Recession?

 

It's been awhile since we have examined the current state of the economy, so we thought that it would be a good time to update the outlook.

 

After growing at a paltry 0.6% annual rate of growth in the fourth quarter of last year, the economy appears to have come to a virtual stop in early 2008.  The ongoing drag from housing-combined with declines in the stock market, deteriorating credit markets, and sharply higher oil prices-robs the consumer of any residual confidence, bringing consumption to a halt and further weakening business investment. Even the continued strong performance in exports is unlikely to be sufficient to keep the economy moving forward.

 

We are projecting growth to average less than 1.0% for the first half of 2008 before rebounding in the second half as the Fed's aggressive action and the president's stimulus package begin to impact growth. Growth from the third quarter of last year through the middle of this year is expected to be so weak that even if the economic situation avoids being labeled an outright recession (the current odds of which are a coin flip), no one will notice the difference!

 

Whether we end up in a recession, and how long and deep that decline may turn out to be, will depend, in large part, on the consumer. Consumption slowed in the fourth quarter to an annual rate of 2.3%, down from 2.8% in the third quarter, and may have actually declined in the first quarter of this year. How quickly and strongly it rebounds will depend on whether, and how soon, the stock market stabilizes and oil prices drop, as well as how quickly monetary and fiscal stimuli are felt. One positive sign is that growth in real disposable income-the primary driver of consumption-continues to increase, albeit very slightly, despite declines in payroll employment.

 

As for the housing market, we continue to see weakness and expect this trend to last. However, it appears that the most recent sales data were not quite as bad as expected, so we may be nearing the end of the initial free fall stage in the correction. With lower interest rates, lower prices, and continued income growth, housing affordability has risen sharply, and improvement in sales may not be too far down the road. Moreover, while delinquencies and foreclosures in the subprime areas are increasing and are expected to go higher, the traditional end of the market has fared much better and shows few signs of contagion, other than weak sales.

 

On the construction front, housing starts are still falling and are currently at levels not seen since the early 1990s. We may not see improvement here until the end of this year or early next year.

 

While there are considerable problems in residential investment, equipment and software investment rebounded a bit over the final three quarters of last year but remains weak by historical standards. The bonus depreciation and increased Section 179 expensing provisions in the stimulus package should encourage some firms to make investments now rather than wait, so we expect to see modest improvement in this category over the remainder of the year.

 

Investment in structures increased at a 14.7% annual rate in the fourth quarter, after rising at a torrid pace of 26.2% in the second quarter and 16.2% in the third quarter. We expect investment in structures to remain a positive factor for GDP, though at a more moderate pace going forward.

 

Corporate profits remain relatively robust by historical comparisons, but with stock prices depressed and the threat of takeovers rising, it appears that businesses may be using this internal cash flow to buy back shares and adopt a defensive posture rather than investing in new equipment. Hopefully, the stimulus package, with its bonus depreciation component, will shift the equation back in favor of investment growth.

 

The trade sector continues to be a life preserver to the rest of the economy. With the dollar down by more than 35% from its peak in 2002 (down 13% in the last year alone), import growth is falling and exports are soaring. Export growth in the fourth quarter increased 6.5% at an annual rate, offsetting much of the weakness from housing. With solid growth abroad and the dollar expected to remain weak, we should see continued improvement in the trade balance and strong export growth over the course of this year.

 

The economy lost 232,000 jobs in the first quarter of 2008, down sharply from a gain of 241,000 net new jobs in the fourth quarter of last year and well off the gain of 1.1 million new jobs for all of 2007.

 

Not surprisingly, the housing debacle has contributed to the decline in jobs, with employment in the construction industry falling by 394,000 since its peak in September 2006, mainly due to losses in residential construction. The manufacturing sector continues to experience problems as well, with a first quarter loss of 129,000 jobs on top of a 261,000 job decline for all of 2007.

 

The unemployment rate increased to 5.1% in March. This rate has gradually been trending up, increasing from an average of 4.5% in the first half of last year and 5.0% at year-end. Given continued weakness, we are projecting the unemployment rate to climb through the remainder of the year to just below 5.5%. 

 

Overall inflation, which had picked up throughout 2007 owing to higher oil and gas prices, has subsided a bit with the softening economy in the early part of this year. Core inflation (net of food and energy components), which had exceeded most estimates of the Fed's comfort range at the end of last year, has also dropped over the most recent period, giving the Fed more leeway to address problems in the credit markets. Despite the recent easing in inflation, market expectations for future price increases continue to put upward pressure on long-term interest rates, offsetting some of the impact of the Fed's recent moves.

 

The Fed cut interest rates for the sixth consecutive time on March 18 by 75 basis points, lowering the target rate to 2.25%. The Fed has now cut rates by 300 basis points since the middle of last year. As we write this, prior to the next Fed meeting on April 29 and 30, we expect at least one more rate cut.

 

The Fed acted aggressively to stem the problems in financial and credit markets by creating two special lending facilities to re-liquefy markets and provided about $30 billion in debt swaps to help grease the buyout of Bear Stearns by JP Morgan. Finally, the Fed took the unprecedented action of opening the discount window for direct lending to primary dealers. 

 

The recent aggressive actions by the Fed and the aforementioned stimulus package should be enough to get growth growing again by the end of the second quarter. In the interim, however, we will likely be growing slowly, if at all. Is this a recession? The question is really academic. Whether it is or it isn't, we are going to feel bad for the time being, but it shouldn't last long.