2008 Economic Outlook: Dominoes All in a Row

Includes: DIA, QQQ, SPY
by: Ray Hendon

If ifs and buts were candy and nuts, we'd all have a feast! When economists speak of the future, they are often guilty of equivocating their predictions. In their defense, there is always uncertainty about the future. It unfolds in its own way, impervious to ideology, politics, condition of servitude, or level of erudition. So, beware when anyone takes the cover off of a crystal ball! That said, this is my take on what the professionals are saying about what to expect in 2008. Here are three possible scenarios of how the dominoes will fall, and there are no feasts in the offerings:

  • A slowdown in growth to a "below trend" level, meaning little or no growth. This is the best outcome we can expect. Unemployment would rise, but probably not much, and we would continue growing, but more slowly. Most all agree there will be a slowdown.
  • A mild recession where actual GDP falls for two or three fiscal quarters. This is the mild form of a bad outcome. This is not the preferred scenario for incumbents in an election year, so expect to hear a lot of jawboning about how good things are from one side and how bad from the other. Opinions are mixed about this prediction. Probably less than half give this a big chance.
  • Either of the above combine with a much higher level of inflation, producing the worst of all worlds, "stagflation." In this context, stagflation means a stagnant economy with high inflation. This is the worst case we can expect, at least for now, and it is bad. At its worst, it will mean falling real incomes for almost everyone: jobs will be harder to get, and falling or stagnant wages and rising prices make it worse. Few actually predict this scenario, but all fear it.

 There is no uncertainty about the prime cause of these scenarios. It is the subprime mess. The only disagreement is over how bad it will be, and how many dominoes will fall once full steam is achieved in the decline. The New York Times had this summary, which I think is accurate:

The crisis has generated almost $100 billion in losses or write-offs at the world's largest financial institutions, cost a couple of Fortune 100 chief executives their jobs, wiped out billions of dollars in stock market value and hammered the reputations of the nation's top credit rating agencies. Reports of the devastation that foreclosures are wreaking on borrowers also bring home the effects of this remarkable financial mess. (NY Times, 12/30/07)

The complexity of the situation is compounded by the fact that the effects are not confined to a single sector of the economy.

The consumer sector, today, is characterized by falling real estate prices and increasing mortgage defaults. Furthermore, real estate prices are expected to continue falling through 2008 (or longer) and home foreclosures are expected to accelerate. The construction sector is down, and sales of existing homes are about as bad. This is a sign of reduced consumer spending that will probably get worse as the year matures. What makes it even worse is that in the last couple of years, GDP growth has been pumped up by high consumer spending. The problem is that much of this spending has been fueled by the money borrowed against home equity. With home equity now declining, this source of growth is disappearing. The financial sector is also reeling, and here the consequences are more complex, and, unfortunately, scarier. Banks, brokers who packaged subprime instruments, and hedge funds that bought them are all vulnerable.

But for now, no one seems to know how many other shoes are to drop before we can finish counting the casualties. As you might think, repercussions from the world of high finance do affect the rest of us. Changes in lending policies and instability in their balance sheets can hit borrowers hard. If short term credit dries up, many legitimate businesses will have their short term financing needs denied. This is the domino most feared, because the implications are quite serious! The manufacturing sector has already been hurt by the lack of bank liquidity, since manufacturers finance much of their production with short paper.

But the effects would not be confined to manufacturing. Virtually all businesses would be hurt. Tight credit is not what you want when things are slowing down. There is always the possibility that government action will help ameliorate the worst effects. In this kind of situation, all we can hope for is that if the government acts, they don't make it any worse than it already is. The other element that is hanging over the entire economy is the threat of inflation. The reason this is particularly dangerous now is that the monetary policies we use to combat a slowdown or recession are those that will tend to increase inflation. So, if the Federal Reserve Open Market Committee continues lowering short term interest rates in order to stimulate the economy, they are adding pressures on prices. Again, this is not what you want when prices are already rising past the comfortable level. The Federal Reserve is further constrained in that its tools are effective at the macro level of price inflation, but it does not have any tools appropriate to the micro level. Energy prices, for example, have been skyrocketing for some time. This itself is like a consumer spending tax, and it has already reduced disposable income for working families. Although the United States economy has been able to accommodate the rise in energy costs so far, our ability to soak up these increases in costs is not unlimited.

In addition to energy costs we must also be cautious about other commodities, especially food. Commodity prices are rising world wide, but food prices are rising even faster. In other words, this is not just a U.S. problem and is somewhat out of our hands. Policy makers have almost no tools to combat world food and commodity price spirals. On the plus side, food costs are quite small in relation to other spending categories, so we can take a large increase in food prices without suffering unduly.

The differences in the three outlooks discussed lie mostly in how much the bursting real estate bubble and subprime crisis will reverberate throughout the economy. If they are contained, then you get the first scenario—a simple slowdown. If they aren't, and the banks continue retrenching because of their increasing losses in their subprime portfolios, then you get a recession. The third possibility of combining slow to no growth with increased inflation reflects economic forces mostly independent of U.S. real estate conditions. But, they are a serious threat. A little help on the inflation front might be on the horizon if the dollar stabilizes and regains some of its value. It has been in something of a free-fall for almost a decade, and it may be nearing its nadir. There are self-correcting forces in currency devaluation, and it would not surprise me to see the dollar recover modestly in 2008. This will, of course, lower our import costs a little. If the dollar recovers, it will be because everything America sells to the rest of the world is cheap, since the dollar is so low. This will increase the demand for dollars by foreigners, thus pushing up its value. This would be at least one bright spot for 2008. But I don't expect the U.S. economy to end next year in a robust fashion.

As far as my investments go, I'm keeping on keeping on and will stay fully invested for the year. But I may tuck a little more into fixed income instruments while the worst part of the year unfolds. The stock market has been forecasting a downturn for some months, so there probably aren't any great fortunes to be made in the U.S. securities market for 2008—at least for buy and hold investors like me. The brightest spot in my portfolio will be fixed income and a fairly large international allocation. I hope I am wrong about the U.S. in 2008, but I'm not optimistic. Economic adjustments are decidedly not fun, but they are necessary.

Happy New Year!