Who's Afraid of a U.S. Recession?

April 24, 2008

August 9th, 2007 was the day investors caught their first scent of the rot in the subprime mortgage lending market. Many other parts of the global financial system spoiled subsequently. Well-respected analysts have called this debacle the worst financial market breakdown since the 1930’s, and a 62% decline in new home sales from peak underscores the severity of the housing sector’s downturn. It is peculiar, therefore, that the Dow Jones Industrial Average is only 2.6% weaker than its level last August 9th. The Nasdaq has fallen less than 5%. Both drops are smaller than equity declines of 21% in Japan or 9% in Germany. The resliience of equities contrasts with their sharp meltdown in the Great Depression. Job layoffs also belie the grim tone of U.S. growth forecasts for 2008 amd 2009. We are two weeks short of nine months into the banking crisis, and new weekly jobless claims amount to less than the 400,000 threshold that usually gets breached in a recession. In fact, the latest four-week average of jobless claims, 369,000, was smaller than the average for the previous four weeks to March 22nd, 374,750, which suggests that labor market weakness might already be stabilizing.

In other areas, much has changed since August 9th. With a 25-basis point short-term interest rate cut next Wednesday that I expect the Fed to authorize, cumulative interest rate relief will reach 325 basis points, or a 62% drop from 5.25% to 2.0%. The dollar has declined by similar and substantial amounts against the euro (12.6%) and the yen (11.9%). The 12-month rate of U.S. consumer prices rose from 2.4% to 4.0%, as crude oil soared 62%. Food price inflation has become a pressing humanitarian crisis. Amid general inflation fears, ten-year Treasury yields, down 96 basis points, have matched less than a third of the Fed’s rate cut.

With so much that is unique about the current business cycle, one cannot be very confident about what lies ahead. Three developments persuade me that U.S. equities do not discount downside danger sufficiently. The Fed has not shown enough sensitivity to the sinking dollar. America loses everything if it squanders the dollar’s dominance in reserve currency portfolios. Secondly, house prices have not yet fallen half as much as I expect them to drop in total, and without stable real estate values, the healing process in financial markets cannot begin in earnest. My final big concern is the still near-zero U.S. savings rate. This is the mother of all economic imbalances, and one that will wreak havoc if a return to historic norms occurs rapidly.

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