The subprime mortgage mess is finally spreading to the real economy, money managers fear.
But just how far the slowdown goes and how deep it reaches remains to be seen. Managers and economists think the main blow will be felt in the U.S., with some collateral damage occurring in Europe. Asia, by contrast, is expected to be little affected, although some think Chinas over¬heated economy might cool a bit.
The U.S. economy remains the chief source of concern. Managers worry that consumers will cut back spending because of tightened mortgage availability.
The (U.S.) economy will slow, but its still a bit of a crapshoot as to whether it will be a slowdown or a real recession, said Ben Inker, chief investment officer of quantitative investments at Grantham, Mayo, Van Otterloo & Co. LLC, Boston.
The subprime mortgage market is dead. The question is whether the entire mortgage securitization market is dead. If so, then were headed for a recession. Mr. Inker said there is less than a 50% chance of that happening.
Managers are cutting their U.S. gross domestic product projections to less than 2% for 2007 from 2% to 2.3% previously. In general, they expect 2008 to be better but not great, with GDP estimates ranging from 2.2% to 2.9%. (GMO is an outlier, expecting growth of only 1% to 2% next year.) However, the risk of a recession has clearly increased.
Scott Mather, managing director and portfolio managing at PIMCO Europe Ltd., London, said company officials expect low growth, and they think there is a 30% to 40% chance of a recession in the U.S.
Most companies are starting the new economic cycle in a strong place in terms of the balance sheet and profits, so its not the end of the world to see a slowdown, he said.
Percival Stanion, head of asset allocation at Baring Asset Management Ltd., London, thinks there is a 20% to 25% chance of U.S. recession. He said the odds increase if there are big drops in global equity markets or a collapse in the banking sector.
Too soon to tell
But analysts say its too soon to gauge the full impact of the credit crunch on the U.S. economy.
The contraction of credit which is going to occur is going to slow economic activity. How much of a drag it is on the overall economy remains to be seen, said David Resler, chief economist at Nomura Securities International Inc., New York.
Mr. Resler expects the Federal Reserve will lower the federal funds rate by 25 basis points at each of its next three policy meetings.
But Neal Soss, managing director and global head of economist at Credit Suisse Group, New York, disagreed, saying U.S. fundamentals are still solid.
Im a believer in evidence. Its not at all clear to me why we should be fearful of the consumer. The trend of consumption has not changed at all, he said. Mr. Soss doesnt think the Fed will lower the funds rate target, currently at 5.25%.
The employment report for August, which comes out on Sept. 7, could give a good indication of whether the Fed will reassess its economic forecast.
Andrew Phillips, managing director at BlackRock, said Fed officials so far have downgraded their forecast to growth, but they are not projecting a recession.
Robert Seller, a senior U.S. equities manager in Aberdeen Asset Management PLCs Philadelphia office, said consumer spending will not drop as much as the market is anticipating. He said stocks of retailers such as Macys Inc., Supervalu Inc., VF Corp. and Staples Inc. now are attractively priced.
Added Uri Landesman, head of global growth equity at ING Investment Management, New York: Its going to have to get a lot worse before big spenders are affected, he said. Id be more bullish on Neiman Marcus than Wal-Mart, he said.
Numerous equity managers have shifted to more defensive stocks.
ING has lowered its allocations to financial, consumer discretionary and consumer staples stocks, but is bulking up allocations to health-care and technology stocks. Companies such as Cisco Systems Inc., International Business Machines Corp. and Hewlett-Packard Co. are particularly attractive, Mr. Landesman said.
Dan Frascarelli, partner and director of a $1.3 billion U.S. large-cap core strategy at Lord Abbett & Co., Jersey City, N.J., said he cut his holdings in financial stocks in 2005, anticipating credit problems. He also thinks energy and technology stocks will get hit as the economy slows. Energy prices decline as demand falls, while tech stocks will do fine this year, but could suffer in 2008 as corporations slow capital spending. Mr. Frascarelli has been underweight energy since mid-2005 and is equal weighted in technology now.
PIMCOs Mr. Mather believes credit-market turmoil will choke off U.S. consumer spending and will trigger a global slowdown faster than initially expected.
Reduced U.S. consumer demand will affect exporters to the U.S., he said. European growth will also be hit by a decline in sentiment and a slowdown in business-led investment, stemming from lower stock prices.
However, economic growth in emerging markets will offset the economic impact of a slowdown in U.S. consumer spending, Mr. Mather said.
Meanwhile, European financial services companies a key driver of economic growth could get hit by weaker investment markets, said Keith Wade, chief economist, Schroders PLC, London.
Barings Mr. Stanion noted that European banks have been big investors in the U.S. subprime market, and smaller banks might reveal problems during the next six months. As a result, European banks might slow their commercial lending activities, he said.
Despite those storm clouds on the horizon, Schroders has left its GDP forecasts for Europe unchanged at 2.4% for 2007 and 2.2% for 2008.
The manager has been selectively buying credit now that spreads have widened, Mr. Wade said. Schroders is slightly overweight equities and is debating whether to increase its exposure in the belief that corporate earnings will grow.
At the moment, there are a lot of forced sellers in the credit and equity markets, so markets could be weak for a month or so. Its a question of when to pull the trigger, he said.
Managers agree that Asia will remain largely insulated from any U.S. economic slowdown. A fall in exports to the U.S. will do no more than pinch Chinese growth as long as Europe and Japan are able to largely shrug off the U.S. slowdown, said Rob van de Wijngaert, investment strategist at ABN Amro Asset Management, Amsterdam.