A Major Recession Is Coming

12/20/2007 12:00 am EST


Gary Shilling

Columnist, Forbes

Gary Shilling, editor of Gary Shilling's Insight, says the housing bust will trigger a major recession and that buying bonds is the best way for investors to protect themselves.

[In past housing cycles] construction as a percentage of GDP normally fell from around 5.5% to 3.5%, and in this super cycle we expect a decline from the 6.3% peak to below 3.0%, or a cumulative negative impact on real GDP of more than 3%.

A 3% drop in GDP is a major recession. Only two in the post-World War II era, the 1957-1958 slump and the 1973-1975 retreat, had peak-to-trough declines in real GDP of over 3%.

In other words, unless strength in some other sector offsets it, the normal cyclical drop in housing is enough to register a recession, and the collapse in the current super cycle implies a major recession.

Like investors, homeowners have been in denial, but that too is ending. In the past, this time of denial has lasted about two years after sales start to fall. This time, existing house prices hit
the skids in September, exactly two years after sales peaked in September 2005.

As the housing crisis spreads, the economy is highly vulnerable even if the many other speculative financial areas don't unravel. You don't hear much any more about capital equipment spending riding to the rescue and replacing housing as a source of economic stimulus.

Employment growth is slowing, and recent employment patterns are compatible with a recession starting about now. Sluggish income growth is only augmenting consumer concerns. Meanwhile, consumers seem to be becoming very cautious and their loan sources are becoming constricted.

Without any follow-on effects or other negatives such as high fuel prices and falling stocks, the 25% decline in house prices we foresee could alone slash consumer outlays by 3%. Since consumers account for 70% of GDP, that's a 2% drop in GDP. Added to the 3% or greater GDP decline we expect from the collapse in residential construction, that would result in by far the worst recession in the post-World War II era.

Fed fears over inflation, normal for central bankers, will likely continue to be overcome by concerns over financial crises and the economy. So, the campaign of rate cuts commenced in September will probably persist, and it could take the target federal funds rate back to 1% if financial woes spread.

In any event, as the recession unfolds and then spreads globally, commodity prices will fall and inflation will fade, perhaps into chronic deflation. Credit demand will atrophy, at least among creditworthy borrowers. These forces, combined with massive Fed ease, will drive Treasury bond prices up as yields fall, ultimately to 3%. Yields started at 14.7% in 1981 and the price appreciation has been spectacular since then, but they're still very attractive gains ahead, even from current 4.5% yields.

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