2007 December 11 Tuesday
Morgan Stanley Foresees 2008 Recession

Richard Berner and David Greenlaw at Morgan Stanley say a recession will hit the United States for the first 3 quarters of 2008.

We’re changing our calls for US growth and monetary policy. Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth. But the time for incremental changes is over. A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period. Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing.

Time to put aside money to ensure you can make it through a period of unemployment.

Lenders are cutting back on available credit.

First, compared even with a few weeks ago, financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available. Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened. Three-month dollar Libor-OIS spreads have jumped by 60 bp to 100 bp over the past month, so that Libor rates in that tenor are merely 20 bp lower than where they were in the spring. Some of that jump in Libor rates reflects the transitory impact of year-end precautionary demands for liquidity. But we think that some also represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008 (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007).

Leveraged loan and credit default swap spreads over Libor, meanwhile, have been mixed: They have tightened appreciably over the past fortnight but have widened by 40 bp or more over the past month, measured by either the LCDX leveraged loan index or the S&P secondary LCD/LSTA measures. High-yield and CMBS spreads have widened even more significantly, increasing the cost of borrowing appreciably for lower-rated borrowers, including those in commercial real estate. As a result, the absolute cost of borrowing is higher than in June.

They expect further decreases in credit availability even as the US Federal Reserve lowers rates.

They expect a huge contraction in home construction and continued high oil prices.

While investors are expecting that an ongoing housing downturn and threats to consumers already menace growth, it’s worth noting some lesser-plumbed features of the domestic scene. First, we think tighter lending standards will depress housing demand further. But even if demand stabilizes, so large is the supply-demand mismatch that builders must slash single-family housing starts by 40% from current levels to eliminate the inventory of unsold homes. As a result, we think overall housing starts will run below one million units in each of the next two years — a level not seen in the history of the modern data since 1959. The housing downturn will likely subtract 0.9% from growth in the next four quarters, and the housing recovery in 2009 will hardly merit the name.

Second, while energy prices have come down from their recent peaks and may continue to slip, the rise in energy and food quotes between June and December of 2007 likely will have drained about $45 billion, or 0.4%, from consumer discretionary income. Moreover, long-term relief is unlikely; Doug Terreson and our oil team expect that crude oil quotes (measured by WTI) will average about $83/bbl in 2008, or about $10 higher than this year (we translate that into a $7 increase for Brent to $79.40).

Oil could go higher than that if Saudi Arabia can't maintain exports at current levels.

I think commodity price inflation makes a US recession much harder to avoid.

Overall, commodity prices are showing the largest sustained gains since the late 1970s and early 1980s. The Reuters (RTRSY) CRB index, which measures the price of a basket of basic foodstuffs, metals and fuels, has soared 18% in the past 12 months, and 121% since Dec. 31, 1999.

Rising Asian demand combined with the approaching world peak in oil production seem very inflationary. If this starts translating into an increase in general inflation then the Fed is going to run out of room to maneuver.

Share |      By Randall Parker at 2007 December 11 10:12 PM  Economics Business Cycle


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