Don't This Road Look Rough and Rocky

By Marshall J. Vest
EBR and Forecasting Project Director

June 1, 2011

Arizona’s economy shows evidence that it has finally entered the recovery stage but serious headwinds will restrain progress.  The most serious issue is housing (too much inventory and falling prices).  A close second and related issue is the lack of mobility of the population, which will keep population growth depressed for some time.  Finally, reduced spending at the state and local levels will subtract significantly from aggregate demand.  Results from the 2010 Census highlight the importance of the Hispanic population in Arizona, which accounted for nearly half of population growth during the past decade.

The nation’s economy is performing well, considering a number of factors that are challenging growth including the dreadful situation for housing, rising prices, supply chain disruptions from disasters in Japan, contractionary effects of reduced state and local government spending, and bad weather. Consensus forecasts are for growth to accelerate in the second half and continue growing at almost a 3% annual rate over the next two years.

By contrast, Arizona’s economy has been stuck in neutral and bouncing along the bottom since the recession officially ended in June 2009.  Only in the past few months has evidence begun to appear that the recovery has finally arrived.

Arizona’s consumers have started to “squeeze the trigger” on spending.  Retail sales reached bottom in June of last year and have increased at double-digit annual rates (seasonally adjusted) in each of the past six months (data through February) (Exhibit 1).  Auto sales have been particularly strong, registering increases in the 20-30% range in recent months as consumers satisfy the need to replace aging vehicles.  Higher gasoline prices, which climbed in recent months to near $4.00 per gallon, haven’t exerted much constraint on other categories either.  Apparel sales are growing by 15-20%, general merchandise sales at a 9-10% annual rate, and even building materials sales are growing at double-digit annual rates.  Even furniture and food & liquor store sales are no longer declining, although the increases remain in the low single-digit range.  Restaurant and bar sales also are showing increases in the neighborhood of 20% annual rates.

Although initial unemployment insurance claims nationwide moved upward recently, that’s not the case in Arizona.  Claims continue to decline rapidly although they are still much higher than normal.  Arizona’s unemployment rate fell to 9.5% in March, down from 10.4% at the end of 2009.  Unemployment should fall another full percentage point by year end.

Recent downward revisions to employment show that the jobs recovery in Arizona didn’t start until September of last year.  After falling 312,000 during the recession, all of 23,500 jobs have been restored.  Strong growth in export-based manufacturing is a key component in the nation’s recovery, but manufacturing employment in Arizona remains near cycle lows.  After falling by nearly 30%, or 60,000 jobs over the past decade, manufacturing employment is now back to a level was first attained back in 1980!  Only a modest recovery is expected.  Aerospace manufacturing, buoyed by missile production, has been the strongest component in recent years but is now declining and will move lower going forward as defense spending shrinks.  Computer and electronic parts as well as nondurable manufacturing have little upside potential.  That leaves fabricated metals and other durables (such as biotechnology and solar) to lead the way.

Given budget challenges at both state and local levels, government employment statewide has declined by an unprecedented 25,000 so far.  Parents also have been sending their children to (privately-owned) charter schools rather than public schools.  While private educational services continues growing at double-digit annual rates, public school enrollment actually declined in 2009 and grew very little in 2010 (Exhibit 2).

With the ending of federal assistance, the state cut $1.1 billion from the FY2011-12 budget.  As expected, the cuts came largely from Medicaid ($511 million) and education (K-12 at $163 million and universities at $198 million).  Some costs also were shifted to cities and counties.  The public sector will continue to be a drag on the economy for the next 2-3 years.

The biggest concern and downside risk is the continuation of falling housing prices and large inventory of vacant housing.  The 2010 Census found 463,000 vacant houses statewide.  That’s enough to accommodate an entire decade of population growth at “normal” rates.  During the past decade, Arizona’s population increased by 1-1/4 million. Roughly 180,000 of the 463,000 are vacation or second homes so even if the house was occupied, the owners are counted in their home state and the house recorded as vacant.  Subtracting second homes leaves roughly 280,000 or roughly 10% vacant.  Historically, “normal” vacancy rates range between 1-2% for the entire housing stock (and roughly 8% for apartments).

Home sales, driven by investor interest, have strengthened in recent months in both Phoenix and Tucson metro areas.  Even so, home prices, as measured by realtor data and Standard & Poor’s Case-Shiller indexes, continue to fall due to the large number of vacant houses and the large portion (over 55% in 2010) that are distressed sales (bank-owned and “short sales”).

We continue to forecast an anemic recovery for the next 2-3 years due to the drag from the public sector, delayed recovery in construction activity, and lack of mobility of the nation’s population, which will depress migration flows and population growth.

After declining in 2010 and virtually no change in 2011, population will grow by a small amount in 2012.  Annual growth won’t top 100,000 until 2014 and doesn’t exceed a 2% growth rate until 2015.  We expect a little less than million new residents to be added over the decade of the teens compared to a 1.25 million increase during the aughts.   Most of the growth will occur in the latter half of the decade.

Subdued gains in population will limit growth in other aggregate measures as well.  Employment will grow very little near term, and it will be 2015 before job growth tops 3%.  Personal income will grow 3.3% this year, then only 2.7% in 2012.  The payroll tax cut boosted growth this year and will subtract next year when it expires (contributions to social security represent a subtraction from income).  After a temporary splurge in spending, retail sales growth will slow next year. 

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