Financial Perspectives – Spring 2008
Economic Outlook – Facing Risks
Timely Commentary from Raymond James
Chief Economist Scott Brown
The U.S. economy was slammed on a number of fronts in early 2008, as the potential downside risks seen in late 2007 moved closer. The housing correction intensified, fueled by tighter credit and a steeper decline in home prices. Credit market conditions were further strained, despite aggressive rate cuts by the Federal Reserve in January. Higher food and energy prices continued to pinch household budgets, leading to flat growth in inflation-adjusted consumer spending (which accounts for about 70% of overall economic activity). Monetary policy (the lagged effect of Fed rate cuts) and fiscal policy (tax rebates) should provide support into the second half of this year, but the economy appears to be facing increased headwinds in the near term.
Most housing market indicators were suggesting a slower rate of decline in the spring of 2007. However, credit market disruptions, largely centered on valuation problems for securities backed by subprime adjustable-rate mortgages, soon spread, leading to a tightening of credit for conventional mortgage borrowers.
Whether the Fed’s easing of monetary policy, along with fiscal stimulus, will be enough to turn the economy is an open question, but these policy moves aren’t going to hurt either.
Many have worried about the large number of adjustablerate mortgages resetting at higher rates this year and next. However, the bigger problem is the drop in home prices, which has left many of those who purchased within the last few years now owing more than their home is worth. Obviously, that’s not good. The large inventory of unsold homes indicates that it will be a long time before homebuilding recovers and home prices are likely to continue to head lower. Troubled housing markets are concentrated in the regions that had the largest run-ups in home prices (California, Florida), but the economic effects will be felt on a national level.
Consumer spending growth will be dampened to some extent by the decline in home prices. Homeowners will be less likely to pull equity out through mortgage refinancings. Longer-term, the biggest drive of consumer spending growth is income. Wage income growth has remained relatively strong in recent months, but higher inflation, led by increases in food and energy costs, have resulted in no gain in aggregate purchasing power – and hence, little support for consumer spending growth.
The credit markets now appear to be on the edge of an adverse feedback loop, where tighter credit leads to weaker economic growth, which in turn leads to even tighter credit. The Fed has lowered short-term interest rates to prevent such a cycle from gathering speed.
Typically, it takes six to 12 months for changes in monetary policy to have an impact on the economy. Hence, January’s 125 basis point reduction in rates won’t be felt until the summer. Whether the Fed’s easing of monetary policy, along with fiscal stimulus, will be enough to turn the economy around is an open question, but these policy moves are not going to hurt either. The economic downturns of the last couple of decades have been shallow, but with long recoveries. There’s no reason to expect much difference this time around.
There is no assurance that the trends mentioned will continue in the future. Investing in alternative energy stocks, as well as investing in stocks in general, does entail risk and investors may incur a
profit or a loss.
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The information contained in this newsletter has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. We may, from time to time, have a position in the securities mentioned and may buy or sell such securities in the course of regular business.
Before making an investment decision, always consult with your financial advisor. Articles in this publication are presented to help broaden your perspective on investment opportunities and the investment process. Whether a particular subject is applicable to your situation or not should be determined by you and your financial advisor based on your financial objectives, time horizon, risk tolerance and current portfolio structure. There is no assurance that the trends mentioned will continue in the future. For additional information about topics in this edition of Financial Perspectives, please contact your financial advisor today. Thank you.
