S&P US Economic Outlook

How Low Can We Go?

Projections are a stock in trade for economists. Here are Standard & Poor’s.

By David Wyss From Standard & Poor’s Equity Research

The economy will likely suffer a moderate, but long recession, and a sluggish recovery, according to S&P Economics. From the December 2007 peak to a trough in May 2009, this expected 17-month recession would be longer than the 50-year average of 10.7 months, and near the longest recessions of 1975 and 1982.

S&P is also projecting two additional scenarios: one better than the baseline, and one worse.


We’re forecasting negative gross domestic product (GDP) growth for the fourth quarter of 2008 and the first half of 2009 for a total decline of 0.9%. While business tax credits should likely provide some boost to the fourth quarter, borrowing restrictions will mean that boost will be smaller than we originally thought.

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Still, this should be a moderate recession. Unemployment will likely climb to 7.5% by summer 2009 from its March 2007 low of 4.4%. The S&P 500 dropped nearly 40% through October 10, near the historical average decline of 36% during a recession. As stock prices normally lead the economy by three to six months, they should bottom in the fourth quarter.

The Fed chopped the Fed Funds rate to 1.5% from 5.25% last September. We expect the central bank to remain on hold until the recession is over before raising rates in the fall of 2009. The 10-year Treasury yield dropped to 3.8% from a peak of 4.5% last summer. However, the cost of funds for businesses and individuals has risen due to the credit crunch.

The fiscal stimulus package will likely bring the fiscal 2008 federal deficit slightly above the 2004 record of $413 billion. We expect the record to easily be broken next year, with a deficit exceeding $700 billion, depending on how the Troubled Asset Relief Plan is treated.


In our worst-case scenario, oil rebounds to its summer peak of $150 a barrel. Average home prices drop 40% by early 2010 from their July 2006 peak, compared with a 30% drop in the baseline forecast. Financial markets remain frozen. Foreign investors flee a falling dollar and bond defaults. Bond yields have to rise to attract the funds needed to balance the trade deficit, despite a cut in the Fed Funds rate to 0.5%.

Weak home prices will hit the consumer hard. Wealth drops 14% from its peak compared with 10% in the baseline. Consumer spending drops more sharply in the third quarter as households try to rebuild the wealth lost to weaker home and stock prices.

Real GDP declines 3.5% from its second-quarter 2008 peak to its third-quarter 2009 trough, the largest drop since World War II. At 20 months, this downturn would be longer than the 1975 and 1982 recessions. Unemployment tops out at 9.1% in early 2010 in this scenario.

Capital spending suffers from the weak economy and borrowing difficulties. Business investment falls 11% in 2009. Companies cut back on staffing. Nonfarm employment drops by 3.3 million during 2008 and 2009.

The slumping economy, various rescue plans, and the higher costs of federal retirement and health care programs hit the budget deficit, which jumps to $824 billion in fiscal 2009.

The current account deficit, on the other hand, improves to $326 billion in 2009 from the record $788 billion in 2006, as weak domestic demand cuts imports, and exports find support from the weaker dollar. The narrower trade gap helps reduce the need for foreign capital. However, the yield on the 10-year Treasury rises to 6.5% in 2011.


In our optimistic scenario, we see a modest slowdown in growth this year and a return to above-normal growth in 2009 and thereafter. While optimistic, it’s not unreasonable, by our analysis. In fact, it’s near what our expectations were at this time last year.

In this scenario, a recession is not yet certain. Lower oil prices and a more rapid calming of financial markets could still keep the economy in “borderline recession” range.

A revival of productivity increases keep inflation under control despite stronger economic growth.

Oil prices drop to $75 a barrel by late 2009. Bond yields fall in response to lower inflation and increased confidence in the U.S. economy, which attracts more foreign inflows. Unemployment still rises to 6.6% next year from its current 6.1% rate, as real GDP growth recovers to 2.5% after the first quarter.

More robust growth also helps control the budget deficit.

Business investment rebounds more quickly because of the renewed demand growth, although nonresidential construction still declines in 2009 and 2010.

Housing recovers more quickly thanks to lower mortgage rates and a stronger economy. Starts rise from 950,000 in 2008 to 1.60 million, near their trend level, in 2011.

Consumer spending rises 1.6% in 2009, with auto sales getting the biggest boost from the rebounding economy and lower gasoline prices.


The real worry, we believe, is that the U.S. economy could do even worse than our pessimistic scenario — and repeat Japan’s “lost decade,” when growth averaged 0.8% from 1992 through 2002.

We think the parallels are clear. In both nations, the banking system was constrained by heavy capital losses resulting from property loans.

There are, however, some important differences. In Japan, the Bank of Japan was concerned about inflation well into the 1990s, when deflation had become the problem. As a result, they were too slow to cut interest rates. Consumers sharply increased their savings rate. Americans, so far, aren’t letting prudence get in the way of spending. The more open U.S. financial markets should permit a quicker resolution, in our opinion, but political gridlock could delay any fixes.

The U.S. reliance on foreign capital exposes markets to greater risk than Japan, which was a major capital exporter. Commodity markets were calm during the 1990s; that’s not the case now. Out-of-control health care costs are imposing a fiscal risk on the United States that wasn’t apparent in Japan in the early 1990s.

Our hope is that policymakers in the United States have learned from Japan’s failures. But, in our view, Congress and the press seem determined to repeat many of the same mistakes. To misquote Santayana, “Those who believe people have learned from the past haven’t.”

Wyss is chief economist for Standard & Poor’s in New York


4 Responses

  1. The IMF once commented that the recovery may begin in the end of 2009. I translate this to that the Dow Jones Index may be reaching the level of 14,000 by the end of 2009 as in Oct last year and the bull market may start again.

    Every investment has its own time frame depending on its goal. As far as I concern, even for investors age 50 (retired at 65) can still approach his retirement goal with the time horizon that is longer than the time needed by the market to recover and accelerate. Even in 3-5 years the worst.

    Thus, no worries…

  2. One more thing, if people want to spend their money in three years or less, better put it n the bank or money market funds. Don’t think equity market. Is that right?

  3. DJIA won’t make it into 14000 soon. (it’s Dow’s all time high, remember?). Why? Because most of the profit propelling Dow into that territory comes from financial sector.

    And financial sector won’t recover anytime soon. Not even in 2009.

    Come on, do you think those who selling at Dow 10,000 or 12,000 are stupid?

  4. Yes, because they realised their loss. What are you going to say to your clients Poltak? Did you know that DJI was going to 8,000 when it was at 12,000?

    We (planners/advisers) have a standard approach like this “Every investment has its own time frame depending on its goal. Clients can still approach their retirement goal with the time horizon that is longer than the time needed by the market to recover and accelerate.”

    Nothing we can’t do but just mind our time frame. We have clients who have been more than 10 years with us. In the next 20 years, we’re sure they can still meet their retirement goal.

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