October 3, 2013

Economics Group
Special Commentary
John E. Silvia, Chief Economist
john.silvia@wellsfargo.com (704) 410-3275

Michael A. Brown, Economist

michael.a.brown@wellsfargo.com (704) 410-3278

Zachary Griffiths, Economic Analyst

zachary.griffiths@wellsfargo.com (704) 410-3284

How Does North Carolina Stack Up Today?*

It has been a long road to recovery in North Carolina, as the state has struggled to add jobs and bounce back following the economic downturn. There are now signs that the economy is on the mend as key growth drivers, such as manufacturing exports and a stronger housing market recovery are helping to support growth. Yet, even with the moderate pace of economic activity, many challenges remain facing the Tarheel State as the U.S. economy continues to evolve. These challenges range from skills disconnect between the labor force and the skills demanded by firms to the need to put policies in place that are supportive of the states future economic activity. The key for state policymakers today is to focus on the long term, as opposed to the short term, factors to support growth. Through a focus on the states labor market, ensuring a competitive business climate, promoting entrepreneurship based on innovation and investing in targeted infrastructure projects that support economic activity, policymakers can provide the tools needed to establish a solid foundation for the states future economic growth.

Economic Outlook: The Big Picture

The North Carolina economy today remains a highly cyclical economy that primarily follows national consumer spending activity. Economic growth at the national level, as measured by GDP, has grown 2 percent, annualized, over the course of the past four years and is likely to finish around 2 percent again this year (Figure 1). While the state tracks national consumer spending trends closely, Figure 2 shows the path of the N.C. economy in recent cycles, where the expansion of 2004-2006 was much stronger than the U.S. economy, while the recession of 2007-2008 was less severe than the nation. Currently the North Carolina economy is experiencing slightly stronger growth than the U.S. economy. Figure 1
U.S. Real GDP
Bars = CAGR 10% GDP - CAGR: Q2 @ 2.5% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 2000 Forecast GDP - Yr/Yr Percent Change: Q2 @ 1.6% 8% 6% 4% Line = Yr/Yr Percent Change 10%

The North Carolina economy today remains a highly cyclical economy.

Figure 2
North Carolina Gross State Product & U.S. GDP
Year-over-Year Percent Change
8% 8%

6%

6%

4%
2% 0% -2%

4%

2%

2%

0%
-4% -6% -8% -10% 2002 2004 2006 2008 2010 2012 2014

0%

-2% U.S. GDP: 2012 @ 2.5% North Carolina GDP: 2012 @ 2.7% -4% 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

-2%

-4%

Source: U.S. Department of Commerce and Wells Fargo Securities, LLC * Some of these comments reflect a presentation made at the Future of North Carolina Forum, September 26, 2013.

This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

How Does North Carolina Stack Up Today?* October 3, 2013

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

As can be seen, over the course of 2012, the state began to perform better as U.S. employment growth picked up and consumer spending growth slowly began to come back, driving overall consumer spending activity higher. This volatility should reinforce the element of caution for private and public sector decision makers given the current composition of the states economy. In good times there is the imperative to save for a rainy day or, in other words, maintain caution in the good years. After several challenging post-recession years for North Carolina, there are signs that economic growth is beginning to pick up. One leading indicator for the N.C. economy is jobless claims as illustrated in Figure 3, which has come down dramatically over the past year. Furthermore, manufacturing exports, an important sector for the state, have begun to rebound as global economic conditions have begun to stabilize. Figure 3
NC Initial Claims for Unemployment
Seasonally Adjusted, In Thousands 150 NC Initial Claims: Aug-31 @ 39,568 Year-Over-Year Percent Change: Aug-31 @ -31.6% 3-Month Moving Average: Aug-31 @ 41,767 12-Month Moving Average: Aug-31 @ 51,323 150

Figure 4
North Carolina Manufacturing Exports
Millions of Dollars $8,000
130

$8,000 Manufacturing Exports: Q2 @ $7,293.4 Year-over-Year Percent Change: Q2 @ 8.4% $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 98 00 02 04 06 08 10 12

130

$7,000 $6,000

110

110

$5,000
90 90

$4,000 $3,000 $2,000

70

70

50

50

$1,000 $0

30

30 92 94 96 98 00 02 04 06 08 10 12

The other key sector helping perpetuate growth has been the gradual housing market recovery.

Source: U.S. Department of Labor, U.S. Department of Commerce and Wells Fargo Securities, LLC

The other key sector helping perpetuate growth has been the gradual housing market recovery. The slow pace of the housing market recovery is tied to the different characteristics of this recovery with a heavier emphasis on multifamily housing. In part, this reflects a change in character of the buyers as shown in Figure 5. Figure 5 Figure 6
Median Home Size vs. Average Household Size
Square Feet; Number of Persons 2,400 2.80

North Carolina Housing Permits

Thousands of Permits, Seasonally Adjusted Annual Rate 120 120 Single-Family: Aug @ 40,284 Single-Family, 12-MMA: Aug @ 33,971 Multifamily, 12-MMA: Aug @ 14,991
Single-Family Average (1998-2003): 62,968

2,200

2.75

100

100

2,000

2.70

80

80

1,800

2.65

60

60

1,600

2.60

40

40

1,400 Median Square Footage: 2012 @ 2,305 (Left Axis) Number of Persons per Household: 2012 @ 2.55 (Right Axis) 1,200 80 84 88 92 96 00 04 08 12

2.55

20

20

2.50

0 90 92 94 96 98 00 02 04 06 08 10 12

Source: U.S. Department of Commerce and Wells Fargo Securities, LLC

From the early 1980s on, the median square footage of homes rose and yet, at the same time, the average family size declined. This suggests that there may be a mismatch of smaller families that have found themselves in homes that may be too large. As a result, this economic expansion has witnessed a rise in the share of multifamily housing starts reflecting a combination of economic, demographic and lifestyle changes. This rise in multifamily housing has helped boost apartment

How Does North Carolina Stack Up Today?* October 3, 2013

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

market rents in several metro areas around the state in addition to supporting further construction activity (Figure 6). With support to economic activity stemming from renewed momentum in manufacturing exports along with a gradual housing market recovery, the states economy appears to have the momentum needed to perpetuate growth. These factors should help support further job growth and, in turn, more robust and sustainable economic activity. Even with somewhat better economic fundamentals, in order for North Carolina to maintain its competitiveness in the future, the state needs to focus on preparing itself for the economy of tomorrow, beginning with the labor force.

Labor Market: Education and the Talent Supply

Economies do not prosper by counting the number of jobs alone. There are two key aspects of a states labor force, quantity and quality, both of which are important. We get a look at the quantity of employment gains so far this cycle in Figure 7. When it comes to employment growth since the end of the recession, North Carolina falls toward the middle of the road relative to other states in the region. The strongest growth comes from neighboring Tennessee, up 5.1 percent as of July 2013, while North Carolina has seen growth of 4.1 percent. This is comparable to the nation as a whole, which has seen job growth of 4.3 percent since the end of the recession. Figure 7
Employment Growth by State: July 2013

There are two key aspects of a states labor force, quantity and quality.

Figure 8
North Carolina Employment Growth By Industry
Year-over-Year Percent Change, 3-MMA
Total Nonfarm Trade, Trans. & Utilities Government Educ. & Health Services Prof. & Bus. Svcs. Manufacturing Leisure and Hospitality Financial Activities Construction Other Services Information -4% August 2013 -2% 0% 2% 4% 6% Less Number of Employees More

Source: U.S. Department of Labor and Wells Fargo Securities, LLC

Job growth in North Carolina is actually in line with neighboring states as well as the nation over the past year. Of course, North Carolina does not receive the benefits and costs from the Washington, D.C., effect on jobs in Northern Virginia so there is a different pattern of job gains there. As suspected, the pace of job gains are more modest than in the prior two economic expansions, as is consistent with the experience of the United States in general. Turning to the quality aspect of job growth, as shown in Figure 8, recent job gains have been concentrated in information, leisure & hospitality, and professional & business services sectors. However, growth in leisure & hospitality likely reflects gains in the restaurant business, which typically employs more part-time workers, which is a bit less of a positive for the area. Unemployment rates in North Carolina, Figure 9, reflect the influence of two aspects of unemployment that are important to distinguish. First, there is the aspect of cyclical unemployment, unemployment associated with the economy and the natural traffic of hiring, voluntary quits and layoffs. For North Carolina, the in-migration of younger workers tends to raise the unemployment rate since younger workers are less tied to any one position and often change jobs as they search for the right career.

How Does North Carolina Stack Up Today?* October 3, 2013

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Second, there is also the element of structural unemployment linked to the skills/geography mismatch associated with the closure of many manufacturing and construction facilities and the associated retail and service positions associated with those facilities. On the demand side, we can see that the influx of retirees and their associated wealth to North Carolina creates an increase in demand for servicesrestaurants, leisure & hospitality and health care that requires a broad set of talents. Are we creating talent to meet those needs? What about the talent needs for the fast growing information and professional and business services sectors? These needs suggest a focus on resources on a broad range for talent at many different levels. Therefore, not everyone needs to go to college to meet all these position needs but they do need to finish high school and, in many cases, some get post-high school training. Moreover, for those that go to college, there needs to be a better sense of balance on student loans between the marginal cost of student loans and the marginal expected benefit of the education in the job market. While North Carolina has a number of superior colleges, there is too much focus on a few select schools and a few select disciplines. While North Carolina has a number of superior colleges, there is too much focus on a few select schools and a few select disciplines. This will not provide support and incentives for students to first, finish high school, and then develop trade skillswelders, skilled manufacturing workers that are needed for the job market in the 21st century. Moreover, computer literacy in many positions has become a necessity so that even at the high school level these skills have become necessary to be competitive in the job market. Projected job creation by education is illustrated in Figure 10 and reinforces the message that job opportunities exist across a broad level of educational attainments but that the high school diploma remains a key marker. For North Carolina, high school graduation rates are at 78 percent and just 48 percent for those with limited English proficiency according to the U.S. Department of Education, for the 2010-2011 school year. While for Tennessee, these rates are 86 percent and 71 percent, respectively.1 Figure 9
North Carolina Unemployment Rate
Seasonally Adjusted 12% Unemployment Rate: Aug @ 8.7% 12-Month Moving Average: Aug @ 9.2% 10% 10% 12%

Figure 10
Projected Net Job Creations by Education Attainment
35% 2000-2010 30% 25% 20% 15% 2010-2020 30% 25% 20% 15% 10% 5% 0% Less than H.S. H.S. Diploma Some Associate's Bachelor's Advanced College/ Degree Degree Degree Technical 35%

8%

8%

6%

6%

10%
4% 4%

5% 0%

2% 90 92 94 96 98 00 02 04 06 08 10 12

2%

Source: U.S. Department of Labor, NC Department of Commerce and Wells Fargo Securities, LLC

The composition of jobs by sector continues to change. For example, since the 1990s, there has been a steady decline in manufacturing jobs but, in addition, the character of manufacturing jobs has been moving up from the low-skilled machines that were previously used to highly skilled machines that are now used that require computer literacy more and more. The blue collar job of the past is not the manufacturing job of today in many sectors. Manufacturing and nonmanufacturing jobs have been trending in two different directions since the 1990s as illustrated in Figure 11. Therefore, the imperative for education is to focus on training workers for the high-quality jobs in the manufacturing sector and realizing that low1 Governing The States and Localities. High School Graduation Rates by State. Accessed Sep. 27, 2013 from http://www.governing.com/gov-data/high-school-graduation-rates-by-state.html.

How Does North Carolina Stack Up Today?* October 3, 2013

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

skilled manufacturing jobs that some associate with textile and furniture manufacturing will not return. One final point should be emphasized. There is a difference between manufacturing output and employment. While manufacturing jobs have declined since the 1990s, industrial production has continued to rise over time and sets a new high in each cycle since 1990. What has changed is the way we produce goods today. We now use more capital and less labor, but with a labor force that has moved up the scale in terms of skills. To be competitive, North Carolina needs those manufacturing workers who can handle the monitors and computer systems associated with 21st century manufacturing. Finally, for all those service sector jobs, there is also the need for better communication and social skills, as well as a set of social skills that comes from the home as well as a sense of community. These are often skills not necessarily associated with formal education but are nonetheless required for job success. This is especially true in the leisure & hospitality sector as many of us can relate to the experience of good or bad service at a restaurant. Figure 11
North Carolina Nonfarm Employment
Index 1990 = 100 160 160

There is a difference between manufacturing output and employment.

Figure 12
Corporate Tax Rates by State 2013

140

140

120 100

120 100

80

80

60

60

40

Manufacturing Employment: Aug @ 53.3 Non-Manufacturing Employment: Aug @ 157.1

40

20 90 92 94 96 98 00 02 04 06 08 10 12

20

Source: U.S. Department of Labor, The Tax Foundation and Wells Fargo Securities, LLC

Competitive business climate

A competitive business environment is initially associated with corporate and income tax rates but there is much more than that required for a competitive environment in North Carolina. As illustrated in Figure 12, the corporate tax rate in North Carolina puts the state at a competitive disadvantage and so the governor and the legislature have put in place a reduction of the tax rates, that are illustrated in Figure 13, such that North Carolinas tax rate will be more in line with its border states, especially South Carolina. Yet, a competitive business climate does not circulate around just a low tax rate policy. There is also the tax base to consider, workers compensation rules, tort reform and the general set of the rule of law and property rights. There are always the problems of special interests that will alter the tax base, for example, that will introduce arbitrary changes into the relative competitiveness of firms and industry sectors and thereby, create uncertainty for business and community decision making. In the past North Carolina, and its surrounding states, have used subsidies and tax incentives to attract business. The challenge is that such subsidies alter the business environment for existing firms in the state. Moreover, such subsidies or tax breaks should be examined under clear benefit/cost analysis to insure a proper assessment of the economic balance for the state. Another aspect of a competitive business climate is stability. The challenge here is that political cycles are two or four years and yet businesses must plan for the next five to 20 years. Investment and hiring decisions made today face a risk premium from political decisions that may be reversed in the future. In this way, to create a competitive environment there must be a buy-in for all political parties on the long-run strategy for business development over time.

How Does North Carolina Stack Up Today?* October 3, 2013

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

Figure 13
Corporate Tax Rate
2013
Corporate Tax Rate, 2014 @ 6.0 percent Corporate Tax Rate, 2015 @ 5.0 percent

Figure 14
Commercial & Industrial Loans by Bank Type
Billions of U.S. Dollars $1,800 $1,600 $1,400 Foreign Banks: Aug @ $261.9 B Small Domestic Banks: Aug @ $448.8 B Large Domestic Banks: Aug @ $860.2 B $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0

Tennessee

Virginia

$1,200 $1,000 $800

South Carolina

$600 $400

North Carolina

$200 $0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

2%

4%

6%

8%

10%

Source: The Tax Foundation, Federal Reserve Board and Wells Fargo Securities, LLC

Entrepreneurship and Innovation

Another key factor in perpetuating the future economic growth of the state is to have a strong foundation of entrepreneurship rooted in innovation. Another key factor in perpetuating the future economic growth of the state is to have a strong foundation of entrepreneurship rooted in innovation. An innovator is not necessarily the same as the entrepreneur. The innovator creates a new product or service that solves a problem but the entrepreneur builds on these innovations to create a business. The skills of entrepreneurship, however, are not so easy to teach and, hence, the attempt to promote entrepreneurship in North Carolina faces a number of hurdles but can provide great benefits.2 Moreover, the states leaders must ask themselves if they are willing to change? The entrepreneur thrives on change but that change can be disruptive to existing established businesses. The challenges that the railroad brought to the steamship and riverboat business are great examples in America of the challenges to innovation and entrepreneurship that faced greater political challenges than technical challenges.3 Sometimes these changes lead to dislocations and costs. Vested interests will be harmed, workers dislocated and small and large businesses will be hit. Societies suffer from an anchoring bias in decision making, which tends to make us prefer the familiar to the uncertain future. The first challenge to the entrepreneur is the challenge of acceptance in a society that prefers things as they are. Rules, regulations and credit are often barriers to entrepreneurs. What are the local and state barriers to the entrepreneur with regard to the rules set up on commerce and trade? While the state policy makers may talk about supporting the entrepreneur, the challenge is that many state regulations may stand in the way by the manner in which they regulate trade. Zoning, for example, can be logical but also onerous, in many ways. Meanwhile, credit cycles are readily apparent in Figure 14. In recent months, the availability of credit has improved and part of the entrepreneurs tool bag is the access and effective use of credit. Besides the private sector, the judicious use of state support will lend aid to the entrepreneur. There is a cycle of change in science and in business that must be recognized for effective policy making if North Carolina wishes to be competitive on the global stage. First, there is the framework of how we perceive the world works. This framework reflects the received knowledge of the past and a model of how things work today. Next comes change, and this upsets that framework. Consider the challenge that globalization represented to the established manufacturing firms in the United States. Once that change occurs, there are feedback effects. In the case of North Carolina, this meant that many, but not all, traditional textile, furniture and low-skilled labor intensive industries were challenged and became economically uncompetitive.
2 3

WSJ Sep 11, 2013 Teaching Entrepreneurship is in the Startup Phase by Bill Aulet. Daniel Webster and Abraham Lincoln were both associated with landmark legal decisions that focused on this balance of entrepreneur and change versus the established way of doing things.

How Does North Carolina Stack Up Today?* October 3, 2013

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At that time public and private policymakers had a choice. For public policy makers there is the choice of attempting to subsidize established firms and by how much and how long. For private firms, the choice was to shut down, move production abroad or modernize production here. In the end, a new framework for the economy will evolve and await for the next disruptive change, which will always come. For North Carolina policymakers, the pursuit of entrepreneurship is also the pursuit of change that will upset the established framework. Are the leaders of North Carolina willing to accept that change? Entrepreneurship and innovation are easier to sponsor as principles but more difficult to accept in practice.4

Infrastructure (Public and Private Capital)

Infrastructure (public and private) provides the backbone for efficient production and distribution of economic activity. Along the route from Charlotte to Raleigh, one crosses the new Yadkin River Bridge on I-85. The old bridge was an economic transportation hazard to the state as the construction and design of the curves, ups and downs, and several exits around the bridge represented a risk to this core transportation link in the state. The first challenge for infrastructure is the recognition that the infrastructure needs vary across the state and, moreover, the economic benefits of improvements are not evenly distributed across the state. This sets up a public policy problem right away where residents of a section of a state may not perceive themselves as getting their fair share. From an economic growth perspective there is a divide between the regions of Raleigh, Charlotte, Asheville, Durham/Chapel Hill and Greenville and the other regions of the state. Population growth, as well as economic growth, is not evenly distributed across the state or across voting districts. The challenge is to attempt to be fair and distribute spending across the state when needs differ. Another issue for infrastructure is finance. Over the past five years, the growth of the U.S. and the N.C. economy has slowed relative to the period of the 1970s-1990s. This represents a slowdown in revenue growth and therefore a greater challenge to finance infrastructure going forward. Moreover, consumer spending habits have changed. Consumers spend a greater share of their income on services relative to goods and therefore when infrastructure projects are financed out of sales tax receipts it is not surprising that the funding falls short of projections. Finally, we need to improve on our assessment of benefit/cost calculations for infrastructure projects as well as some assignment of responsibility when those estimates are way off base. The fallout from failure cannot always fall on the taxpayer. While the fashion is to focus on rapid transit, it is important to note that bus systems continue to provide service with flexible schedules and work quite well in global cites such as London or Hong Kong. Moreover, the benefit/cost calculations should consider the long- and short-run effects and beyond the political two-year cycle. How often have you asked yourselfwould it not have been less expensive to add a lane to this highway years ago? Alternatively, some public projects also suffer from the sunk cost bias whereby decision makers have put lots of money into a losing proposition and yet cannot stop funding the white elephant because, well, they have put so much time and money into this project. Infrastructure provides the backbone for efficient production and distribution of economic activity.

Recapping the Keys to Success

As economic indicators of the North Carolina economy continue to point up, the state needs to continue to adapt to perpetuate economic growth. Improvement in not only the quantity, but the quality, of employment will be one of the most important drivers of growth as the manufacturing sector, and labor market as a whole, continues to transition into a more highly skilled industry. With corporate tax rates set to decrease in the coming years, the outlook for the business climate throughout the state is set to become more favorable, however, other challenges still persist on the quest to lure more new businesses into the state. Encouragement of entrepreneurship and
4

This framework is further developed in John E. Silvia Dynamic Economic Decision Making, Wiley, 2011.

How Does North Carolina Stack Up Today?* October 3, 2013

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

innovation is another key for the future success of North Carolina as the need continues to diversify the states employment base. Last, public and private infrastructure investment is the backbone for future growth and provides a solid foundation within the state to increase potential growth going forward. As policymakers embark on debates over the future economy of the state, these factors should serve as key focus areas on the path to more robust and sustainable economic activity in the future.

Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg John E. Silvia, Ph.D. Mark Vitner Jay H. Bryson, Ph.D. Sam Bullard Nick Bennenbroek Eugenio J. Alemn, Ph.D. Anika R. Khan Azhar Iqbal Tim Quinlan Michael A. Brown Sarah Watt Michael T. Wolf Sara Silverman Zachary Griffiths Mackenzie Miller Blaire Zachary Peg Gavin Cyndi Burris Global Head of Research, (704) 410-1801 Economics & Strategy (212) 214-5070 Chief Economist Senior Economist Global Economist Senior Economist Currency Strategist Senior Economist Senior Economist Econometrician Economist Economist Economist Economist Economic Analyst Economic Analyst Economic Analyst Economic Analyst Executive Assistant Senior Admin. Assistant (704) 410-3275 (704) 410-3277 (704) 410-3274 (704) 410-3280 (212) 214-5636 (704) 410-3273 (704) 410-3271 (704) 410-3270 (704) 410-3283 (704) 410-3278 (704) 410-3282 (704) 410-3286 (704) 410-3281 (704) 410-3284 (704) 410-3358 (704) 410-3359 (704) 410-3279 (704) 410-3272 diane.schumaker@wellsfargo.com john.silvia@wellsfargo.com mark.vitner@wellsfargo.com jay.bryson@wellsfargo.com sam.bullard@wellsfargo.com nicholas.bennenbroek@wellsfargo.com eugenio.j.aleman@wellsfargo.com anika.khan@wellsfargo.com azhar.iqbal@wellsfargo.com tim.quinlan@wellsfargo.com michael.a.brown@wellsfargo.com sarah.watt@wellsfargo.com michael.t.wolf@wellsfargo.com sara.silverman@wellsfargo.com zachary.griffiths@wellsfargo.com mackenzie.miller@wellsfargo.com blaire.a.zachary@wellsfargo.com peg.gavin@wellsfargo.com cyndi.burris@wellsfargo.com

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