Major Recession Raises Risks

02/14/2008 12:00 am EST


Gary Shilling

Columnist, Forbes

A. Gary Shilling, editor of Gary Shilling's Insight, says the deep recession he thinks we're in will take a big toll on consumers' pocket books and investors' portfolios.

The [emerging] recession will be major because it is propelled by three extremely virulent forces-the collapse in housing, the rapid disappearance of home equity on which consumer spending depended, and the spreading credit crunch.

The gap between real consumer spending in recent years and real earnings has been filled by home equity loans and cash-out refinancing. In addition, homeowners have viewed their housing as continually self-filling piggy banks that will cover all future savings needs.

[Yet] home equity as a source of funding is falling fast and will disappear for most with our expected 25% fall in house prices. Home equity, after all mortgage debt is removed, has fallen from 70% of the average house's market value in the early 1980s to 50% [now].

Furthermore, house price declines are having widespread effects since, in contrast to stocks, home ownership is widely dispersed. About 50% of Americans own stocks or mutual funds, but 68% own their own abodes. And in recent years, home ownership has leaped among young, low-income and minority households-those with little or no additional net worth to cushion house price declines.

The US recession will probably be major by post-World War II standards. We foresee a decline in real gross domestic product of 3.4% from the peak in the fourth quarter of 2007 to the fourth quarter of 2008. This would rank with the 3.7% decline in the 1957-1958 recession and the 3.1% fall in the 1973-1975 slump, the two most severe in the postwar era.

We expect consumer spending to fall by 1.6% from peak to trough. That may not sound like a lot, but it is compared to past recessions. In the 1957-1958 recession, consumer spending fell by only 0.6%. Similarly, in the deep 1973-1975 business decline, consumer outlays dropped 0.6%.

We are forecasting, then, much more weakness in consumer spending in this recession than in its predecessors, because consumers have never before relied so heavily on house appreciation to support their spending. And since we believe it will take until 2010 to work off the huge excess inventories of houses, home prices will probably be falling until then.

Apparently policy makers are so scared over financial market meltdowns and severe effects on the economy that they are acting with uncommon speed. We don't believe, however, that they can prevent a major recession and the deepening of financial woes.

Even if the Federal Reserve, joined progressively by other central banks, succeeds in pumping money into the system, their efforts will continue to be dwarfed by the collapsing derivatives market.

We're not necessarily forecasting that the Standard & Poor's 500 index will fall by over another 40% to reach the 2002 low. But with corporate profits likely to drop 20% or more in the course of the recession, stocks are probably a long way from their bottom. The risks are on the downside.

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