Global: Recession Coming

We’re changing our calls for US growth and monetary policy. Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth. But the time for incremental changes is over. A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period. Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing.

The prospect of real GDP growth persistently between 0-1% changes the character of and risks to the outlook. Thus, even if the data do not immediately validate our call, we expect the Fed to insure against worse outcomes. That process should start this week with a 25 bp reduction in the Federal funds rate, a 50 bp cut in the discount rate, and possible extensions of term open-market operations to as long as 65 business days to help ease strains in money markets. Following that, we think officials will ease by at least another 75 bp over the next 7-9 months. Here’s why.

First, compared even with a few weeks ago, financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available. Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened. Three-month dollar Libor-OIS spreads have jumped by 60 bp to 100 bp over the past month, so that Libor rates in that tenor are merely 20 bp lower than where they were in the spring. Some of that jump in Libor rates reflects the transitory impact of year-end precautionary demands for liquidity. But we think that some also represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008 (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007).

Leveraged loan and credit default swap spreads over Libor, meanwhile, have been mixed: They have tightened appreciably over the past fortnight but have widened by 40 bp or more over the past month, measured by either the LCDX leveraged loan index or the S&P secondary LCD/LSTA measures. High-yield and CMBS spreads have widened even more significantly, increasing the cost of borrowing appreciably for lower-rated borrowers, including those in commercial real estate. As a result, the absolute cost of borrowing is higher than in June.

Credit availability, moreover, likely has dwindled beyond where the Fed’s November Senior Loan Officer survey left it. As delinquencies and defaults soar, lenders and investors are tightening credit for commercial, credit card and auto lending, as well as for mortgage borrowers. Delinquency rates on all 1-4-unit residential mortgages jumped to a 19-year high of 5.59% in the third quarter, and the foreclosure start rate rose to a record 1.69%. With home prices just now falling by some measures, credit tightening, and resets looming, more foreclosures are likely. The new plan to freeze ARM resets for five years may be a win-win for some borrowers and lenders; foreclosures are costly for all. However, US bank analyst Betsy Graseck estimates that the partial freeze will only be a modest positive and will not appreciably lower the expected level of bank provisioning (Subprime Rate Freeze Benefit Too Modest to Matter, Sticking with Cautious View, December 10, 2007). In addition, it may add a risk premium to mortgage credit and further reduce its availability. Delinquencies and net charge-offs (NCOs) for other forms of credit are still low by historical standards but they are rising.

The second new factor is coming weakness in business capital spending. This tightening in financial conditions likely will undermine spending to some degree, but three other factors account for most of the prospective weakness in corporate capex. Slower top-line growth itself, sagging operating rates, and a downturn in corporate profits all seem likely to promote a 1.7% contraction in real business capital outlays over the four quarters of 2008.

At work will be the time-honored “flexible accelerator” model of investment, which implies that business investment will respond with a lag to changes in the desired stock of capital in relation to output. As a result, a slowing in the growth of economic activity will depress the level of investment. Managers will tend to extrapolate a slowdown in business activity into dimmer expectations of future growth, lower perceived returns from investing, and a reduced need to invest. Until the economy re-accelerates, therefore, capital spending probably is at risk (see “Capex Recession Ahead?” Global Economic Forum, October 1, 2007). Moreover, the coming earnings recession means internally generated cash flow that has helped to finance investment over the past six years is fading fast as earnings decline — just as lending markets have turned inhospitable (see “The Earnings Recession,” Investment Perspectives, December 6, 2007).

The final factor behind our change in view is that while growth abroad is still strong, slowdowns in Europe and Japan are undermining it. Our European colleagues have cut their GDP growth forecast for the euro area by 0.4 percentage point for 2008, to 1.6%, and by 0.3 pp for 2009, to 2.2%. Eric Chaney notes the reasons: On top of spillovers from the US slowdown, a strong currency, and elevated energy prices, increased stress in money and credit markets is likely to hurt corporate spending for most of 2008. Likewise, David Miles and Melanie Baker think tighter credit conditions and falling home prices probably will undermine UK growth.

And in Japan, our team has just cut their 2008 forecast by a full point to 0.9%. While Japan doesn’t face a full-blown credit crunch, Takehiro Sato believes that domestic policy blunders will combine with the US slowdown to produce serious weakness. Changes to regulations are hurting consumer and small-to-medium business financing; revision of the Building Standards Law has led to a sharp drop in housing starts; and fear of tax hikes has further harmed consumer sentiment. The upshot: Global growth likely will slip from 5% in 2007 to 4.2% in 2008, and the risks lie south of that still-hearty pace. That’s because spillovers into other parts of the world may yet undermine legitimate resilience in Asia and Latin America. And that means downside risks to growth in US exports.

While investors are expecting that an ongoing housing downturn and threats to consumers already menace growth, it’s worth noting some lesser-plumbed features of the domestic scene. First, we think tighter lending standards will depress housing demand further. But even if demand stabilizes, so large is the supply-demand mismatch that builders must slash single-family housing starts by 40% from current levels to eliminate the inventory of unsold homes. As a result, we think overall housing starts will run below one million units in each of the next two years — a level not seen in the history of the modern data since 1959. The housing downturn will likely subtract 0.9% from growth in the next four quarters, and the housing recovery in 2009 will hardly merit the name.

Second, while energy prices have come down from their recent peaks and may continue to slip, the rise in energy and food quotes between June and December of 2007 likely will have drained about $45 billion, or 0.4%, from consumer discretionary income. Moreover, long-term relief is unlikely; Doug Terreson and our oil team expect that crude oil quotes (measured by WTI) will average about $83/bbl in 2008, or about $10 higher than this year (we translate that into a $7 increase for Brent to $79.40).

Thus, consumers still face what could be a perfect storm. Job gains have been supportive of income growth, with monthly gains in nonfarm payrolls running an average 103,000 in the past three months. That is hardly surprising, as the economy grew at a 4.4% annual rate in the past two quarters, and employment lags GDP. But the number of nonfarm self-employed workers fell by a monthly average 138,000 over the same period, although that job canvass is certainly less reliable than the payroll survey. And more timely labor-market indicators such as jobless claims are weakening; the rise to 340,000 on average over the past four weeks is a two-year high. With wages decelerating, income gains are slowing significantly. (As an aside, revised data show that the level of wage and salary income is $45 billion lower than previously thought). Housing prices and stock markets are both under pressure; we expect a 10% real decline in home prices over the next year, and that has just begun. Thus, consumers will be more cautious.

In addition, the same factors that are hitting capital spending are also depressing inventories. Such stocks aren’t especially high in relation to sales, but slipping sales and tightening credit are pushing companies into liquidation mode, especially in motor vehicles. Auto analyst Jonathan Steinmetz thinks that Detroit is switching from “putting money on the hood” to accepting lower sales and making production cuts. We estimate that cuts in motor vehicle output will trim 0.3% and 0.5% from Q4 and Q1 GDP, respectively. Moreover, slipping revenues and rising health costs are constraining state and local government budgets. In response, some officials, like California’s Governor Schwarzenegger, are calling for sizable spending cuts. Finally, a faltering economy will create uncertainty, which itself is the enemy of growth. It will impair willingness to lend and dampen animal spirits.

Those negatives sound like the recipe for a serious recession, so why do we think it will be mild? Although it is slowing, global growth is still strong, and we expect that net exports will add about ¾ percentage point to growth through the end of 2008. In addition, we think that corporate capital and hiring discipline in this expansion mean that there are no business-investment or labor-market excesses to unwind, adding to US economic resilience. Finally, low inflation gives officials the latitude to respond to weakness. But while any downturn in our view will be short and mild, the range of possible outcomes is high.

The Fed, in response to this unfolding weakness, will have more work to do. As Fed Chairman Bernanke noted ten days ago, “[market] developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors. Needless to say, the Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.” Just to keep monetary policy neutral, the Fed must ease to offset tighter financial conditions, yet we think policy ultimately will need to turn accommodative. At a minimum, therefore, officials will want to bring the real Federal funds rate down significantly. Inflation risks are not dead, with the dollar having weakened, import and energy prices rising, and productivity growth slowing. But the Fed will likely judge that the downside risks to growth outweigh upside inflation risks.

A more aggressive Fed, an earnings recession, healthy growth abroad, and a scramble for liquidity all will reinforce our longstanding market calls for steeper yield curves, higher volatility, and challenges for risky assets. While many of these themes are in the price, economic uncertainty may extend them further. And markets are not priced for the weakness in either US capital spending or the coming deceleration in overseas growth. As our colleagues Abhijit Chakrabortti and Stephen Jen outline in separate pieces, despite the US downturn, those factors lead to two paradoxical and out-of-consensus market conclusions: Outperformance in US stocks and a stronger US dollar (see Atonement – Navigating a US Recession and The Dollar Smiles in a Recession, December 10, 2007).

One risk is that both our outlook and the Fed’s are too optimistic, because they pay too much attention to the economic resilience of the past, and not enough to the future effects of financial and economic headwinds and the dynamics of the downturn. Dramatically slower growth in domestic demand leaves it vulnerable to shocks. Insufficient Fed action could again threaten a deeper economic slowdown. A contrasting risk is that we’re swayed by Wall Street pessimism and that things may be better on Main Street. In our view, downside risks still dominate.

By Richard Berner & David Greenlaw New York
Morgan Stanley
December 10, 2007