2008 Economy: On the Edge of Recession

From the ongoing credit crunch to stingier state and local governments, the economy faces plenty of challenges in 2008. Fortunately, it also enjoys a number of offsetting strengths.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

January 2, 2008

For every negative in this economy, there's a positive, offsetting or at least tempering the downside. The result is a precarious balance -- an economy highly vulnerable to any shock: weather or war induced, energy related, financial or other. But barring such a blow, the U.S. economy in 2008 should limp along, with little or no growth in some quarters and a lousy feeling to many businesses and consumers, but avoiding outright recession.

Here's how we size up the ledger, headed into the new year.

First, take a look at the liabilities -- challenges that must be met.

1. Flat or falling U.S. housing prices, which will act as a drag on consumer spending. We expect home prices to slip an average of 5% in the coming year, with declines of up to 20% over two years in formerly red-hot regions. That'll weigh on consumer spending as cash-out refinancings continue to dwindle and loss of equity makes consumers feel poorer.
2. More-costly borrowing, despite cuts by the Federal Reserve. Spreads are widening to reflect a better appreciation of risks. Junk bond yields, now running at four percentage points over Treasuries, will climb to six points above. Plus the LIBOR, the global benchmark for bank loans and adjustable mortgages, is already 150 basis points over the federal funds rate, more than 10 times the spread of a year ago.
3. High energy prices, crimping consumers' disposable income and draining business revenues, particularly for manufacturers and retailers paying fuel surcharges to transport goods and raw materials.
4. Sluggish growth in business profits, due to all of the above. Plus write-downs on mortgage-backed securities will hurt financial firms.
5. Cutbacks by state and local governments as tax receipts shrink.
6. More global competition for investment funds. Saudi Arabia, China and others with scads of dollars are seeking greater diversity in their investments, turning more to euro-denominated stocks and bonds.
7. Stirring inflation. Food prices, as well as energy prices, remain high. And whenever possible, companies are passing along cost hikes to buyers. The Consumer Price Index from Dec. 2006 to Dec. 2007 will come in at about 4%, the biggest one-year hike since 1990, when it rose 6.1%, Dec. to Dec.
8. Some big industries that are clearly in pain. Among them: Home building and anything related to it -- appliances, carpeting, furniture and so on. After falling 25% in 2007, housing starts will slip an additional 15% in 2008. Autos and, of course, financial services are also ailing.

Now count down the other side of the ledger -- offsetting assets, many of which have gone largely ignored.

1. Three buoys for consumer spending. Per capita personal income, from wages, salaries, bonuses, dividends, interest and rental income, remains a strong positive. This past year, for example, it racked up gains at an annual rate of 2.5% in each quarter, after taxes and inflation. Employment continues to gain, albeit more slowly than earlier...about 118,000 net new jobs a month, compared with 188,000 a year in 2006. Moreover, the national unemployment rate remains at a modest 4.7%. And productivity growth persists. Though it's decelerating to nearer 2% than the 2.5% annual pace it achieved during the 1990s, U.S. businesses are still getting more output from an input hour of labor.
2. A Federal Reserve determined to keep economic growth going, having already trimmed the fed funds rate by one percentage point and cut a full point from the discount rate. Chairman Ben Bernanke and company will take whatever steps are needed to keep the credit pump primed.
3. Energy conservation and technology advances, blunting the force of high oil and gas prices. Businesses use just half as much energy today as they did three decades ago to produce the same amount of output.
4. Strong corporate balance sheets, cushioning skimpier profits. Before this year's big write-downs, banks enjoyed years of record profits and remain largely in good fiscal condition. S&P 500 industrial firms hold $623 billion in cash -- 40% of long-term debt, twice the 1997 ratio.
5. Uncle Sam's open hand. Federal spending will keep climbing. Increases in defense and entitlement programs, such as Social Security, will more than make up for restraint elsewhere in the federal budget as well as for budget cutbacks by state and local governments.
6. Foreign investment in the U.S. that remains strong and steady, despite competition. More foreigners are taking stakes in U.S. companies, notably banks and financial firms, which are fundamentally sound, though struggling with setbacks caused by the subprime lending crisis.
7. A tame core inflation rate, which omits energy and food. Tough global competition is keeping a lid on prices. Many foreign firms that sell in the U.S. are absorbing additional costs to maintain share. Plus a run-up in oil prices equivalent to the 2007 hike isn't likely.
8. And a slew of industries enjoying robust growth -- health care, IT, defense, aerospace, electronics, heavy machinery, food and agriculture. Exports in particular are thriving. They'll increase 9% in 2008 after a nearly 12% growth spurt in 2007. What's more, demand from abroad is boosting sales not only of goods, such as chemicals, pharmaceuticals, IT gear, aircraft and auto parts, but also of services, such as law, engineering, insurance, education, transportation and logistics. Plus the soft dollar will continue to spell boom times for restaurants, hotels and shops drawing in foreigners eager to snatch up bargains.

The bottom line: We see an economy that could easily tip into recession, but that, if dealt with confidently and aided by good fortune, won't.

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