Budget analyst’s bleak outlook

Legislative Analyst Elizabeth Hill, who examines budget issues for the Legislature, has offered an assessment of California’s economic outlook. Hill, although hired by a Legislature controlled by Democrats, is a nonpartisan analyst who each February compiles a detailed assessment of the governor’s proposed state budget. Her study serves as the linchpin of the Capitol’s budget negotiations. In addition to her budget analysis, Hill provided her view of the state’s economic outlook. What follows was taken from Hill’s report on California’s economic climate, which offers an overarching view of business conditions, employment, and fiscal and population growth.

California’s economic situation and outlook are generally similar to the nation as a whole, although the turmoil in the state’s housing and mortgage markets has been more pronounced than nationally, making its outlook a bit more sluggish.

Economic growth in 2008 is expected to be slow, especially in the first half of the year, with recovery beginning later in the year and continuing into 2009. After healthy gains in 2004 through 2006, economic indicators suggest that economic growth slowed for the state as 2007 progressed. For example, growth in both wage and salary employment and taxable sales declined, the unemployment rate rose, and new residential building permits dropped.

The key forces behind the economic slowdown that is being experienced in California are the same as for the nation. Those are sharply declining real estate markets and, to a somewhat lesser degree, high energy and gasoline prices. In fact, the adverse effects of these negative forces tend to be even greater in California than for the rest of the country because of the state’s volatile real estate sector and its higher-than-average gasoline prices and gasoline consumption.

While both of these factors are expected to negatively impact California’s economic performance in 2008 and 2009, this is especially true for the real estate sector. A major real estate correction is currently under way that is expected to get worse before it runs its full course. Although its initial major adverse effects appear to be primarily falling on homeowners, housing-related industries and financial institutions directly involved, there will undoubtedly also be various eventual negative spillover effects on the economy at large.

California’s real estate-related industries — which include developers, contractors, real estate brokers, financial institutions, title companies and insurers — have in recent years accounted for 15 percent to 20 percent of the state’s private-sector economy.

Changes in real estate asset values and mortgage refinancing activity can also have substantial indirect impacts on other sectors of the economy, such as consumer spending.

Hill said her projections for California’s economic outlook included a number of factors.

Personal income growth is predicted to slow, from 6.5 percent in 2006 to 5.3 percent in 2007 and then to 4.9 percent in 2008. It is then seen to be partially rebounding to 5.3 percent in 2009 before averaging roughly 5.6 percent through the remainder of the forecast period.

Wage and salary employment growth is predicted to drop significantly, from 1.7 percent in 2006 to 1.1 percent in 2007 and a bit further to 1 percent in 2008. Thereafter, it is forecast to accelerate slightly to 1.3 percent in 2009 and average 1.7 percent for the rest of the period.

Taxable sales growth is expected to be soft in 2008 at 3.8 percent following 2007’s very weak 3.2 percent, before firming up a bit in 2009 at 4.7 percent. In all three of these years, taxable sales growth is expected to be well below that of personal income.

New residential building permits are expected to bottom out in the vicinity of 120,000 units in both 2007 and 2008.

Performance by industry will vary. The weakest areas will clearly involve real estate-related industries such as residential construction and finance. In contrast, solid growth should occur involving international trade, which is benefiting California manufacturers and farmers that sell abroad, as well as transportation, warehousing and distribution activities associated with trade activity through California’s ports. Likewise, continued strength is foreseen for information-related industries including motion pictures, sound recordings, publishing and Internet service providers. Healthy growth in California’s high-tech and related professional services industry is also expected, including software development, computer systems and design, biotechnology and pharmaceuticals.

But Hill cautioned that her economic assessments carried risks. “The main ones continue to involve housing and energy,” she noted.

On the housing front, California continues to be in uncharted territory in terms of exactly where the current market correction will end up regarding home prices and building activity, as well as how long it will take for the correction to run its course. For example, her forecast assumes that price and construction declines will not become extreme by historical standards, reflecting the overall long-term positive outlook for California’s economy. However, steeper reductions could occur, which in turn would further depress economic growth in the state over the next couple of years.

Regarding energy costs, the main concern is that recent sharp increases in oil prices might continue, due to such factors as the market’s vulnerability to unexpected supply disruptions, rising political tensions in various global regions, and increasing worldwide demand for oil as China and certain other nations continue to rapidly industrialize. Gasoline prices also are always vulnerable to supply disruptions involving not only crude oil, but also refinery operations. Adverse developments in these areas could place upward pressures on inflation and interest rates, as well as significantly disrupt general economic activity.

California’s population currently totals approximately 38 million people. The state’s population growth is projected to average just under 1.3 percent annually. In terms of numbers of people, this modest annual growth rate translates into about 500,000 people yearly and is roughly equivalent to adding a new city the size of Long Beach to California each year. As a result, California will add about 3 million people over the forecast interval and reach more than 40 million by 2013.

The projected population growth rate is somewhat slower than that experienced in the late 1990s and early 2000s, when annual growth was averaging about 1.6 percent. This reflects a number of factors, including the dampening effects of the large housing price increases and more subdued employment growth rates of recent years. Another factor is the reduced birthrates being recorded by certain segments of California’s population.

California’s population growth can be broken down into two major components: natural increase (the excess of births over deaths) and net in-migration (persons moving into California from other states and countries, minus those leaving California for out-of-state destinations). On average, these two components have tended in the past to contribute about equally over time to the state’s population growth. However, their relative shares can vary significantly from one year to the next depending largely on the strength of the net in-migration component — by far the most volatile element. For example, during the past several years, in-migration has accounted for about 30 percent of California’s annual population change, reflecting a sharp drop in growth from interstate population flows.

The natu
ral increase component will average close to 315,000 new Californians annually over the forecast period. This net natural gain reflects an average of somewhat more than 565,000 births annually partially offset by somewhat more than 250,000 deaths annually.

The forecast incorporates the well-documented trend of declining birthrates that has been in effect for essentially all ethnic groups in recent years in California. Despite these declining birthrates, however, the number of new births in the forecast actually trends up a bit through 2013. This is due to significant growth in the female population of child-bearing age groups in the faster-growing segments of California’s population, including Hispanic and Asian women. As a result, even after accounting for growth in the number of deaths occurring annually in California, it is projected that the natural increase component will grow slightly during the latter half of the forecast period.

Combined domestic and foreign net in-migration will average roughly 185,000 annually over the next six years. This is less than during the latter half of the 1990s and in the early 2000s, when annual net in-migration averaged about 260,000. It also is considerably less than the projected 315,000 natural-increase component noted above. Regarding this in-migration:

Most of the projected net in-migration reflects foreign net in-migration from other nations. This component has been relatively stable over the past decade and has proved to be less sensitive to the economy than domestic population flows between states. The forecast net foreign in-migration is to be fairly constant through 2013, averaging about 200,000 annually.

Regarding domestic net in-migration, this is arguably the single most difficult demographic variable to forecast at this time. The available data indicate that this component turned negative starting in 2004 (that is, more people left California for other states than flowed in from them), and became even more so in the following couple of years, reaching over 78,000 in 2006. In large part, this appears attributable to California’s continued modest job growth and high home prices.

The 45-to-64 age group (largely the baby boomers) continues to be by far the fastest-growing segment of the population numerically and the second-fastest percentage-wise. Nearly 1.3 million new people are expected to move into this age category over the next six years for an annual average growth of 2.2 percent. At the other extreme, slow growth — well under 1 percent — is anticipated for preschoolers and the K–12 school-age population. This reflects several factors. One is the movement of children of the “baby boom” generation beyond the upper end of the 5-to-17 age group, which partially explains the above-average growth in the 18-to-24 age category. Other factors include the slower rate of net in-migration, and the decline in birthrates in recent years that has reduced the number of children moving into the preschool and school-age categories.

The single fastest-growing age group percentage-wise and second-fastest numerically is the 65-and-over category, reflecting the well-known “graying” of the population. This cohort is expected to increase at an annual average pace of 3.3 percent.

These various age-group demographic projections can have significant implications for the state’s revenue and expenditure outlook. For example, strong growth of the 45-to-64 age group generally benefits tax revenues since this is the age category that routinely earns the highest wages and salaries. Likewise, the growth in the young adult population affects college enrollments, those for the 0-to-4 and 5-to-17 age groups drives K–12 enrollment growth, and that for the elderly impacts medical care costs.