Tougher Times Ahead

S&P: A weak housing market, a slowdown in consumer spending, and tight credit markets are likely to result in slower economic growth in 2008

Standard & Poor’s Economics expects continued economic expansion in 2008, but at a slower pace, particularly in the first half of the year, as the contraction in the housing sector plays out and turbulence continues in the credit markets.

The large inventory of unsold homes is likely to delay any recovery in building activity. We expect starts to hit bottom this year, and they should stay near that level throughout most of 2008. However, prices will continue to drop even after the recovery begins since there are so many homes on the market.

We expect the economy to grow at an annual rate of 1.3% in the first half of 2008, down 1.5% from an expected 2.8% for the second half of 2007, before rebounding to a 2.5% rate through the second half of 2008. Some economists now believe a recession is likely next year. While we are less bearish, we still put the probability of a recession over the next 12 months at 40%.

We think a recession would be more likely if there is a sharper-than-expected drop in the housing sector and an extended and more severe credit correction. U.S. dependence on foreign capital could cause a spike in bond yields, as foreign investors see the dollar sink and credit losses increase, thus complicating the housing contraction.

The geopolitical risk coming from the Middle East and a renewed surge in oil prices (which earlier in 2007 hit $98 a barrel) could also end the recovery prematurely. The lower growth assumed for early next year gives less room for policy mistakes or external shocks.

However, an accommodative monetary policy, a decline in the price of oil, and solid exports from a lower dollar and global growth should help lower the recession risk.

On December 12, the Federal Reserve and four other central banks announced plans to extend loans to banks to encourage borrowing and lending.

The slowdown should hit jobs. We expect the unemployment rate to climb to 5.2% in the third quarter of 2008 from the expected 4.7% at year-end 2007. Payroll increases are expected to average about 100,000 per month in 2008, somewhat slower than in the last 12 months, but this is subject to substantial risk. Employment and personal income trends largely drive consumer spending, which is expected to slow to 1.8% in 2008 from an expected 2.8% in 2007. Consumer spending is also likely to suffer from the effects of the slow housing market and reduced credit availability.

However, we think business equipment spending growth will be higher in 2008 than in 2007. Timing issues, given a three-year replacement cycle and strength in 2005 (up 9.6%), also support our forecast for 2008 growth. Aggregate demand from global economic expansion and the softer dollar will also support business investment next year. We expect business equipment spending to rise to 4.3% in 2008 from 1.5% in 2007.

S&P predicts the price of oil will decline from the current level above $90 a barrel, but remain elevated by historical standards at around $75 a barrel by the middle of next year on supply concerns and geopolitical risks. As a result, the consumer price index (CPI) is expected to average 2.9% in 2007, but decelerate to a 2.1% rate in 2008, before falling back further to 1.6% in 2009.

In terms of monetary policy, we think the Federal Open Market Committee will likely reduce the target Fed funds rate by another 25 basis points to 4.0% at the January meeting, and cut another 50 basis points in the first half of 2008 to reach 3.5% by April.

On the earnings front, S&P chief investment strategist Sam Stovall says it appears the S&P 500 will eke out less than a 1.5% improvement in operating profits in 2007. S&P analysts and the consensus previously expected a 10% advance in earnings, following a jump of nearly 15% in 2006.

But worries surrounding the near 5% decline in the median U.S. home value and a jump in oil prices combined to slow consumer spending in October. In addition, there were more than $50 billion in writedowns associated with subprime mortgages. It’s easy to understand why the S&P 500 consumer discretionary and financial sectors will each post an estimated 13% decline in operating earnings in 2007.

For 2008, the earnings outlook for the S&P 500 looks a lot rosier, possibly as a result of the projected impact of the Fed’s interest rate cuts that began in the third quarter of 2007. S&P analysts expect earnings to improve 15.6% in 2008, led by profit increases of more than 20% for the consumer discretionary, information technology, and telecommunications sectors. They also expect below-average, but positive, growth from consumer staples, energy, and materials.

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