Saturday, July 15, 2006

Odds of recession increasing? (WSJ)

Warning Signs
Consumer Caution, Oil Prices
Increase Risk of a Recession
Economy Is Still Expanding,
but Middle East Fighting
Shakes Market Confidence
A Slowdown in Retail Sales
July 14, 2006 11:38 p.m.; Page A1
With oil prices surging, financial markets gyrating and consumers turning cautious, the risks of recession are rising.

For now, the U.S. economy is still expanding, unemployment is a low 4.6% and most forecasters predict higher energy prices and interest rates will slow the economy -- not shrink it.

But this past week's fighting in the Middle East is shaking Wall Street's confidence. The Dow Jones Industrial Average fell 106.94 points Friday and was down 3.2% for the week, wiping out most of 2006's gains. (Read more.) Stocks of retailers and home builders, susceptible to rising interest rates and tight-fisted consumers, sagged. Yields on long-term Treasury bonds fell below short-term yields, a phenomenon often seen as a harbinger of recession.

A big worry is surging oil prices, which have contributed to several past recessions. Amid the Middle East turmoil and militant attacks in Nigeria, crude oil for August delivery rose 33 cents to close at $77.03 a barrel on the New York Mercantile Exchange on Friday, a new nominal record.

In all, oil prices were up 4% for the week, hitting stocks of auto makers, airlines and other oil-dependent industries. They also increased the chances that the retail price for a gallon of regular gasoline -- which averaged $2.96 on Thursday, according to the American Automobile Association -- could breach $3.

"Given that the U.S. economy is already under the weather, the [Middle East] conflict does carry the potential of bringing the economy into a recession," said Carlos Asilis, a Miami-based portfolio manager for hedge fund Vega Plus Capital Partners.

In another sign of a slowdown, the Commerce Department said Friday that retail sales in June slipped by a seasonally adjusted 0.1% to $363.80 billion, led by a 1.4% fall in sales of autos and parts. Excluding sales of autos -- and price-driven increases in gas-station sales -- retail sales were up just 0.1%, far short of the inflation rate. Total retail sales are up 5.9% over the past year.

A recession-warning gauge devised by Federal Reserve economist Jonathan Wright -- based on yields on the three-month Treasury bill and 10-year Treasury note and the Fed's current target for short-term rates -- calculates the odds of recession in the next year are now at 36%, up from 14% six months ago. (See Mr. Wright's paper.)

Merrill Lynch economist David Rosenberg put them even higher, at 40%, noting that a slowing economy could pose problems for business and consumer borrowers and deepen the slowdown. And Ian Shepherdson, chief U.S. economist at High Frequency Economics, a Valhalla, N.Y., consultant, sees a 50% chance of recession. "Hopefully, the Fed will recognize that risk and not be crazy enough to raise rates again next month," he said.

As the economy has perked up and the threat of deflation has faded, the Fed has taken short-term interest rates to 5.25% from an extraordinarily low 1% over the past two years. But with growth slowing at the same time that inflation is accelerating, the Fed faces a tough call at its Aug. 8 meeting.

As markets fell and oil prices rose Friday, futures markets were putting at 52% the odds of another Fed increase. That was down from 59% on Thursday. Markets hope for more clues to the Fed's thinking when Fed Chairman Ben Bernanke testifies before Congress Wednesday and Thursday.

Even those who don't foresee recession expect a significant slowdown. "I'm not bold enough to forecast a recession at this point," said Paul Kasriel of Northern Trust Co., Chicago. "But I do think that the economy has entered a very soft patch here."

Complaining About Gas Prices

Signs of that can be seen at Dunham's Department Store, in Wellsboro, Pa, where some shoppers are complaining about energy costs. John Dunham, the store's president, quoted one customer as saying: "You wouldn't believe -- it cost me $90 to fill up my tank the other day."

In June, sales at the 42-employee store fell 5% from a year earlier; revenue for the year is expected to be flat. "Everyone feels a little bit pinched" by high energy prices, Mr. Dunham said.

"Consumers are ... no longer simply willing to spend everything they have to sustain their lifestyles," said Joel Naroff, of Naroff Economic Advisers. They're more cautious and are now beginning to cut back on spending. That's what's beginning to show."

It's not only low-income consumers who are pulling back. Makers of boats and recreational vehicles say demand is softening. Fleetwood Enterprises, a maker of recreational vehicles, posted lower-than-expected earnings this past week.

Brunswick Corp., the world's largest maker of recreational boats, cited "significant declines in retail demand" -- unit sales were off 10% in the second quarter -- and pared profit predictions and production plans. The company said demand was weakest for boats costing between $100,000 and $250,000. "We believe the marine business is not alone in experiencing weakness," Chief Executive Dusty McCoy said in a conference call Wednesday.

The University of Michigan's midmonth report on consumer sentiment fell to a reading of 83 in July from 84.9 in June, according to those who saw the report Friday. Consumers' assessment of present conditions fell sharply. Consumers expect consumer prices to rise 3.1% in the next year, down from 3.3% last month, a development likely to please the Fed.

Anxiety about the housing market intensified as well, particularly after a profit warning from D.R. Horton Inc., which had been dubbed the Teflon builder because of the way it stood out for sticking with its guidance for the year. The Fort Worth, Texas, company, which had been expecting to close on 58,000 houses this year, said Thursday night that it now expects to close on only 50,000.

The company's bleaker earnings guidance raises questions about whether the housing market slowdown will prove more painful than many had predicted. Some analysts expect similar bad news from other builders in the coming weeks.

Of course, recessions are notoriously hard to predict, and early-warning gauges can be misleading. "You have to monitor movements among so many indicators," said Victor Zarnowitz, a longtime business-cycle watcher now at the Conference Board, a business-research organization in New York. "It's complex to find a consensus in economic activity."

The U.S. has shaken off a surprising number of shocks in the past few years. "We have found that the U.S. economy has been surprisingly resilient, surprisingly able to manage the increase in prices that we have already seen," Energy Secretary Sam Bodman said at a Friday news conference with Canadian government officials. "I am hopeful that it will continue to do so."

Lakshman Achuthan of the Economic Cycle Research Institute in New York, which tries to predict the turns in the economy, expects just that. "In terms of recession risk, we don't see that yet," he said. "Our leading indicators of growth, while they're down, are not in recessionary territory."

Welcome signs of life in the Japanese and European economies and continued vigor in China, moreover, suggest they might help sustain world economic growth as the U.S. slows.

But in a sign of concern over the economy, investors have been shifting money toward long-term Treasurys, as they often do during times of trouble. That has driven the yield on 10-year Treasury notes, which began the month at 5.15%, down to 5.07%.

That puts the 10-year yield below the Fed's 5.25% target for the federal funds rates, which banks lend to each other overnight, and below the 5.1% yield on two-year Treasury notes. Because investors usually demand higher returns for locking up money for longer periods, it's unusual for long-term interest rates to fall below short-term rates. When that happens, it's often a sign that investors believe the economy is about to slow, forcing the Fed to cut short-term rates.

When this phenomenon -- known as an inverted yield curve -- occurred last year, many economists dismissed its significance because the Fed was keeping rates extraordinarily low. But that's no longer true.

Retailer Shares Take Hit

On Wall Street, shares of retailers have been hit particularly hard, as investors worry that high energy prices will cut into shoppers' ability to spend on other items. Shares of Wal-Mart Stores Inc., whose many lower-income customers are especially sensitive gasoline prices, slipped about 2.5% on Friday after the retail data was released.

Also hit hard were shares of General Motors Corp. and Ford Motor Co., hurt in part by the view that high gasoline prices are cutting into the sales of sport-utility vehicles, their most profitable products. Investors have instead been favoring utilities and other companies whose earnings have held up in past downturns.

Stewart Pillette, head of Pillette Investment Management in San Francisco, said even fund managers who typically put their money into technology stocks and other traditionally high-growth areas, are loading up on defensive stocks. "They've turned extremely cautious," he said.

Though Byron Wien, chief investment strategist at hedge fund Pequot Capital Management, said he doesn't see a recession coming, he said his firm has taken a more defensive posture amid the tensions in the Middle East, rising oil prices and slowing corporate earnings.

"Our job is to make money when we can and protect capital when we can't," he said. "Right now, we're in capital-protection mode." But every downturn has its bottom. "When people get alarmingly pessimistic," he added, "that's when it's time to buy. It looks like that day is coming."

Additionally on Friday, the Labor Department reported that import prices were up 0.1% in June after rising 1.7% in May. Excluding oil, import prices climbed 0.4% last month.

Fed's Recession Risk Paper


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