Apr 11 2008
Economic Outlook Summary April 2008
The long-awaited slowdown in growth of economic output finally began to bite in the fourth quarter of 2007. The fourth quarter’s real Gross Domestic Product (GDP) grew a mere .6% (annualized), according to the advance estimate of the Bureau of Economic Analysis (BEA). This anemic performance followed growth of 3.8% in the second quarter and 4.9% in the third quarter. Housing continued as the main impediment to growth as the rate of decline in residential investment moved up a notch from 20.5% in the third quarter to 23.9% in the fourth. Deteriorating economic conditions led households to behave a little more cautiously, and consumer spending growth declined to 2.0% in the fourth quarter after 2.8% growth in the third quarter. The fourth quarter growth rate for business fixed investment moved down, but was a still respectable 7.5%. Government purchases grew modestly, and net exports added fractionally to growth, but a draw down of inventories cut more than a full percentage point from the reported GDP growth.
A crisis of confidence, initiated by unexpected increases in subprime home mortgage defaults, has had an ongoing and undesirable fallout in the credit markets. The Federal Reserve (Fed) largely solved the worst of the liquidity problems that nearly froze the interbank lending market last summer, but liquidity in the secondary mortgage market remains quite limited. This has resulted in substantial write-downs of asset values by large financial institutions and has led lenders to become very cautious. The result: higher credit standards creating a de facto tightening of credit. Thus, credit has become harder to obtain and the price of credit risk has continued to advance. The impact on the real economy is evident in most economic data, and the odds of a recession have moved up materially.
By our calculations, growth will average close to zero in the first half of 2008. Frankly, given the uncertainty in economic projections this could be easily off a percentage point or so either way. It will be touch and go for a while. After flat-lining in the first half, we anticipate second half growth to rebound, bringing real GDP growth for 2008 in at 1.5%.
Although the Fed shifted its policy stance modestly in the second half of 2007 by enhancing credit facilities for banks and cutting short-term rates modestly, it only started to address recession risks aggressively in January 2008. Because monetary policy acts with a lag, the full impact will not be felt by the economy until the second half at the earliest. Similarly, the economic stimulus package recently passed into law will not put additional purchasing power into the hands of consumers until about mid-year.
Holders of Treasury bonds did quite well over the past year due to the flight to quality, Fed easing, and mounting recession fears that drove down yields on securities free of credit risk. Bonds bearing credit risk did not do as well because credit spreads expanded considerably. However, even high-yield corporates were generally able to eke out small total returns. The stock market has dropped materially from its October 2007 peak. Although recession-related risks to the market are clearly present, they are not overwhelming and stocks remain considerably undervalued. Continue Reading »