U.S. Macro Outlook: The Worst Is Over

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• Consumers, businesses and financial markets are showing signs of improving health.

• Fiscal and monetary policy steps are cushioning the recession.

• Layoffs need to ease, consumers need to regain confidence, and loans need to become more available for the economy to recover.

• For the first time in nearly two years, the near-term outlook is a bit brighter.

• Full recovery remains a long way off.

The worst of the economic and financial crisis is over. Consumers are no longer retrenching, and businesses are successfully clearing out unwanted inventories. Global financial markets continue to rally, and even the beleaguered banking system seems to be on the mend. The recession continues, but it is moderating, and an end to the severe downturn is coming into view.

Consumers are still nervous and are buying cautiously, but steadily less so. Consumer confidence has improved meaningfully from its record low earlier this year, and retailing has stabilized since Christmas. Households have been buoyed by lower energy prices, a sizable mortgage refinancing wave, and bigger tax refunds. Members of higher-income households, who account for the bulk of spending and were panicked when their wealth was evaporating, appear to feel better now that stock prices have improved and they have ramped up their saving. Under some reasonable assumptions regarding future asset price growth, most will be able to rebuild their depleted nest eggs before they hit retirement age.

Investors are responding

Businesses have also moved aggressively to get their costs down, slashing payrolls and investment. The massive inventory liquidation is particularly notable, as it was responsible for nearly half the stunning 6% decline in first quarter real GDP. Judging by earnings reports from a range of companies for the quarter, their cost-cutting is working. Profits are down a lot, but not nearly as much as revenues. Once there is even a small pickup in sales, profits and cash flow should rebound quickly.

This potential isn't lost on investors. Stock prices are more than 30% above their early-March lows, and gains in credit markets are even more impressive. The yield spread between junk corporate bonds and 10-year Treasury yields—a good measure of investor worries over corporate bond defaults—are half what they were at the height of the financial panic late last year. The difference between three-month Libor and three-month T-bill yields—a good proxy for banks' angst regarding borrowing and lending to one another—has narrowed and is almost back to historical norms.

Moment of truth

Optimism that the recession will end in coming months depends on the effectiveness of a range of policy efforts now being implemented. Households are receiving a big cash boost this month: Withholding for payroll taxes has been reduced for most workers, and Social Security recipients will soon receive checks in the mail. The infrastructure spending in the stimulus package should also significantly ramp up in coming months.

Policy steps to shore up the housing market will soon reap benefits. The Federal Reserve has successfully engineered record-low mortgage rates, and when combined with much lower house prices, they have made homeownership affordable again. The stimulus package also provides for a tax credit of up to $8,000 to first-time homebuyers through November, which could be enough to get consumers who are nervous about falling house prices to take the risk and buy homes .

Foreclosures set to surge

House prices are expected to hit bottom once the foreclosure share of total home sales peaks. That won't happen soon, as foreclosures will surge this summer as various foreclosure moratoriums expire, but it is likely by early next year as the Obama administration's mortgage loan modification plan goes into full swing. By then, enough mortgages will have been modified to reduce payments and stanch foreclosures, and house prices will stop declining.

Policy efforts to quell the financial crisis and get credit flowing again are also approaching a critical juncture. Stress-testing of the nation's 19 largest banks with over $100 billion in assets and that account for two-thirds of total bank assets will ultimately prove therapeutic. The process provides a consistent framework for determining which institutions need capital and how much they need under a fairly adverse economic outlook. Institutions with capital holes will have no choice but to fill them, putting them on very solid financial footing and reducing a major impediment to lending.

Guideposts to watch

Whether the economic downturn is winding down as anticipated critically depends on whether businesses soon ease up on their cost-cutting. The credit crunch and low capacity utilization will ensure that investment will continue declining sharply, but more importantly, job losses must soon moderate. If by late summer the economy is still losing over half a million jobs per month, fiscal and monetary stimulus measures will be overwhelmed and a recovery will not take hold this year.

A good guidepost of whether job reductions are abating as expected is initial claims for unemployment benefits. Initial claims are now running near 650,000 per week, consistent with monthly job losses of about the same amount. Claims need to fall below 600,000 in the next several weeks and below 500,000 by September for the outlook to stick to script. For context, 350,000 weekly claims would be consistent with a stable rate of unemployment.

Also important to the expected timeline to recovery is a clear and meaningful improvement in confidence. What distinguishes this downturn from the typical recession since World War II is the shattering of the collective psyche. Investors, consumers and businesses lost faith late last year in the wake of the financial crisis, causing the economic free fall as people all but stopped spending and investing.

Judging by the rally in financial markets and a range of consumer and business surveys, confidence has since stabilized. But for this downturn to come to a definitive end, sentiment has to take on a much brighter hue. The Conference Board's monthly consumer confidence survey is an excellent barometer of households' mental state. The index plunged to a record low of 25 in February and has since risen to nearly 40. A reading of over 60 would signal that households are feeling good enough to spend just enough to lift the economy out of recession.

The economy will recover only if credit flows more freely. Bank lending and bond issuance have both been significantly impaired as capital-short banks battened down their underwriting standards. Only multinational investment-grade businesses and banks with government guarantees have been able to issue debt.

A sensitive measure of whether banks are able and willing to lend again is commercial and industrial loans outstanding. C&I loans are an important source of cash for small and midsized businesses that can't tap the credit markets directly. They were falling through late April, suggesting that the economy is still sliding. An upturn in C&I lending will be a strong signal of one in the economy, too. A meaningful revival in junk corporate bond issuance would also signal that the bond market is coming back to life for businesses with less than pristine balance sheets.

For the first time in nearly two years, the near-term outlook for the economy has actually improved a bit. The downturn that began in December 2007 and that in last month's forecast was expected to hit bottom this December is now expected to bottom out this October. Peak-to-trough real GDP is projected to decline by 3.5%, and employment will fall by 7.5 million jobs. The unemployment rate is expected to peak near 10% by early 2010.

The risks to this baseline outlook remain skewed to the downside, although they are becoming more balanced. Given that the baseline outlook represents about 50% of the distribution of possible economic outcomes, there is a 30% probability that the outlook is measurably worse than the baseline and a 20% probability that it is better.

A slow recovery

Although the recession is expected to wind down by year's end, the subsequent recovery will be muted, at least through much of 2010. Historically, recoveries have been powered by the interest rate-sensitive housing and vehicle industries. Although housing construction and vehicle sales in coming months will rise off their current record lows, the gains will be limited. The housing market remains awash in vacant homes, and spent-up vehicle demand remains ample. It would be overly optimistic to expect global economies to recover quickly from their recessions, and thus U.S. exports won't pick up substantially for a while. The problems in the banking system and credit markets will also take time to resolve, suggesting that the credit crunch will lift only slowly. Given these headwinds, economic growth won't be in full swing before 2011, and full employment won't be restored before late 2013.