United States: Is Recession Now in the Price?

Incoming data suggest that tighter credit has pushed the US economy to the brink, and we reiterate our call for a mild US recession in the first half of 2008. Weak employment data and slowing in export orders reported by purchasing managers undermine the case that a healthy consumer and strong global growth would forestall a downturn. Moreover, the ongoing housing recession is deepening, declines in capital goods bookings hint that business equipment spending will contract, and inventory liquidation seems likely. Our headline growth forecast for 2008 is unchanged at 1.1% using year-on-year arithmetic, but that largely reflects a stronger-than-expected 4Q07. On a Q4/Q4 basis, we now see real growth at 0.5%, 0.3% lower than a month ago. Most of the weakness is concentrated in the first half of the year; we project the economy will contract by about ¾% annualized in the first half of 2008, compared with 0.3% last month.

The key question now is how deep the recession will be and how long it will last. We continue to expect that the downturn will be comparatively mild and short; after all, recessions abroad are unlikely, so global growth will still be a prop; US excesses are modest away from housing, and peaking inflation should give the Fed latitude to ease monetary policy further. However, the slide in job growth hints at near-term downside risks. Private payrolls contracted by 13,000 in December; that’s the first such decline in four years. And more employment weakness is likely in construction and housing-related industries, in retailing, and in capital-goods producing industries. While wage income as measured by the 5.2% annualized gain in weekly payrolls over the past three months has so far held up well, such gains seem unsustainable.

The bad news, moreover, is that surging energy prices represent an additional threat to such wage gains when adjusted for inflation, and more broadly higher energy quotes threaten real income and spending. Because the recent oil price hikes are more the product of shocks to supply than demand, they will depress global growth and push up inflation. Only half of the $25 jump in crude quotes since the summer (to just shy of $100/bbl) has so far shown up in gasoline prices at the pump, as crack spreads have been stable and lags have delayed the pass-through to refined products. So far, that 30 cent/gallon increase has cost consumers $39 billion in annualized discretionary spending power; full escalation of refined product prices by another 30 cents would hammer consumer wherewithal at a time when soaring food quotes are also draining spending power, jobs are slipping, consumer lenders are more cautious, and household wealth is under pressure. Moreover, the escalation of both energy and food quotes seems likely to keep headline inflation as measured by the CPI above 4% at least through February, potentially complicating the Fed’s ability to respond to a weakening economy.

The good news is that aggressive central bank action to ease the tightening in money markets is working, and the pace of reintermediation may be fading. Action by the Fed and four other central banks to alleviate money-market pressures through the Fed’s Term Auction Facility (TAF), reciprocal currency swaps, and liquidity provisions abroad have all reduced market pressures (see “Bold Action: Central Banks Likely to Succeed,” Global Economic Forum, December 14, 2007). The Fed’s resolve to contain those pressures is evident in increasing the size of upcoming TAF auctions from $20 billion to $30 billion. However, money-market rates in relation to policy rates remain elevated. For example, although three-month dollar Libor-OIS spreads have declined from 108 bp over the past month to 73 bp, they are still 65 bp higher than they were in the spring. In our view, ongoing reintermediation likely will keep spreads wide — and possibly drive them wider again — at least through mid 2008, although the increase in Asset Backed Commercial Paper (ABCP) outstanding in the week ended January 2 may be a sign that the intensity of the pressure to move assets back on balance sheets is diminishing.

Nonetheless, financial conditions are becoming tighter as markets are in transition from a liquidity crunch to a classic credit cycle, which is just now spreading beyond mortgages as credit quality has peaked. In part, that reflects the fact that the earnings recession is gathering steam beyond financials. Consequently, financial restraint will persist, as lenders likely grow more cautious, high volatility sustains loan spreads over interbank lending rates, and equity prices continue to slide. For example, the spread over Libor for the LCDX 9 index of leveraged loans widened by about 20 bp to 340 bp over the past month, and yield spreads on bank loans over those money-market rates have stayed high or widened.

Against this backdrop, talk of fiscal stimulus is gaining popularity inside the Beltway and elsewhere, as some lawmakers and analysts view monetary policy as incapable of dealing with the current economic malaise. For example, former Treasury Secretary Summers has proposed a “timely, targeted and temporary” $50-75 billion package that would “contain the fallout from problems in the financial and housing sectors" and sustain growth. And NBER President Martin Feldstein advocates a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability that would automatically end when signs of recovery in employment appeared. More discussion will come up on Thursday at a Brooking panel including Former Treasury Secretary Rubin, Feldstein, CBO Director Orszag, and former Fed Vice-Chair Rivlin. Most analysts, us included, believe that fiscal stimulus is typically late to be enacted and is thus “pro-cyclical” — it kicks in as the economy is recovering. The 2001-03 tax cuts were the exception that proves the rule. Nonetheless, politicians want to be perceived as responding to voter angst about the economy.

While such talk may spur hopes for a quicker turnaround, we think genuine fiscal policy action is unlikely soon. The President, recognizing concerns about housing, energy prices, and the deterioration in the economy, is weighing alternatives. But he will wait until his State of the Union speech on January 28 to make any announcement.

Most important, we think it is unlikely that the President and the Democratic-led Congress will be able to agree on any substantive measures such as tax cuts or spending increases to spur growth. Their preferred policy tools are quite different from one another. The Administration will be eager to extend the Bush tax cuts beyond 2010 when they are scheduled to expire. Those include the 15% top tax rate on dividends and capital gains. For their part, Democrats may support extending those tax cuts only for middle- and lower-income taxpayers, including the 10% bottom bracket, the $1,000 child credit, and marriage penalty relief, and argue for relief on the Alternative Minimum Tax. But they don’t favor extending breaks on dividends and capital gains and they probably would push for targeted spending and expansion of unemployment benefits to help lower-income families and workers. Thus, a compromise seems unlikely unless the recession deepens and public opinion favors additional action.

With the economy weakening and headline inflation rising for a few months, the Fed will ease monetary policy further — we think by another 75 bp — and the yield curve will continue to steepen. Like our strategy colleagues, we aren’t bearish on US bonds, but much of this news is now in the price. Not so for US equities; despite more favorable valuations, our strategy team expects a 10% decline from start-of-year prices (see “There Will be Blood: 2008 Outlook,” January 7, 2008). Nor is our expectation for slower growth abroad in the price in overseas markets. Consequently, we expect that signs of a non-US slowdown will eventually promote a stronger dollar against the euro and a reversal in transatlantic spreads.

Risks for growth and inflation abound. We expect energy prices to come off their peaks in the spring, but further increases in energy and food quotes could push up inflation expectations, creating a whiff of stagflation and a deeper downturn. Likewise, with uncertainty high, additional consumer and business hesitation that shows up in consumer outlays, in hiring, or in capex orders could fuel the dynamics of the economic downturn, making it deeper or longer.

By Richard Berner & David Greenlaw New York
Morgan Stanley
January 7, 2008