The risks of a US recession this year are high, and there is little likelihood that the rest of the global economy can uncouple itself to prevent a sharp global slowdown, writes Nouriel Roubini.

The odds that the US will slide into a recession in 2007 are very high: a hard landing of the economy is more likely than the soft landing scenario predicted by the consensus of macro forecasters. The US Federal Reserve (Fed) will cut the Fed Funds rate too late in the first quarter of 2007, when the signs of the coming recession are stronger; but such easing will not prevent the recession.

The implications of a hard landing will be felt globally. The rest of the world will not decouple from the US recession, as some analysts predict. When the US sneezes, the rest of the world still gets the cold.

The US recession will be triggered by three unstoppable bearish forces: the housing bust, one of the worst in decades; the high oil and energy prices; and the delayed effects on the economy of the increases in the Fed Funds rate in 2006. The US consumer, already burdened with negative savings, high debt ratios, falling housing wealth, rising debt servicing ratios, flat real wages and a weakening labour market, is being hard hit by these shocks.

Housing slump

The effects of the housing slump will be more severe than those following the tech sector bubble implosion in 2000-2001 that led to the 2001 recession, for three reasons. The reduction in real residential investment will end up being larger than the fall in real investment in tech goods. The negative wealth effect on consumption of falling housing prices – and the related sharp fall in home equity withdrawal – are also larger than the wealth effects of the collapse of tech stock in 2000. Property, unlike the tech stocks, is a significant part of household wealth and US households have been able to consume more than their incomes (negative savings) only by using their homes as their ATM machines via massive mortgage equity withdrawals. And about 30% of US employment in the latest recovery has been related to housing; thus, the bust of housing and related sectors will affect employment severely in 2007.

The latest quarters’ figures on US gross domestic product (GDP) growth are an ominous signal of the slowdown, with growth falling from 5.6% in Q1 to 1.6% in Q3. Residential investment is in free fall and the housing bust is nowhere near bottoming out. Inventories are up as still-high production faces falling sales growth. Net exports are again being a drag on growth. There are signs of a sharp slowdown in non-residential and corporate investment, and consumption growth is weakening as consumers are retrenching. As consumer demand is slowing, profit-rich companies are not finding good investment opportunities to increase capacity, and are thus returning such profits to shareholders in an unprecedented share buyback bonanza – the largest in US history.

Inflationary forces

In spite of high inflation, inflationary forces are falling because of the sharp economic slowdown; thus, the Fed will ease rates in early 2007 because of the incoming sharp recession. But its monetary easing will not prevent the coming recession, for the same reasons that the pause applied by the Fed in June 2000 and the sharp easing in 2001 did not prevent the 2001 recession. Once the housing and consumption slump starts, demand for durable goods becomes interest-rate insensitive. The recent housing bubble has led to a glut of housing stock, autos, consumer durables and lingering excess capital capacity in the rest of the economy. Thus, as in 2000-01, the housing and consumption slump will dominate any monetary easing effort by the Fed.

Many sectors of the US are already in a recession. The housing sector is in a severe recessionary slump with home prices falling sharply. The housing bust is also infecting non-residential investment: why build shopping malls and offices around ‘ghost’ towns, the empty residential developments that are widespread throughout the US? The auto sector is in a recession as a glut of supply and slowing demand (partly because of the housing bust) is hitting automakers. The manufacturing sector is in a recession as manufacturing production has been falling for some time, manufacturing employment is falling and leading indicators of the manufacturing sector are showing strong weakness ahead. Even the retail sector is showing signs of weakness as most major retailers experience mediocre sales growth.

Consistent with the view that part of the economy is already in a recession, employment is falling in the housing, manufacturing, durables consumption, temporary employment and the retail sectors.

Global impact

Will the rest of the world decouple from the US recession? The market consensus is that there will be a divergence in patterns of global growth between the US on one hand, and Europe and Asia on the other. But that is only wishful thinking – world growth will slow down quickly once the US slumps.

Trade links are one important reason for this. But also the oil shock will have the same stagflationary effect on the eurozone and Asia as on the US. Monetary policy is being tightened in Japan, the eurozone and emerging markets. Global chief executives’ confidence is down and rising geo-strategic shocks may hit consumer and business confidence.

The fall of the dollar following the US slowdown will lead to deflationary forces in Europe and Asia; and room for monetary and fiscal easing is much more limited now than in 2001, when the G7 countries slashed interest rates and eased fiscal policy.

Even though global inflation is up, fiscal policy cannot be eased because almost all of the G7 face serious fiscal imbalances. Thus, a decoupling would occur only if the US experiences a soft landing. In the hard landing scenario, which is becoming more likely by the day, a sharp global slowdown in Asia, Europe and Latin America can be expected.

Implications for financial markets will be serious. Although there may be an equity rally in the wake of the Fed’s pause and then ease, this will be a ‘sucker rally’. When the reality of a recession sinks in, US and global equity markets will fall steeply, along with currencies and bonds in emerging markets (especially those with large external deficits). Credit spreads will increase as the recession leads to corporate distress.

Increasing defaults on mortgages will have severe effects on bank lenders and the risk of an outright US banking crisis cannot be discounted. Long-term interest rates, as well as energy and commodity prices, have already fallen. They will fall further once the recession sets in.

The US dollar risks a disorderly fall as the US current account deficit becomes unsustainable, and the willingness of foreign private and official investors to finance it is reduced. Central banks and private investors are now concerned about losses on holdings of dollar assets. Thus, US consumer ‘burn-out’ may be followed by the flight of foreign investment amid rising trade and protectionist pressures.

Nouriel Roubini is professor of economics at the Stern School of Business, New York University, and chairman of Roubini Global Economics.

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