Market insight: US economy left exposed to consumer recession

Market insight: US economy left exposed to consumer recession
By David Rosenberg
Copyright The Financial Times Limited 2007
Published: August 15 2007 17:15 | Last updated: August 15 2007 17:15


No economic expansion has relied more on credit and leverage than the one we have been experiencing since 2001. But it was always a matter of when, not if, this liquidity-driven bull market would run out of steam.

And run out of steam it has. The stresses to the system that started with the subprime mortgage upheaval have expanded not just into junk but also to high-grade corporate debt, to the prime mortgage sector and beyond the US border to hedge funds in Europe and Australia.

The economic impact of these stresses is likely to be far-reaching, with weaker gross domestic product growth, poorer performances by US corporates and a possible consumer recession.

As lenders become more cautious, reduced liquidity should damp economic activity at a time when the US economy already appears vulnerable. Underlying GDP growth has slowed to little more than 2 per cent. Private domestic spending growth is even weaker, at about 1 per cent.

We have stress-tested our model to allow for sharply lower equity prices, wider credit spreads and a further dip in house prices.

These new assumptions change the economic outlook significantly. Real GDP growth will take a notable hit, and we believe that the consensus view of 2.5 per cent to 3 per cent growth for the next few quarters remains too high. We see real GDP growth at 1.5 per cent in 2008, below our prior call for 2.3 per cent and down from an expected 1.8 per cent trend this year.

We could see the first consumer recession in 17 years in the first-half of 2008. The consumer is likely to take the brunt of the impact from the depressed wealth effect that comes from lower home and equity prices. Our worst-case scenario paints a picture of a perfect storm for consumers: a $130bn tax from petrol at $4 per gallon, a combined $3200bn in lost home values and equity portfolios.

We believe that consumer spending growth will average 0.5 per cent in 2008, a significant drop from our prior call of 2.2 per cent. We expect declines in consumer purchases of “big ticket” durable goods through most of 2008, with the weakest parts of the cycle to be felt in the first half of 2008.

Corporations are feeling the pain of tighter credit. We now see operating earnings per share for 2008 at $92 (down from $97 before), which is a 1.1 per cent decline from the $93 tally we expect to see for 2007. This would be the first annual decline since 2001.

Since we forecast industry capacity utilisation rates falling from about 82 per cent now to 77 per cent by the end of 2008, corporate pricing power in general is also expected to recede, although slowing wage growth and range-bound oil prices should prevent margins from collapsing.

In the next few weeks the US Federal Reserve may well turn its attention away from inflation and towards financial market in stability.

In our opinion the Fed will cut interest rates sooner than the consensus and markets currently expect – if econ omic weakness continues and the financial market jitters are sustained. As a result, we have moved our easing call back to October, although this is a close call because the Fed typically does not cut until there is maximum pain.

As was the case in the prior two asset cycles in the early 1990s and just six years ago, we see the cuts being deep, with the funds rate falling to 3.75 per cent by mid-2008. This would continue to spark a rally in bonds. Looking to 2009, we see a classic post-bubble U-shape recovery unfolding as the expected interest rate cuts bump up against the tightening in lending standards. With lags from Fed easing and lower bond yields, as well as a full cleansing of the housing excesses, growth should recover to 2.5 per cent.

But for the meantime we welcome a new economic phase – one where growth slows enough to generate declines in real per capita income and a rising unemployment rate. Looming Fed rate cuts will act as a buffer, but since there is nothing left to reflate, there will be no more easy fixes.

The author is chief North America economist at Merrill Lynch