The U.S. economy will avoid a recession, but only by a hair, money managers predict.
Strong corporate earnings growth and increasing demand for U.S. products abroad will keep the economy churning, albeit at a slower rate, according to the investment professionals interviewed for this story.
Those positives should be enough to keep the economy afloat, although managers say there are still two big unknowns: how big a hit the financial services sector will take over subprime losses; and whether consumer spending will slow down.
“I think we can skirt a full-scale recession, but we’ll come mighty close in the fourth quarter of 2007 and first quarter of 2008 in the immediate aftermath of the credit crunch,” said Richard B. Hoey, chief economist for the Bank of New York Mellon Corp. Consumer spending “is the big debate among economists. It’s a very tricky call.”
Clearly, Federal Reserve officials are concerned. Federal Reserve Chairman Ben S. Bernanke told Congress on Nov. 8 that the Federal Open Market Committee expected the gross domestic product “would slow noticeably in the fourth quarter from its third-quarter rate” of 3.9%. He added that growth would remain “sluggish” in the first part of 2008, picking up later in the year.
But the Fed chairman added some cautions: “(T)hat financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected;” and that housing prices “might weaken more than expected,” which could lead consumers to spend less and investors to worry more about mortgage credit.
The stock market’s response was mild, with major indexes falling only a few points by the end of the day, after a lot of intraday volatility.
The Dow Jones industrial average fell sharply Friday morning, experiencing more intraday volatility until it closed down 223.55 points at 13,042.74. The Standard & Poor’s 500 fell 21.07 points Friday, to close at 1,453.70.
That volatility comes on top of major turmoil among financial services firms.
Merrill Lynch & Co. Inc. and Citigroup Inc. said they expected to take write-downs of $8.4 billion and up to $11 billion, respectively, prompting their CEOs to step down. UBS AGand Morgan Stanley also had announced write-downs.
What’s more, General Motors Corp. recorded a $39 billion quarterly loss because it had to write down deferred tax credits it no longer would be able to use.
And the dollar fell to an all-time low of 1.4752 against the euro on Nov. 9.
Subprime woes
Some managers worry the other shoe will drop when Citi and Merrill appoint new chief executive officers, who might want to write down any remaining subprime exposure.
“If you take the stuff marked to market and then there’s another $10 billion hit (later on), they blame it on you,” said Scott Simon, managing director and head of the mortgage- and asset-backed securities teams at Pacific Investment Management Co., Newport Beach, Calif.
But subprime exposure hangs over many Wall Street firms.
“What future earnings will be (for financial services firms) is the question everyone is asking,” said David Honold, a portfolio manager who covers the financial sector at Turner Investment Partners Inc., Berwyn, Pa. “The write-downs thus far have been significant, but it’s still difficult to say whether all the pain has been realized.”
More write-downs could do more damage to the financial services sector.
Estimated 2007 earnings for the sector have been revised downward 8.5% the last three months, a disheartening sign considering the year is almost over, said Julie Van Cleave, managing director and lead portfolio manager of the U.S. large-cap growth strategy at Deutsche Asset Management, New York.
Another question is whether new leadership at Citi and Merrill will flood the market with heavily discounted collateralized debt obligations.
“My concern is that the staying power of the banks to hold these positions to the point there will be more attractive valuescould be compromised with new management teams,” said Greg Stoeckle, a managing director and head of bank loans in INVESCO PLC’s New York office. “If you put more paper on the street, it could (drop) prices further.”
Other investors said the new management teams are more likely to just write down the values, hoping they will improve later, than to sell them off.
Another concern is whether structured investment vehicles — bank-created pools that issue short-term debt and invest in structured instruments — will be forced to sell off assets since the commercial paper market has closed to some SIV issuers.
Consumers are vulnerable
Subprime mortgage problems already have led to tightening of credit. But it’s not yet clear how that will affect consumer spending.
“My concern is that the banks have got a big problem from subprime lending and CDOs,” said Michael Atkin, managing director and director of sovereign research for Putnam Investments, Boston. “There is less willingness to extend credit because they need to repair balance sheets.
“The economy is very dependent on fresh infusions of credit. If we don’t have these new infusions of credit, the economy will weaken,” he said.
“Consumers at the low end are already showing additional signs of stress beyond housing,” Mr. Stoeckle said. Earnings are soft among retail stores that typically cater to the low end of the consumer spectrum, and credit-card repayment data are also showing signs of weakness. Plus, the rising cost of oil also could take a bite out of consumers’ budgets, he said.
Still, higher-income households have not been hit — at least not yet.
Spending by wealthier households is influencedby the prices of their homes, but wealthier individuals also benefit from buoyant U.S. and foreign stocks, said Bank of New York Mellon’s Mr. Hoey.
“The wealth effect story becomes more complicated when you’re dealing with the high-spending income and wealth population,” he said.
Exports to benefit
Despite the doom and gloom, investors remained optimistic that some strong fundamentals for most U.S. companies will keep the economy afloat.
“On the bright side we have very positive valuations,” said Deutsche’s Ms. Van Cleave. She predicted a “consumer recession” but not an overall economic recession. She said the technology, health-care, consumer staples and energy sectors are all doing well.
“This crisis is a mile deep and an inch wide,” added James W. Paulsen, chief investment officer, Wells Capital Management Inc., Minneapolis. “It’s very narrow (in the economy), made up of housing and autos. Combined, they make up 9% of GDP. For them it’s a deep recession. But the great bulk of the economy is in good shape.”
Mr. Paulsen added: “That 9% of the GDP is off 10% from the third quarter of 2006 to the third quarter of 2007. The rest of the … GDP is up 3.8% during that period.”
Economists and portfolio managers expect the GDP to dip but to remain in positive territory.
Josh Feinman, chief economist for Deutsche Asset Management, predicted the GDP will be 1.7% in this quarter, 2% for the first quarter of 2008, 2.4% in the second quarter of 2008 and 2.7% for each of the remaining two quarters. All are down from the third-quarter GDP of 3.9%.
Mr. Hoey predicts GDP will come in between 1% and 1.5% in the fourth quarter of 2007 and first quarter of 2008, 2% for each of the second and third quarters of 2008 and 3% for the final quarter.
While declining home values might hurt consumer spending, managers expect exports by U.S. manufacturers to be aided by the falling dollar.
“There’s going to be a substantial increase in the volume of net exports,” Mr. Hoey said.
Heavy exports are making the consumer durables, and energy sectors more attractive, said Arvind Sachdeva, chief investment officer of large-cap value at Victory Capital Management Inc., Cleveland. He named BP PLC, Halliburton Co. and BHP Billiton as particularly attractive stocks.
Barry B. Burr contributed to this story.
