FT.com print article
Financial
Page 1 of 2
HOME UK
UK
Close
Worst-case scenario could be a consumer recession
By David Rosenberg
Published: August 16 2007 03:00 | Last updated: August 16 2007 03:00
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 and a combined $3,200bn 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 that 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
http://www.ft.com/cms/s/0/651882d2-4b90-11dc-861a-0000779fd2ac,dwp_uuid=4e6...
22.08.2007
FT.com print article
Page 2 of 2
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
Copyright The Financial Times Limited 2007
"FT" and "Financial Times" are trademarks of the Financial Times. Privacy policy | Terms
© Copyright The Financial Times Ltd 2007.
http://www.ft.com/cms/s/0/651882d2-4b90-11dc-861a-0000779fd2ac,dwp_uuid=4e6...
22.08.2007