Outlook 2008: Avoiding the “R” word

Outlook 2008: Avoiding the “R” word

The U.S. economy is throwing off plenty of negative signs, and the dollar is under water. But solid GDP growth and an export boom have the potential to offset the negatives in the coming year.

As the end of 2007 approaches, the U.S. dollar index is near its all-time low, U.S. stock indices are well off this year’s highs, and the ongoing sub-prime mortgage implosion continues to undermine financial market confidence.

Heading into 2008, there are growing whispers about the possibility of recession in the U.S. A retrenchment in consumer spending in the wake of the continuing housing recession poses one of the biggest risks to the economy. Throw in crude oil near $100 per barrel and the potential for slower global growth and things indeed begin to look worrisome.

Despite these dangers, however, there are some bright spots for the U.S. economy, with exports leading the way. For now, most economists seem to believe the threat of recession will remain simply that — just a threat.

Recent economic data
Let’s take a look at some of the recent numbers. First, preliminary third-quarter U.S. gross domestic product (GDP) growth of 3.9 percent hardly looks recessionary.

The standard rule of thumb for defining a recession is two consecutive quarters of negative GDP growth. Of course, there is some wiggle room in that definition, and in the U.S., the privilege of labeling an economic downturn a recession has fallen onto the shoulders of the National Bureau of Economic Research (NBER) http://www.nber.org.

The third-quarter GDP data follows a second-quarter reading of 3.8 percent and a first quarter reading of 0.6 percent. However, the International Monetary Fund recently downgraded its U.S. GDP forecasts for both 2007 and 2008, cutting this year’s overall forecast to 1.9 percent and predicting 2008’s final number to be 1.9 percent as well.

Paul Kasriel, director of economic research at Northern Trust Company, is forecasting 1.7-percent GDP growth from the fourth quarter of 2007 to the fourth quarter of 2008.

“But the risk is to the downside,” he says.
Kasriel is one of the economists who believe the U.S. economy faces a number of critical risks ahead. Consumer spending, which represents about two-thirds of the overall economy, is one of the main engines of growth in the U.S. It is also precisely where Kasriel sees problems.

“There is a very definite potential for recession,” Kasriel says. “We are starting to see the housing recession spreading to the consumer-spending sector. Also, in 2008 I think state and local government spending will be restrained because of lower tax revenues.”

However, Diane Swonk, chief economist at Mesirow Financial, has a much more upbeat outlook.

“After a slow start and a slow end to 2007, I think we will see a reacceleration of growth in the second quarter of 2008,” she says. “That is when the effect of recent Fed easing will kick in.”

Swonk is forecasting overall 2008 GDP growth around 2.5-2.75 percent. She does, however, see a drop in the fourth quarter of 2007 to 1.5 percent.

The end of the home ATM
Probably nothing is hanging heavier over the economy than the far-flung repercussions of the sub-prime mortgage crisis and the developing housing recession. In the Nov. 5 New York Times article, “Homeowners Feel the Pinch of Lost Equity,” Peter Goodman wrote: “From 2004 through 2006, Americans pulled about $840 billion a year out of residential real estate, via sales, home equity lines of credit and refirefinanced mortgages, according to data presented in an updated working paper by James Kennedy, an economist, and Alan Greenspan, the former Federal Reserve chairman.

“These so-called home equity withdrawals financed as much as $310 billion a year in personal consumption from 2004 to 2006, according to the data. But in the first half of this year, equity withdrawals were down 15 percent nationally compared with the average for the last three years, and consumption supported by such funds plunged nearly onefourth, according to the Kennedy and Greenspan data.”

U.S. home sales dropped 8.0 percent in September to an annualized rate of 5.04 million units — the lowest pace since the National Association of Realtors (NAR) began tracking this data in 1999, the NAR says. The September decline followed a 4.7-percent drop in August, a 0.2-percent fall in July, and a 3.7 percent decline in June. Also, in September, the most recent data available, home prices fell 4.2 percent, while the month supply (inventory) rose to 10.5 months.

New home sales in September jumped 4.8 percent following a 7.9-percent decline in August. However, housing starts plunged 10.2 percent in September to 1.19 million units — a 43-percent decline from the recent high in 2005, according to the NAR.

Consumer confidence has definitely taken a hit in the wake of the decline in residential real estate sales. The preliminary November Michigan sentiment survey revealed a sharp drop in sentiment from 80.9 in October to 75.0 in November. Higher energy prices, a weak housing market, and overall concerns about the U.S. economy were blamed for the decline.

Two-tier economy?
One problem with the current situation might be the disconnect many people see between some of the economic numbers vs. their personal experience.

“We continue to get numbers that make the economy look better on paper than it feels to a lot of people,” Swonk says. “Higher energy prices and the weakness in housing disproportionately hits middle and lower-income people. Even though the economy will technically skirt a recession,
it may not feel like it to a whole sector of people.”

Despite her relatively optimistic outlook, Swonk sees consumer spending slowing from a 3.0-percent pace in 2007 to a 2.25-percent pace in 2008.

“Consumer spending is moving forward, but it sure doesn’t feel like it,” she says.

The sunny side of the economic street
While the U.S. dollar has been dropping like a brick vs. the euro and the British pound (Figure 1), it has had a positive impact on one sector of the economy — exports. Tim Rogers, chief economist at Briefing.com, calls recent export data, including third-quarter exports totaling $1.4 trillion, “fairly astounding.”

According to the September 2007 figures, imports totaled $197 billion while exports came in at $140 billion — still lower than imports but up about 14 percent year-over-year, according to Rogers.

“The weak dollar helps drive things,” he says.
This phenomenon has helped trim the mammoth U.S. trade deficit, which Rogers says has fallen about 18 percent from its all-time high of $69 billion in August 2006. Swonk also sees continuing improvement in U.S. exports, with an 8.4-percent increase in 2008.

“It is a very robust export picture, with the dollar giving a tailwind to market-share gains,” she says. A related boon to the economy courtesy of a weak dollar is increased foreign tourist spending.

“When you can buy Prada cheaper in New York than in Paris, it makes Madison Avenue look like a flea market to Europeans,” Swonk says.

Ken Goldstein, economist at the Conference Board, believes the U.S. will sidestep recession next year, partly because of the export boom. He is also optimistic the housing sector is nearing a bottom. Lastly, Goldstein addresses the pivotal role of the consumer.

“Two-thirds of the economy is growing by 2.0 percent,” he says. “The consumer is slow, but not stalling out.”

Still some clouds on the horizon Despite some optimism regarding 2008’s economic prospects, economists admit there are still a number of black clouds darkening the horizon. First and foremost is crude oil near $100 per barrel, which has potential inflationary implications throughout the entire economy.

“It is not just that price, but at what price do we see a gallon of milk go up because of gas?” Goldstein says. “How much more does it cost to get the milk from the dairy farm to the grocery store? And it’s not just milk. It’s stretching household budgets — there’s a chance it might tip the consumer.”

The weaker dollar itself is also inflationary because it increases the price of imported goods. While the lower greenback supports the export picture, “the second shoe on the dollar is yet to drop,” Swonk says, pointing to “the full impact of the oil price increases and the full effects of the
inflationary consequences.”

Another black cloud hovering on the horizon is continuing fallout from the sub-prime mortgage mess, which has proven to be more far-reaching on Wall Street than most people initially dared to imagine.

“There is uncertainty as to where the dust will settle with the sub-prime debacle,” Swonk says. “The process will take another three to six months to get some stability and will leave the dollar vulnerable.”


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