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No Recession, But…


Most experts we polled expect growth, however meager, in 2008. A few predict rougher times

For 2008, the economic outlook is Topic No. 1 for almost all investors. Stock prices and bond yields already reflect recession worries, but an actual downturn would hit portfolios hard. To help get a handle on what to expect, BusinessWeek asked 54 forecasters in our annual outlook survey for their views on everything from housing and the credit crunch to Fed policy and global growth. (Click here for full survey results.)

The bottom line looks like this: The economists project, on average, that the economy will grow 2.1% from the fourth quarter of 2007 to the end of 2008, vs. 2.6% in 2007. Only two of the forecasters expect a recession, although it might feel like one if there's sluggish growth over the next couple of quarters, as many predict. Almost all think the risk of a downturn has risen substantially in recent months.

As a group, the forecasters say slow growth will lift the jobless rate from 4.7% in November to 5.1%, and it will hold down inflation. As oil prices level off or decline, the yearly growth in consumer prices will slide from 4.3% in November to 2.4%, while core inflation, which excludes energy and food, will hold steady at a tame 2.2%. Profits will grow in the low single digits. Home prices will fall about 7%, but housing starts will bottom out by midyear.

Almost all "no recession" forecasts are predicated on further rate cuts by the Fed. The target rate is expected to drop from 4.25% to between 2.5% and 4%, with almost half of the analysts projecting it to fall below 4%. The yield curve will steepen a bit, as 10-year Treasuries edge up to 4.5% by yearend.

On balance, the analysts are cautiously optimistic, but with plenty of hedging amid all the uncertainties. Here's how they see the hot-button issues shaping up:

THE CREDIT CRUNCH

Perhaps the biggest surprise of 2007 was the way the housing slump shook the economy. It wasn't just the direct drag of less construction activity, the shrinking outlays on home-related goods, and lost consumer wealth, as economists had expected. It was the way the subprime debacle hit the financial markets, setting off two things: a new downturn in housing activity and a liquidity crisis that now threatens a broad squeeze on credit availability. "The two main risks in the outlook are that sharp further declines in home prices will cause consumers to spend less, and that the ongoing credit crunch will curtail activity in a more general way," says Dana Johnson at Comerica Bank (CMA) in Dallas.

Some worry the Fed isn't doing enough. "The Fed's response to the current financial market troubles and weaker economy has been slow, as they have underestimated the severity of the problem," says Mark M. Zandi at Moody's (MCO) Economy.com. Analysts are encouraged by the Fed's coordinated efforts with other central banks to auction off funds in an effort to relieve strains on liquidity. However, if key market rates, crucial to the short-term funding needs of businesses, fail to come down, most economists believe aggressive rate cutting will be the only way to protect the economy.

With help from the Fed, consumers and businesses should be able to manage the crunch. "While consumers are likely to grow more cautious in 2008, solid income growth should prevent a sharp contraction in spending," says Ethan S. Harris at Lehman Brothers (LEH). Businesses will continue to expand their outlays and payrolls, since they are not overextended with debt, excess production capacity, or inventories, and the lower dollar is providing a stimulus for exports, especially since the rest of the world is doing O.K. But without effective Fed action, the credit vise could begin to squeeze too hard.

THE HOUSING SLUMP

When will the vicious cycle of falling home prices, mortgage defaults, and credit tightening be broken? "It's all about housing and the resolution of current excesses," says Richard DeKaser at National City Corp. (NCC) in Cleveland. The economists agree that, first, home sales have to stabilize. "Housing starts must fall low enough relative to sales to bring a significant reduction in inventories," says Robert Melman at JPMorgan (JPM). Only then can prices bottom out, as supply and demand rebalance.

That will probably take all of 2008. Maybe longer. Keith Hembre at First American Funds in Minneapolis is not hopeful. "Substantial further adjustment in housing appears to lie ahead," says Hembre, who one year ago in BusinessWeek made the best forecast for 2007. He's one of the two economists who expect an economywide recession in 2008. (See "Hembre's Farsighted Forecasts".)

Others are more optimistic. "Most of the decline is behind us," says Ken Mayland at ClearView Economics in Pepper Pike, Ohio. Housing starts have fallen to an annual rate of 1.2 million, from a peak of 2.3 million nearly two years ago. Economists expect them to bottom out around midyear at 1 million, so the drag from housing will ease. Inventories of existing homes are still sky-high, which is keeping downward pressure on prices, but builders' stocks of new homes have begun to shrink.

THE FEDERAL RESERVE

Investors are caught between what appears to be a deep divide at the Fed over how to balance the risk of a slowing economy with the risk of inflation. At the Fed's Oct. 30-31 meeting, one policymaker opposed the quarter-point rate cut because he felt it was too much. On Dec. 11, another member opposed the next quarter-point cut on the grounds that it wasn't enough.

If the economists are right about slow growth in 2008, then inflation pressures will stay down. The potential for businesses to pass along the increased energy costs to the prices of their final products is one Fed worry. Another is tight labor markets at a time when slower productivity is providing less of an offset to rising wage costs. However, if the economy grows at a pace of only about 1.5%, as expected through the second quarter of 2008, the labor markets are sure to loosen up, and higher costs will squeeze profit margins more than they will push up prices.

That would allow the Fed to ease as much as necessary to revive housing, relieve the liquidity and credit squeezes, and restore the economy's pep. Based on its recent words and actions, the Fed seems to be coming around to the thinking of most economists. "I believe the current risks fall more heavily on recession, and I don't think [energy-driven] headline inflation will affect near-term policy decisions," says Robert Shrouds at DuPont (DD).

THE GLOBAL ECONOMY

Foreign trade will be a big support for U.S. growth in 2008. In 2007, a shrinking trade deficit, fueled in large part by an export boom, almost completely offset the direct negative effect of falling residential construction on overall growth. The same will be true in the coming year, given good growth overseas and a competitive dollar. "Foreign trade should add one-half to three-quarters of a percentage point to real GDP growth in 2008," says Alan D. Levenson at T. Rowe Price Associates (TROW). Key beneficiaries will be makers of capital equipment, where the U.S. has an edge, especially in high-tech gear, aircraft, and knowledge-based service industries.

The lower dollar will help, but there could be a dark side if, for example, the euro becomes overly strong and begins to hurt economic growth in Europe. "Having a competitive advantage is worth less if your key markets don't grow," says Robert A. Brusca at researcher Fact & Opinion Economics. The greenback will most likely decline a bit more, but not much. "We don't expect the dollar to fall in 2008 at the same pace it did in 2007, as central banks in other countries move toward policy easing and the worst fears about the U.S. economy are assuaged," says Dean Maki at Barclays Capital (BCS).

As the U.S. trade deficit narrows further, 2008 will mark a second consecutive year of movement toward a more balanced global economy. However, it's a transition that means the U.S. is shifting away from a heavy dependence on consumer spending and toward more reliance on exports. "The quality of economic growth probably won't feel as good to the average American as it has in recent years," says Tom Higgins at Payden Rygel Investment Counsel. "Put simply, it feels better to consume than to watch others consume."

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