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Market Update -- Economic Comment

Written by Jane Caron, CFA, Chief Economic Strategist

December 4, 2007

We raised a few eyebrows last month when we increased the odds for a recession to 60% from 30%. Our increased concern developed from the worsening of the housing market outlook, tighter credit conditions, and a higher risk that a negative feedback loop will form whereby weakness will perpetuate itself. Importantly, we are not defining a recession as two or more consecutive quarters of declining national output, which is the common definition used in the marketplace. Instead, we are using the National Bureau of Economic Research's definition because they are the official arbiter of recession dates. As stated on the NBER website:

The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale retail sales.

Granted, most recessions do consist of two or more quarters of declining real GDP, but not all of them. Indeed, the NBER purposefully avoids this constraint because of the tendency for GDP data to be revised significantly. Instead, the NBER prefers to look at a variety of data.

Our forecast anticipates that real GDP growth will slow from a near 5% rate in the third quarter to less than 1% in the fourth quarter due to significant pullbacks in consumer spending, business investment, residential investment, and government spending. Real GDP growth should continue to be lifted by net exports, although by a smaller amount than seen in recent quarters. Excluding the contribution from net exports, domestic demand is likely to be barely above zero in the fourth quarter.

By NBER's standards, weakness in the fourth quarter could signal the start of a recession because activity is set to decline significantly. The key question is whether or not weakness persists for more than a few months. Our forecast assumes that the economy remains in a slump for the next couple of quarters—which contrasts with the Fed's forecast for a recovery. During this slump, we expect sluggish growth in employment, income, and manufacturing, which are key variables used by NBER's Business-Cycle Dating Committee when determining if the economy is in a recession.

In conclusion, the fact that we assign 60% odds for a recession despite forecasting sluggish, rather than receding, GDP growth over the next few quarters is not as incongruous as it may appear. The central point is that we expect the economy to slow precipitously and remain weak for at least a couple of quarters. While such conditions may or may not be officially labeled a recession, we think it will certainly feel like one.