Outlook 2008: The U.S. Economy Is Down - But Not Out - in the New Year

Editor's Note: This is the Fifth Installment of an Ongoing Series Highlighting the Global Investing Outlook for 2008

By Jennifer Yousfi
Managing Editor

Despite a still-slumping housing market, an escalating credit crunch and spiraling inflationary pressures, the U.S. economy should still manage to advance at a 1% to 2% clip in 2008.

While investors might view that as bad news, there's actually a positive twist, since it means that U.S. economy will likely dodge the recession that some observers have feared.

Even so, the U.S. economy won't be in the investment spotlight in 2008, and investors will see the first signs of the "decoupling" of the U.S. market from those overseas. While the United States is narrowly dodging recession, other global economies will be advancing by as much as 10%. The emergence of a growing middle class in such key markets as China, India and Eastern Europe will make global dependence on the U.S. economy a thing of the past. With tens of millions of newly minted consumers ready to spend in China, that country could easily weather a U.S. downturn.

Even with decoupling, U.S. investors still can profit from markets abroad - regardless of what's going on here at home.

The Homeowner Blues

Volatility and crisis were the watchwords of the U.S. economy in 2007.  As we turn our eyes to the New Year, it's clear we're not out of the woods, yet.  Many fear that 2008 will find the United States in a recession.  Other investors believe we are already experiencing the first elements of a recessionary contraction.

If I had to be bold, I'd say we began a recession in December," Bill Gross, manager of the PIMCO Total Return Fund (PTTAX), told the Financial Times in a recent interview.

But will it be as bad as some fear?

As 2007 progressed, many Americans experienced a growing despair as they watched their largest asset - the family home - decline in value.  The United States is experiencing its worst housing recession in more than 15 years. And it's far from over. Even as consumers watch as the ongoing crisis siphons off the equity they've built up, and shaves the market value of their homes, consumers with marginal credit who'd signed up for adjustable-rate loans watched their monthly mortgage payments balloon - until they could no longer afford those payments.

Unfortunately for many, refinancing hasn't been an option. The vanishing homeowners' equity made the deals unfavorable to lenders. Add to that a growing credit crisis that quickly became global in nature, and banks and mortgage firms began to ratchet back on the refinancing loans that homeowners needed to escape their soaring mortgage payments.

Soon, the banks that had made the questionable calls on subprime loans were in trouble, too. With the housing market cooling, the homeowners who couldn't refinance also discovered that they couldn't sell. Homeowner defaults - loans that are 30 days or more past due - soared and started a firestorm that has swept through the global financial-services sector, singing such stalwarts as Citigroup Inc. (C), Fannie Mae (FNM), UBS AG (UBS), and others.

"It will take most of the year to work out of the housing slowdown. Currently, the inventory of unsold homes is at an eight to nine-month level. We have to get this down to a more normal level of four to five months. In order to get to this level, housing starts will remain low," Dr. Robert Sweet, an economist at MTB Investment Advisors, the investment-advisory subsidiary of M&T Bank Corp. (MTB), said in an interview with Money Morning.

Fannie Mae Chief Executive Officer Daniel Mudd recently said the U.S. housing market wouldn't revive until 2009.

To try and keep the subprime-mortgage crisis from escalating, the U.S. Federal Reserve recently proposed changes to Regulation Z [Truth in Lending]. The plan highlights four areas of protection for higher-cost loans, including a requirement that creditors to verify a prospective borrower's income and assets before providing actual loans.

"Unfair and deceptive practices have harmed consumers and the integrity of the home-mortgage market," Federal Reserve Board Governor Randall S. Kroszner said in a statement.  "We have listened closely and developed a response to abuses that we believe will facilitate responsible lending."

Most financial institutions have already moved billions of dollars in Structured-Investment-Vehicle (SIV) fund assets onto their balance sheets.  In the past few months alone, banks have also written down billions of dollars in mortgage-backed assets.

"That was really the last major outstanding piece of the SIV problem," Peter Crane, founder of Crane Data LLC, told Bloomberg News in mid-December, after Citigroup moved $49 billion in SIV assets onto its balance sheet. "The SIV problem is very close to resolution."

The Fed to the Rescue?

After holding rates steady for more than a year, the U.S. central bank's policymaking Federal Open Market Committee (FOMC) opted to slash short-term interest rates three times in the last four months of the year. The benchmark Federal Funds Rate now stands at 4.25%.

While the central bank's policy statement after its Dec. 11 FOMC meeting didn't seem to indicate that future rate reductions were on the way, many experts believe that U.S. Federal Reserve Chairman Ben S. Bernanke and his policymaking colleagues will have to reduce rates further if the U.S. economy is to skirt a recession in 2008.

"The Fed is closely watching the slow economic growth and the potential of inflation," said Sweet, the MTB economist. "My view is that the Fed will cut the Fed Funds Rate to 4.0% when [it meets] in early 2008."

The FOMC's next regularly scheduled meeting is Jan. 29 - Jan. 30.

PIMCO's Gross told the Financial Times that the Fed would need to drop the target rate even further - down to 3.0%  - to fully restore economic growth. Gross is widely viewed as the top fixed-income guru in the financial-services industry.

But while the Fed is definitely looking to do what it can to avoid a contraction in the U.S. economy, Bernanke faces a second - equally troubling - challenge. And no matter which route he chooses to take, the solution to one problem will exacerbate the second.

Seventies Flashback?

The Fed has demonstrated caution with regards to interest-rate reductions due to escalating inflation fears.

During the 1970s, the United States was afflicted with stagflation - crippling inflation coupled with stagnant economic growth and high unemployment. Until stagflation appeared, economists believed it to be an almost-impossible combination. Today, investors of a certain age remember the high fuel costs and long gas lines - along with the headlines about rising unemployment and a stalled U.S. economy that refused to be jump-started.

As U.S. economic troubles mount anew, some experts are using the "S-word" again. But stagflation is a worst-case scenario. The only thing worse than having either a recession or a period of inflation is to have them occur together. And for that reason alone, Keith Fitz-Gerald, Investment Director of both Money Morning and The Money Map Report, believes that "the Fed will do whatever it takes to prevent a recession."

However, Fitz-Gerald also believes that the U.S. inflation rate is actually much higher than government statistics show. That "stealth inflation" is currently having a smaller-than-expected impact on the U.S. economy because the United States is currently "exporting inflation to China," Fitz-Gerald says.

But if the U.S.-China "relationship breaks and the dollar continues to weaken - then we'll have stagflation," Fitz-Gerald says.

2008: The Year of the Greenback?

According toa MarketWatch.com report from late December, "although [the dollar is] trading above its 2007 lows in the waning weeks of the year, it's still on track to post a yearly loss of more than 3% against the pound sterling, more than 5% against the yen, about 9% against the euro and about 14% against the Canadian dollar."

While the staggering greenback tumbled to historic lows against key major currencies during 2007, the general outlook for the American dollar is slightly more upbeat for 2008.

The dollar is "widely viewed as the foremost casualty of the entire [subprime] calamity, [and should be] the first to respond to the tonic," Andrew Wilkinson, an analyst for Interactive Brokers, told MarketWatch.

Wilkinson predicts the dollar will rise against the euro in 2008, dropping back to its 2007 start of $1.30, an 11% decrease from its recent high of $1.47.

Money Morning's Fitz-Gerald is a bit less sanguine, noting that the U.S. dollar is "likely to continue to weaken, particularly if the Fed continues to inject liquidity" into the capital markets. And while there will be something of a rebound in the greenback's value in 2008, "don't expect the dollar to come roaring back."

Good Opportunities Exist - Even in a Potential Bear Market

As foreign economies decouple from the United States market, those overseas markets should achieve attractive growth rates - even in the face of a slowing U.S. economy.

But while there are definitely some tough times ahead for the domestic economy in the New Year, don't expect 2008 to be all gloom and doom, Sweet, the M&T Bank economist, said.

"The economy will slow in the first half, and pick-up a little in the second half," Sweet said. "Due to the housing situation, there is about a 50-50 chance of a recession. However, a low unemployment rate may entice the consumer to spend. Therefore, if a recession occurs, it should be short and shallow."

[A recession is technically defined as two consecutive quarters of negative economic growth].

In a report that mirrors Sweet's sentiment, Bloomberg said that Federal Reserve Bank of Richmond President Jeffrey Lacker, in a speech during the recent Annual Economic Outlook symposium hosted by the Charlotte Chamber of Commerce, said he expects "growth to be very weak for several more months."

"Home construction and [home] sales are unlikely to bottom out before the middle of the year, and I expect housing to continue to be a drag on growth well into 2008," Lacker said. Even so, job growth and rising personal incomes "will support further gains in consumer spending.'"

Both Sweet and Lacker expect an economic slowdown, but both also hold out the same hope: Consumer spending will advance enough to keep the economy from slowing to a standstill - or, even worse, falling into a recession.

Money Morning's Fitz-Gerald cautions investors to remember that even though U.S. gross domestic product will advance at a modest pace of only 1% to 2% during 2008, the rest of the global economy will be doing quite well - with economic growth rates as high as 8% to 9%.  With foreign economies growing that briskly, there will be plenty of profitable investment opportunities available in the year to come.

With growth sputtering at home and a recession still possible, investors should turn their attention to such U.S.-based multinationals as McDonald's Corp. (MCD) and Yum! Brands Inc. (YUM). Both firms have substantial portions of their sales coming from overseas, where growth is likely to continue throughout 2008, regardless of what happens to the U.S. economy.

And while they offer significant foreign-market exposure, being U.S. companies, corporations such as McDonald's, Yum! Brands and such others as The Coca-Cola Co. (KO) and PepsiCo Inc. (PEP) at the same time offer investors the transparency of U.S. financial reporting requirements and the relative protection of the U.S. investment-regulatory system.

But if you prefer to invest more directly in foreign growth, Money Morning Contributing Editor Martin Hutchinson says to try South Korea's largest wireless service provider, SK Telecom Co. Ltd. (SKM).  SK is well positioned to capitalize on the growing Asian markets. Likewise, the Hsinchu, Taiwan-based Taiwan Semiconductor Mfg. Co. Ltd. (TSM) [commonly referred to as TMSC], the world's largest dedicated semiconductor foundry, is another Asian tech company that is not currently overvalued and should do well in the New Year, Hutchinson says.

Traditional inflation-sensitive investments such as currencies and commodities are also good plays for 2008, such investment gurus as Fitz-Gerald and "adventure-capitalist" Jim Rogers say. [To see how you can obtain a free copy of Jim Rogers' new bestseller, "A Bull in China," please click here.]
The PowerShares Agriculture Fund (DBA), operated by German giant Deutsche Bank AG (DB), is intended to reflect the performance of four commodities in the agriculture sector - soybeans (31.13%), wheat (28.87%), corn (23.43%) and sugar (16.58%). These include some of the key agricultural commodity plays that Rogers advocates.

Another is Van Eck's recently launched Market Vectors Agribusiness Exchange-Traded Fund (MOO). Like the PowerShares Fund, this reflects the agriculture industry but in a different way. Instead, the ETF's holdings reflect returns seen from agriculture chemicals (34%), agriproduct operations (33.5%), agriculture equipment (24.3%), livestock operations (5.6%) and ethanol/biodiesel (2.3%).

For investors who have the constitution of a Contrarian investor - as well as some patience and a long time horizon - it may be well worth a look at some of the beaten-down financial-sector stocks that state-run sovereign wealth funds are buying into in a wholesale manner. Although many U.S. investors are preaching caution - if not total avoidance - when it comes to companies involved with the American financial-services sector, these government-run investment pools clearly view such stalwarts as Citigroup, UBS, Merrill Lynch & Co. Inc. (MER), and Morgan Stanley (MS), as bargain-basement investment opportunities.
Fitz-Gerald favors Citigroup.

"Citi is trading for a pittance," Fitz-Gerald said recently. "In fact, it's trading at just barely seven times trailing earnings and eight times [projected] 2008 earnings. Yet, if you add up the growth prospects and current valuations, the company reflects a value that could be as high as $60 or more a share. Value investors will recognize this as important because history shows that the lower P/E ratios are when you make an investment, the better your overall returns tend to be. Generally, large globally diversified companies are considered bargains at a P/E of 12, which makes Citi a screaming deal at 7 or 8."

[Money Morning Executive Editor William Patalon III contributed to this report].

Editor's Note: Money Morning's "Outlook 2008" Series Last Covered U.S. Stocks. Next Up: Uranium.

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