Optimists are Finding it More Difficult Not to Use the “R” Word

Below is another point of view on the chances of a recession. What bothers me is that 3 months ago many people were saying that the chances of a recession were pretty small. Now the markets and businesses are flashing recession signals. I don’t know what is going to happen and neither does anyone else, but signals are definitely becoming more pessimistic. Text in bold is my emphasis. From the WSJ:

Battered stock and bond markets are sending an increasingly ominous signal that a U.S. recession could be near.

The markets, however, haven't swayed Federal Reserve officials and most private economists from their view that the nation's economy can escape a downturn and get back on a steadier course.

The disparity between those two views of the economy -- one growing bleaker, the other remaining sanguine -- stood out starkly last week. . . . .

. . . . . Who's right? History isn't much help. The stock market is notorious for predicting downturns that never materialized, while economists have failed to acknowledge some recessions until after their arrival. "Economists are extremely bad at predicting turning points, and we don't pretend to be any better," Fed Chairman Ben Bernanke told Congress earlier this month.

This time around, much depends on how tight a rein financial institutions keep on their lending and consumers keep on their spending.

By itself, the housing slump seems unlikely to choke off U.S. economic growth. Home construction accounts for less than 5% of the nation's gross domestic product. But if banks curb their lending in response to billions of dollars of mortgage-related write-offs, or if consumers cut their spending as home values fall and gasoline prices rise, it could knock the economy out of its delicate balance.

"Even if you're a dyed-in-the-wool optimist you have to say it's a more challenging time than normal," says Michael Feroli, an economist at J.P. Morgan, which cut its U.S. economic forecast last week. It now expects GDP to grow at an anemic annual rate of 0.5% this quarter and 1.5% in the first three months of 2008 -- but no recession. . . .

. . . . . The outlook for the global economy depends largely on whether the rest of the world -- particularly Europe and Asia -- can pick up the slack. But Europe's outlook is growing cloudy. Interest rates are rising in the markets European banks use to borrow money. And the banks have grown wary of lending to each other because of anxiety about potential losses on investments tied to the U.S. mortgage market.

If sustained, the jump in interest rates could further crimp economic growth in the euro zone, which already faces headwinds as a strengthening currency makes its exports more expensive. The European Central Bank, while vowing to pump credit into markets to keep market rates from rising, is also warning about inflationary pressures, a concern that could keep it from following the Fed in cutting its target for short-term rates.

Economists, however, take heart from the U.S. economy's proven ability to withstand shocks, financial and otherwise, something Mr. Bernanke noted earlier this month. So far this decade, the economy has faced terrorist attacks and a historic technology-stock bust with nothing but a mild recession. Since then, it has continued to grow despite the war in Iraq, soaring oil prices and the destruction and dislocations wrought by hurricane Katrina. All the while, consumers kept spending and corporate profits soared.

This week, the Commerce Department will be revising its estimate of third-quarter GDP, and it is expected to show the U.S. economy grew at an annual pace of well over 4% between July and September, even as the financial markets went through credit-related spasms. Part of that growth was due to a buildup of inventories at businesses. But job and income growth, which are still in positive territory, have also proved to be important in sustaining consumers.

The stock market, however, has rendered a different verdict on the outlook for spending and lending. According to Thomson Financial, the current consensus on Wall Street is that earnings of companies in the Standard & Poor's 500-stock index will grow 2% in the fourth quarter and 8% in the first quarter, but expectations are falling fast for retailers and others whose fortunes are tied directly to consumer sentiment.

Consumer discretionary stocks, which also include home builders and auto makers, have been among the market's worst performers. Discretionary stocks in the S&P 500 index are off about 13% on the year. A major cause is the deepening woes of home builders. But shares of companies like department-store operator Nordstrom Inc., handbag maker Coach Inc. and luxury jeweler Tiffany & Co. have also slumped in recent months, a possible sign that even higher-end households are beginning to feel the pinch from lower home prices and costlier oil.

The Conference Board's survey of consumer confidence fell in October for the third month in a row, sending the index to a two-year low. A similar monthly survey conducted by Reuters and the University of Michigan reported that consumer sentiment in November fell to a two-year low and, excluding the months after Hurricane Katrina hit in 2005, reached its lowest point since 1992. The survey's sponsors warned that "the risk that a recession develops is uncomfortably large.". . . .

. . . . "I don't think the consumer is going to pull back for a quarter and then rebound again," says portfolio manager Ed Maraccini, of Johnson Asset Management in Racine, Wis. "This is something that is going to be longer term," especially in light of consumers' reduced ability to borrow against the value of their homes to purchase big-ticket items.

. . . . . Other market indicators are worrisome. Instead of stocks and other risky forms of debt, investors have been buying up Treasury bonds lately. Short-term Treasury yields have plummeted, signaling that many investors believe the Fed will have to cut its own interest-rate target again when policy makers meet next month. Such a move would lower borrowing costs throughout the economy and could help to spur growth.

There are signs the housing and credit crises might be starting to affect business confidence. In a survey of manufacturing from the Institute for Supply Management, the activity index dropped last month to 50.9 -- barely staying above the 50 that indicates growth. "It does appear that the impact of the slowdown in the financial, housing and transportation segments has spilled over into manufacturing, with the exception being continued strength in new export orders," noted survey chair Norbert Ore. . . . .

. . . . . Many economists are looking abroad as a growth alternative. Thanks to a weak dollar and strong growth overseas, U.S. exports grew at a 16.2% annual rate in the third quarter, making them an increasingly important contributor to economic growth.

"The world in 2007 and early 2008 is very different from what it was in 2001," says Brian Bethune, U.S. economist at Boston-based research firm Global Insight. "A strong overseas economy including a strong Asia, Latin America and a lot of demand from Middle East is enough to keep the economy from shrinking."