United States: 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, we expect the Fed to insure against worse outcomes. That process started this week with a 25 bp reduction in the Federal funds rate, a similar cut in the discount rate, and, importantly, coordinated central bank actions aimed at easing strains in money markets. In addition, 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 over the past month; while some of that increase reflects the transitory impact of year-end precautionary demands for liquidity, some represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008. 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. High-yield and CMBS spreads have widened even more significantly, increasing the cost of borrowing 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, but our US bank analyst believes that the partial freeze will not appreciably lower the expected level of bank provisioning. 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. The 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, 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. 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. 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.

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%. On top of spillovers from the US slowdown, a strong currency, and elevated energy prices, the increased stress in money and credit markets is likely to hurt corporate spending for most of 2008. Likewise, 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, domestic policy blunders likely 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 4.3% 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, with downside risks to growth in US exports.

It’s also worth noting some lesser-plumbed features of the domestic US scene. First, even if housing demand were to stabilize, 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. 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. And our oil team expects that crude oil quotes (measured by WTI) will average about $83/bbl in 2008, or about $10 higher than this year.

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. 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. 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.

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. 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, 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.

By Richard Berner and David Greenlaw New York
Morgan Stanley
December 16, 2007