KEY ECONOMIC CONSIDERATIONS

THE NEGATIVES

1. HOUSING CRISIS

• Home Building has plunged
• The downturn in housing has enter a second ominous phase in which the decline in construction deepens and the fall in housing prices continues.
• Housing starts are down 47% from their peak in 2005.
• Residential building accounts for 4.4% of GDP; in 2005 it accounted for 6.3%.
• Since 1960, housing-led recessions lasted an average of 32 months, with housing starts decreasing by 51%.
• Previous construction-led recessions were in periods of tight monetary policy with relatively higher rates.  The current housing bust is caused by a housing bubble and not by tight monetary conditions of high interest rates or inflation. As a result, traditional monetary actions of the Fed may be ineffective in averting a recession.

2. CREDIT TIGHTENING

• The credit expansion from 2000 to 2005 made possible by rising housing prices (consumer spending financing more home-equity loans) increased the rate of indebtedness to new highs: the ratio of household debt to income is currently 130%, compared to 100% in 2000 and 80% in the 1990. These conditions have resulted in a tightening of credit that will impact all spending.
• More than 2 million subprime borrowers with adjustable-rate mortgages face higher mortgage rates. Many will be forced into foreclosure.
• Estimated losses from mortgages:
• The Fed estimates losses to financial institutions from bad mortgage loans could be $150 billion, revised up from their estimates of $100 billion in August.
• Deutsche Bank estimates subprime losses at $400 billion with $130 billion being bank losses.
• The market for securitized assets had dropped significantly over the last four months.
• Asset-backed commercial paper has dropped 30% from August.
• Banks have tightened their credit standards on not only mortgage loans but also consumer loans.

3. WEALTH EFFECT

• Some economists estimate that housing prices could drop between 10% and 20% over the next year or so.
• Housing price declines can have a greater negative impact on consumer spending than other negative wealth effects, such as a decline in stock prices.
• A decline in housing and stock prices, combined with tightening credit conditions, could create a significant negative wealth effect on consumer spending, precipitating a recession.

4. ENERGY PRICES

• The surge in oil prices to almost $100 represents a 25% increase since August.
• The world-wide demand for energy, especially in China, India, and other emerging countries, is likely to keep oil prices high even if the U.S. economy goes into a recession.
• Energy price increases affect the supply side of the economy, leading to higher prices but lower levels of spending and production.

5. EMPLOYMENT

• The low unemployment rate of 4.7% and job growth (166,000 new jobs in October) has kept consumer spending relatively high. However, the pace of new job creation has decreased.
• Household-based employment survey by the Economist indicates very little new job growth in 2007.
• The unemployment rate has increased from its recent trough by three tenths of a point.

6. CONSUMER CONFIDENCE

• The University of Michigan’s Consumer confidence Index is at its lowest level in 15 years.

SOME POSITIVES WITH CAVEATS

1. DOLLAR AND EXPORT GROWTH

• The declining dollar and continued growth in emerging markets has led to an increase in U.S. export sales.
• U.S. export sales grew at an annual rate of 16% in the third quarter of 2007.  This contributed significantly to the 3.9% annual growth rate in GDP in the third quarter.
• With exports only accounting for 12% of GDP, compared to consumer spending that accounts for 70%, the growth in exports is probably too small to offset a consumer-led recession.
• A slowdown in the U.S. economy combined with a decrease in interest rates (relative to the rates in other countries) may lead to a decrease in dollar demand that could slow the declining value of the dollar or possibly increase it. If that occurs, then there could be a decline in export growth.

2. CORPORATE PROFITS AND INVESTMENTS

• Corporate profits of multinationals are still strong.
• Investment spending of domestic, non-financial companies has declined and profits are down by 9%.

Sources: Economist, Barrons, and Bloomberg