Malpass: Slowdown, Not Recession

Earlier today, Bear Stearns economist and top forecaster David Malpass emailed this prediction about Q4 '07 and Q1 '08:

We expect a material, two-quarter U.S. slowdown--1.5% real GDP growth in the fourth quarter and 1% in the first quarter of 2008--but not a recession. We think recent developments are consistent with a low recession probability, say 20% through September 2008 as discussed in "Extra Rate Cut A Big Deal, Not A Band-Aid" on Sept. 19.

--The normal recession predictors--a prolonged decline in profits, a decline in equity market prices, sharply rising jobless claims--are missing. Recessions usually involve cyclical declines in inventories, housing or autos. These have been weak since 2005, arguing against a cyclical recession now. Recessions usually involve an element of surprise, also missing this time, given the high degree of 'recession alert' going on.

--The Fed is maintaining a proactive stance in addressing the slowdown. Despite wider credit spreads relative to Treasuries, we note the relatively low interest rates in most credit markets. We now expect a 25-basis-point cut in the Federal funds rate and discount rate on Dec. 11.

--Extra cash in the global financial system remains massive. The feeling of a credit crunch is coming more from the slowdown in velocity or turnover of money than from a scarcity of liquidity.

We think the losses to the real economy from the credit market problems are being exaggerated in several ways:

--Some estimates of the size of the sub-prime damages appear to us to be double-counting the losses. The losses in SIVs seem to us to be exaggerated. The issue for the economic outlook is primarily the underlying economic loss. The chain of financial losses are timing decisions in which some are realizing their losses in zero-sum financial calculations, while others will realize gains later.

--We think the still-large net real estate gains over the last decade, by adding to household net worth, act as a cushion against a recession. While the decline in house prices is being treated as a purely negative development, we note that much of the realized losses will be born by sturdy corporate balance sheets; the house price reductions add to housing affordability; the price declines act as a transfer of value from older, more well-off homeowners to younger, less well-off home buyers. Housing weakness has been underway for over two years, with little impact on consumption--we think consumption is more related to the labor environment, not wealth or wealth distribution.

--A high recession probability has been largely priced into financial markets. We think the flight into Treasuries on Nov. 26 smacked of capitulation. Whilerecognize some forward-looking drags on growth from the reduced use of securitizations, mortgage structures and SIVs, but this may be offset by a better allocation of capital. the market focus is on losses to past wealth, we don’t think those losses are nearly as important as the impact on future growth. It may not be very large. We think the flight into Treasuries on Nov. 26 smacked of capitulation. While the market focus is on losses to past wealth, we don’t think those losses are nearly as important as the impact on future growth. It may not be very large. We recognize some forward-looking drags on growth from the reduced use of securitizations, mortgage structures and SIVs, but this may be offset by a better allocation of capital.

What do you think?

By the way, I contend that it's still more realistic (and better for your health) to err on the side of optimism. Take the third-quarter GDP. It grew 3.9%, when the consensus was 3.1%. But hold on to your hats: When the Q3 GDP growth figure is revised, it will show 4.9%, according to a Wall Street Journal report today. Who would have thought?