News Analysis
BusinessWeek.com
September 18, 2006
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The Gloomy Side of the Street

They don't call it the dismal science for nothing. While Wall Street nears multiyear highs, some economists make the case for recession

What September sell-off? On Sept. 15, the Dow Jones industrial average rallied to within 170 points of its all-time high, while a fresh batch of data suggested a firm economy with modest inflation. So far, the stock market's historically worst month isn't exactly matching its bearish reputation.

Not so fast. Despite Wall Street's high spirits, a voluble minority of economists continues to warn of a coming recession, possibly arriving as early as this year. The slowing housing market, an inverted Treasury yield curve, and lingering inflationary pressures could mean the U.S. economy is in for a hard landing, some economists say.

POOR TRACK RECORD.  They're not alone. A Ried Thunberg survey out Sept. 11 showed 41% of money managers polled place 50% odds that the Federal Reserve will successfully curb inflation without a recession, while 38% put the odds at 75%. Among chief financial officers, economic pessimism resides at its highest level in more than five years, according to a survey released Sept. 13 by Duke University and CFO Magazine.

On Sept. 15, Morgan Stanley (MS ) economists acknowledged a "vigorous" internal debate over the recession threat. "We all agree that the U.S. housing downturn has escalated recession risks," says Richard Berner, Morgan Stanley's chief U.S. economist. "But the argument over how much collateral damage will result and the nature of the offsets to U.S. housing weakness is far from settled."

Economists have a poor track record for predicting recessions. According to The Economist, 95% of economists in March, 2001, thought a recession would not occur that year, though one actually began the same month. "Professional forecasters…are always way overoptimistic and systematically miss the turn downward of the business cycle," notes New York University economist Nouriel Roubini, who pegs the odds of a recession in 2006 at 70%.

"WHEN, NOT WHETHER."  The cooling housing market is a key impetus behind many recession fears (see BusinessWeek.com, 8/23/06, "A Cool July for Housing"). Recent years of consumers tapping home equity to make purchases could give way to a consumer-spending slowdown, according to some analysts.

"As we've said before, it is a case of when, not whether, falling consumption will precipitate the next downturn," says U.S. Bank (USB ) economist Tucker Hart Adams, who sees a 75% chance of recession before the end of 2007.

Even economists who project continued economic expansion have found the housing weakness unsettling. "The dramatic softening of the housing market has increased the probability of recession in 2007 to one-third," says Larry Adam, chief investment strategist for Deutsche Bank Alex. Brown (DB ). The International Monetary Fund cited the housing slump Sept. 14 as it trimmed its forecast for 2007 U.S. economic growth.

BOND MARKET FACTOR.  Elsewhere, the inverted Treasury yield curve has added fuel to the pessimistic fire. An inverted yield curve occurs when long-term rates drop below short-term rates. Since 1970, every time the yield curve has inverted, a recession has followed (see BusinessWeek.com, 1/9/06, "Does the Yield Curve Matter?").

This historical precedent bodes poorly for corporate profits, some analysts say. "Earnings expectations for 2007 are probably too optimistic," says Richard Bernstein, chief investment strategist at Merrill Lynch (MER ), in a Sept. 7 report. "A profits recession is reasonably likely around mid-to-late 2007."

Meanwhile, inflation may continue to rear its ugly head globally, others say. Central bankers are tolerating higher inflation in order to keep stimulating growth, and so far the bond market is going along, says Andy Xie, chief Asia economist at Morgan Stanley, in a Sept. 10 report. "The decisive downturn in this cycle may happen if the bond market should conclude that policymakers are seeking to accommodate inflation to extend growth," Xie says. "A global hard landing could unfold in 2008."

A SOFT LANDING?  Hugh Moore, partner at Greenville (S.C.)-based Guerite Advisors, says his firm has developed a proprietary economic model that would have predicted all seven recessions since 1960. The indicator is again flashing a "high-risk" signal. "When you take the slowing of the economy and you place on it the largest housing bubble since 1955, I don't see how we're going to avoid a recession," Moore says.

Still, most economists forecast that economic growth will slow without slipping into recession. The chances for a soft landing are better than they might seem, according to Standard & Poor's Investment Policy Committee.

In fact, the housing slowdown need not lead to a broader downturn, some analysts say. "The 2006 housing market retrenchment was relatively easy to foresee," says Citigroup (C ) senior economist Steven Wieting in an Aug. 28 note. "U.S. recessions, however, are much harder to predict than many observers seem to believe."

Nevertheless, the bearish views are worth keeping in mind, even when market gains make them all the more tempting to ignore. While a recession may not lurk on the horizon, investors shouldn't let a surprising September blind them to the risks.