Below is a continuation of last week's Part 1 of the 10 Things to Watch in 2010:4) Gross Domestic Product. GDP is an important metric to watch to get a sense of how our economy is performing. In the third quarter of 2009, we saw GDP grow positively for the first time since the second quarter of 2008 marking a technical end to the recession (I could go on for pages and pages as to whether the "recession" is really over). However, even in light of positive growth in GDP, we saw estimates of growth drop from an initial level of 3.5% (touted by Washington at every opportunity) to a revised estimate of 2.8% and then to a re-revised estimate of 2.2%. Unfortunately, the overwhelming majority of this growth was catalyzed by government intervention in the form of the Cash for Clunkers program and the first time home buyer's tax credit.The consensus of economic forecasters expect 2010 will be a year with growth better than the past two years but at only a modest 3% to 3.5% level (much lower than typical post recession growth). Unfortunately, this level would not be high enough to bring unemployment down significantly. Will GDP growth be sustainable without government intervention which is scheduled to phase out by mid-year? Outside of the labor market, this is the biggest question mark hanging over the economy: How will consumers and businesses respond when government support fades?The two components of growth that we will be monitoring closely moving forward will be the net change in private inventories and business investment (non-residential fixed investment).Inventories have been drawing down rapidly as we have seen nearly $300 billion liquidated in the second and third quarters of 2009. The continuation of this trend is an important step towards recovery. Thin private inventories will allow production to spike quickly when demand returns, resulting in positive economic output.During this recession, the pullback by consumers was outdone by an even sharper withdrawal by businesses. Capital spending tumbled more during this cycle than at any time since the Great Depression. This segment provides, potentially, the greatest upside surprise in 2010. Business balance sheets, for the most part, look promising. Profits are up, the cost of capital is down and productivity is strong. According to the Fed, the corporate financing gap, reflective of how much companies must raise externally, hit a negative $189 billion in the third quarter from a negative $153 billion in the second quarter. A negative financing gap means companies have the funds in-house to support potential capital expenditures. However, a sustained rebound in capital spending is likely not to occur without improvement in consumer spending.5) The Housing Market. To a great extent, the performance of the housing market will impact consumer confidence and consumer spending (key to GDP growth). This market has been hammered as current house prices are at, roughly, fall of 2003 levels, 29% below the peak achieved in the second quarter of 2006 according to the S & P/ Case-Shiller Index. Today, nearly one out of every four homes has a mortgage balance greater than its market value (or one-third of all homes with a mortgage). This leave approximately 15 million homeowners "underwater".Trouble throughout the housing sector is clearly abating, however, homeowners, lenders and builders have a long way to go before they are out of the woods. Home sales data is difficult to interpret as existing home sales look positive but the extent of the impact of government stimulus in this sector is significant. New-home sales data is extremely volatile as it makes up only about 15% of all home sales, thus, the upward and downward readings are taken from a much smaller statistical sample. Four month averages here are a more clear indication of trends.Much of the recent improvement in sales is due to artificially low mortgage rates, created by the Fed's purchases of mortgage backed securities and the first time home buyer's credit. Both of these initiatives are set to expire by the middle of this year. When they do, sales activity will likely take a hit similar to the evaporation of auto sales after the expiration of the Cash for Clunkers program.We believe there is greater downside risk in this sector than upside risk based upon the fact that the spike in foreclosures is nowhere near its end. At the end of the third quarter, 4.5% of loans were in the foreclosure process, up from 3% a year earlier. In 2008, more than 1.7 million homes were relinquished via the foreclosure process, short sales or deeds in-lieu of foreclosure. In 2009, this number grew to 2.0 million and projections for this year expect the number to swell to about 2.4 million.The Making Home Affordable program was rolled out by the White House in February of 2009 with the intention of providing relief to struggling homeowners. While it has lowered mortgage payments on a trial basis for hundreds of thousands of people, it has largely failed to provide permanent relief. As of mid-December, 759,000 homeowners had received loan modifications on a trial basis, typically lasting three to five months. Only about 31,000 of these people had received permanent modifications.This program has had two distinct impacts on the sector. The first is that has raised false hopes among people who simply cannot afford their homes. The second is that by trying to modify-out of this crisis, the crisis will be lengthened. Additionally, banks have been using temporary loan modifications as justification to avoid an honest accounting of the mortgage losses still embedded in their balance sheets.One area of the housing sector could show some hope in 2010. Residential investment (new home construction) fell so sharply during this recession that it has little room to decline further. In fact, starts were at a level of less than 400,000 on an annual basis at various points during 2009 compared to a trend-level of about 1.25 million (It is interesting to remember that about 500,000 homes are taken out of the stock each year by natural disasters or intentional demolition).Sales of new homes peaked in July of 2005 and in November of 2009 stood at 74% below this peak. However, inventories have been reduced to their lowest levels since 1971, so construction is likely to rise providing a contribution to overall economic growth. Home construction, particularly given its depressed level starting point, could be a positive surprise for 2010.6) The Political Landscape. What I mean here is the type and extent of regulation which will be implemented and the impact it will have on our economy.Politicians have been beating the drum of regulation of financial firms and this could have a dramatic impact on our credit markets. A growing concern is the limited availability of credit to fund companies whose growth could help abate the country's persistent high unemployment. Will regulation stifle credit availability?What will be the perspective of those making policy on regulation? Will they embrace the capitalist system of the U.S. in which we have a dynamic, volatile economy with painful episodes (like the recent one) to get faster long-run growth in living standards or will they look at it from a more European perspective, consisting of a more stable economy with fewer crises but also slower growth over time? These are interesting and thought-provoking questions.The European model seems to prize stability over risk even at the cost of less innovation. Some argue that overemphasizing stability in the wake of the crisis will mean less wealth for the next generation. Some argue that the boom was a mirage consisting of false prosperity driven by excessive leverage. Others argue that capitalism is simply not stable and we should just deal with that fact while others promote a system of ups and downs incorporating trying to avoid the very highest peaks and the very deepest troughs.Important for commercial real estate is that any new regulation of the financial industry should distinguish between firms engaged primarily in speculative trading and the lenders linked to the real economy of Main Street. A real danger is that regulation of the former might inadvertently strangle the latter. This issue would become acute if Congress passes measures that force all banks to bear the costs of protecting those institutions whose activities pose systemic risks. Among the unintended consequences of such an approach would be that consumers and small businesses, starving for credit, would indirectly bear the cost of such fixes.New regulation should be implemented only after Congress requires financial institutions to account separately for their trading and traditional banking activities. If history has taught us anything it is that, unfortunately, the regulation we are going to get will be much more a matter of politics than economics. Clumsy, ill-conceived and hot-headed efforts advertised as promoting the ability to avoid a repeat of the current crisis could yield neither more stability nor more growth. It could also result in less credit availability, something the administration claims is something they want to promote.For the conclusion of 10 Things to Watch in 2010, please come back to StreetWise next week .......Mr. Knakal is the Chairman of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career.

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10 Things to Watch in 2010 (Part 2)

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