The California report: three things to watch in 2007.

For most of 2006, our forecast for the California economy has been that the slowing housing markets would be a drag on growth--enough to slow the overall economy, but not enough to create a recession. While both building permits and construction employment have fallen faster than we predicted earlier in the year, other sectors have fared a little better than we expected, leaving the California economy as a whole growing slower than it has been, but slightly faster than we predicted.

In the past year, we have repeatedly made the point that significant declines in nominal home prices have almost always occurred in the wake of a severe local recession, when job loss and financial hardship create sellers who are willing to trade a lower price for a quicker sale. Since our California forecast did not predict anything like a recession, we predicted that housing markets in 2006 could be summed up in four words: flat prices, falling sales. Absent the motivation that comes from economic distress, sellers are unwilling to sell their homes in a weak market because they won't receive the "full value" of the home, and buyers are no longer willing to live up to the sellers' expectations of the what their house is worth. In this climate, sales volumes plummet while prices essentially go flat.

This pattern of flat prices and falling sales is exactly what we've seen in most markets in California in 2006. A few markets like Sacramento and San Diego have seen moderate declines in the mediari sales price, but these are markets where new homes make up a substantial portion of total sales. While owner/sellers have the luxury of riding out a weak market, Wall Street looks unkindly on builders who carry excess inventory. Thus, when owners are sitting on the sidelines, builders are offering free upgrades, interest buydowns, and outright price reductions. When these builders make up a big share of the overall market, their price cutting can pull down the overall average sales price.

Historically, a recession is usually a double whammy: it takes two sources of weakness combined to create enough drag. This is the central question for California in 2007-8: will a second source of weakness emerge to turn the current real estate slowdown into a real estate recession? Or will a new source of growth emerge to offset the drag from weak housing markets? Obviously, this question feeds back in to the housing markets: if the slowdown becomes a recession, the forecast of flat prices and falling sales may be too optimistic.

One of the potential sources of weakness that is often discussed in housing circles is a negative wealth effect: if rapid home price appreciation increases consumption, could the lack of appreciation today cause consumers to put away their wallets? A big enough slowdown in consumer spending could certainly be the second half of a double whammy for both the nation and California. However, our most recent California report concludes that this doesn't look likely. Both the U.K. and the U.S. have seen some slowdown in consumption as the peak of the housing market has come and gone, but it hasn't been a big enough swing to change the overall path of the economy. At the state level, some observers have pointed to a 10% drop in new car sales relative to the summer of 2005 as evidence of a negative wealth effect. We think that this swing came from last summer's sales being abnormally high: "employee pricing" and other aggressive price cutting schemes shifted sales that normally would have occurred this year into last summer's numbers.

A second potential source of weakness that we considered in our most recent report is a repeat of the budget crunch that followed the 2001 recession. The housing boom has led to the fastest five-year growth in property tax collections since Proposition 13 was passed, which has created a temporary surge in revenue. But at the same time that these revenue gains look poised to dry up, the current state budget is once again facing a substantial deficit. If this deficit forced a slowdown in state and local spending and employment like we saw in 2003, this could be another candidate for a second source of weakness in California. Fortunately, we conclude that while some combination of higher taxes and/or lower spending will be required to close the gap between spending and revenue, there is enough flexibility in the timing of these changes to avoid tipping over an already wobbly economy.

So while two of the most likely candidates for sources of weakness look unlikely to become the second half of a California double whammy, our report also concludes that there are unlikely to be any "savior sectors." With no externally-oriented sectors that look poised to grow faster in 2007, there's no other part of the California economy that can pick up the slack from slowing construction and real estate sectors. Thus, our final forecast for the California in 2007 is more of the same: weakness in real estate will continue to drag down the economy, but without a second source of drag the net result in 2007 will be a slowdown, not a recession.

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Ryan Ratcliff, Economist, UCLA Anderson Forecast