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A Rain Delay for the U.S. Recession

S&P thinks the downturn has been delayed, not cancelled

From Standard & Poor's Equity ResearchPayrolls have dropped for five consecutive months, housing starts are at recession levels, and business investment remains weak. So far, the consumer and the trade deficit improvement have kept gross domestic product (GDP) growth positive, but the consumer is likely to be forced to retreat in the face of higher oil prices. Even without a negative quarter, the data supports calling this a recession.

The U.S. economy is amazingly resilient. The housing and financial sector problems were not enough to cause a recession, despite most analysts’ fears. But although the economy has been able to handle one problem — even one big problem — at a time without falling into a recession, it often falters when hit from two sides at once. Although we think the economy has dealt with the housing problem, it can’t deal with the record gasoline prices concurrently. We raised our oil price forecast to $112 per barrel for the end of next year, implying continued pressure on consumers.

We now expect the recession to be at its worst early next year. The stimulus package should keep the economy rising over the summer, but when the spending ends, we think the economy will slide back down. We still believe the recession will be mild, but the low isn’t likely to come until early 2009, given the early rebate payments and higher oil prices, which further lowers our estimate of consumer spending over coming quarters. The exact dates will depend on the judgment of the National Bureau of Economic Research, however. It will be a difficult recession to date because, like the 2001 downturn, the United States will spend several quarters bouncing along the bottom, rather than hitting a clearly defined trough.

Housing prices are sliding downward even more rapidly than expected. The S&P/Case-Shiller home price index was down 14.4% from a year ago (20 major metro areas) in March and 16.6% from its all-time peak in July 2006. (Note that the index is not seasonally adjusted, so the comparison with July is technically distorted.) With the inventory of unsold existing single-family homes at a 23-year high of 10.7 months of sales, prices are heading further south. We expect another 10% drop by this time next year.

The more encouraging side of the equation is home sales, which are doing better than expected. Admittedly, that is largely because our expectations have deteriorated so much. We still expect to set a post-World War II low of 890,000 housing starts this year, but April starts held slightly above one million units, up 8% on the month though still down 34% from a year earlier. Sales of existing homes dropped to 4.85 million (annual rate) in April, down 17.5% for the year. The stronger-than-expected sales could indicate that bargain-hunting is beginning, which would be a sign that we are approaching bottom.

Finding a shard of hope in the housing data takes a lot of work, but it’s encouraging that sales are holding up. Also a good omen is that prices outside of the Midwest and the bubble states are still relatively stable. But the correction will continue. Prices are still too high relative to income, especially in the bubble states, and the correction is probably only half over.

So far, consumer spending has been strong despite the squeeze of falling wealth and rising gasoline prices. Consumer confidence has dropped to its lowest level since the 1991 recession, according to the Conference Board measure, and the University of Michigan’s Consumer Sentiment survey is the lowest since the 1982 downturn. But Americans are so far clinging to their material ways and not letting fear keep them from the shopping mall.

The commodities bubble continues to inflate, and oil prices recently topped $139 a barrel (West Texas Inter-mediate). We now expect oil to remain firm, falling only to $112 by the end of 2009. Energy isn’t as important in the household budget as it was in the early 1980s, however. Even at this year’s oil prices, the average household will spend only 6.7% of its income on energy, down from 7.9% in 1981, but still up sharply from 4.2% in 2002.

Consumer confidence is much worse than one would expect from unemployment and inflation data. The “discomfort index,” the sum of unemployment and inflation, is 9.4%, which is far below its 12.4% level at the end of 1990 and even farther below the 21.8% level of 1980. Why then are consumers feeling such angst?

Part of the reason is that the most visible prices are escalating the most. Prices of electronics and clothing are falling, but people don’t buy these items every week; when they do buy them, the items aren’t the same as the last purchase. Price changes in these categories are much less visible than food and gasoline, which households buy at least once a week. Basic foods and gasoline are also harder to postpone or substitute. One can buy cheaper clothing or shop at Wal-Mart instead of Saks, but milk is milk, and it costs the same at all the grocery stores. In addition, gasoline prices are in two-feet-high numbers on every street corner. These price changes are harder to avoid or ignore.

Wyss is chief economist for Standard Poor's in New York .

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