in loans.  New targeting tools and improved employee training designed around helping staff to identify lending opportunities will have to be employed for us to grow credit effectively.
2. Avoid chasing yield by moving further out on the yield curve.  With loan demand down and interest rates likely to remain low for 2010, there may be the temptation to move further out on the yield curve in your investment portfolio in order to generate yield.  Avoid this temptation.  With the size of our federal debt (currently $12 trillion, or 90 percent plus of GDP), interest rates will eventually rise, and those long on investments will experience a distinct sense of déjà vu (who remembers the thrift crisis of the 1980s?)
3. Margin management will require more effective deposit pricing. Margin management will be more important in 2010 and beyond due to the reduction in fee income resulting from Reg E changes, the decline of refinancing activity, etc.  Margin management will require a greater focus on how we price deposits.  Rather than viewing deposits simply as a raw material for lending, look at deposits as a product to be managed to profitability.  Relationship pricing on deposits will increase in importance.
4. Continue to focus on improving the productivity of your organization. We need to be more closely managing our organizations and measuring our productivity at all levels.  Establish standards of performance for your branches, for example, and track performance on a consistent basis — at least quarterly, but monthly or even more frequently when possible.
5. Adopt the position as your customer’s advocate — and focus on financial literacy. In this changing environment, there is a high degree of uncertainty on the part of customers.  Our focus needs to be on serving as the customer’s advocate and providing them with the tools and educational material to help them navigate in these very difficult waters.  The work that you do in this regard now will create significant levels of loyalty in the longer term.

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