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Recession Fears
Weigh Heavily
On the Markets

November 26, 2007

Battered stock and bond markets are sending an increasingly ominous signal that a U.S. recession could be near.

The markets, however, haven't swayed Federal Reserve officials and most private economists from their view that the nation's economy can escape a downturn and get back on a steadier course.

The disparity between those two views of the economy -- one growing bleaker, the other remaining sanguine -- stood out starkly last week.

Though it rose during Friday's shortened trading day, the Dow Jones Industrial Average -- at 12980.88 -- is 8.4% below its all-time high, set in October. Safe-haven Treasurys, meanwhile, have rallied as investors have lost confidence in a quick resolution of the U.S. housing slump and mortgage crisis, which are behind many of today's economic worries in both the U.S. and Europe.

But in an economic outlook released by the Fed, the central bank's policy makers said they expected U.S. economic growth to pick up as housing hits bottom and financial markets gradually resume more-normal functioning. Fed officials see the U.S. economy growing between 1.8% and 2.5% next year, according to minutes from their most recent meeting.

Who's right? History isn't much help. The stock market is notorious for predicting downturns that never materialized, while economists have failed to acknowledge some recessions until after their arrival. "Economists are extremely bad at predicting turning points, and we don't pretend to be any better," Fed Chairman Ben Bernanke told Congress earlier this month.

This time around, much depends on how tight a rein financial institutions keep on their lending and consumers keep on their spending.

By itself, the housing slump seems unlikely to choke off U.S. economic growth. Home construction accounts for less than 5% of the nation's gross domestic product. But if banks curb their lending in response to billions of dollars of mortgage-related write-offs, or if consumers cut their spending as home values fall and gasoline prices rise, it could knock the economy out of its delicate balance.

"Even if you're a dyed-in-the-wool optimist you have to say it's a more challenging time than normal," says Michael Feroli, an economist at J.P. Morgan, which cut its U.S. economic forecast last week. It now expects GDP to grow at an anemic annual rate of 0.5% this quarter and 1.5% in the first three months of 2008 -- but no recession.

Worries about the U.S. economy have also weighed down overseas stock markets. In particular, any decline in U.S. consumption could hurt demand for imported goods, which in turn would hurt the profits of producers in China and other emerging economies. The Dow Jones World Index, excluding U.S. companies, is off more than 7% so far this month.

The outlook for the global economy depends largely on whether the rest of the world -- particularly Europe and Asia -- can pick up the slack. But Europe's outlook is growing cloudy. Interest rates are rising in the markets European banks use to borrow money. And the banks have grown wary of lending to each other because of anxiety about potential losses on investments tied to the U.S. mortgage market.

If sustained, the jump in interest rates could further crimp economic growth in the euro zone, which already faces headwinds as a strengthening currency makes its exports more expensive. The European Central Bank, while vowing to pump credit into markets to keep market rates from rising, is also warning about inflationary pressures, a concern that could keep it from following the Fed in cutting its target for short-term rates.

Economists, however, take heart from the U.S. economy's proven ability to withstand shocks, financial and otherwise, something Mr. Bernanke noted earlier this month. So far this decade, the economy has faced terrorist attacks and a historic technology-stock bust with nothing but a mild recession. Since then, it has continued to grow despite the war in Iraq, soaring oil prices and the destruction and dislocations wrought by hurricane Katrina. All the while, consumers kept spending and corporate profits soared.

This week, the Commerce Department will be revising its estimate of third-quarter GDP, and it is expected to show the U.S. economy grew at an annual pace of well over 4% between July and September, even as the financial markets went through credit-related spasms. Part of that growth was due to a buildup of inventories at businesses. But job and income growth, which are still in positive territory, have also proved to be important in sustaining consumers.

The stock market, however, has rendered a different verdict on the outlook for spending and lending. According to Thomson Financial, the current consensus on Wall Street is that earnings of companies in the Standard & Poor's 500-stock index will grow 2% in the fourth quarter and 8% in the first quarter, but expectations are falling fast for retailers and others whose fortunes are tied directly to consumer sentiment.

Consumer discretionary stocks, which also include home builders and auto makers, have been among the market's worst performers. Discretionary stocks in the S&P 500 index are off about 13% on the year. A major cause is the deepening woes of home builders. But shares of companies like department-store operator Nordstrom Inc., handbag maker [COMPANY]Coach Inc. and luxury jeweler Tiffany & Co. have also slumped in recent months, a possible sign that even higher-end households are beginning to feel the pinch from lower home prices and costlier oil.

"It is apparent that our customers are feeling the impact of the economic slowdown," Starbucks Corp. Chief Executive Jim Donald told investors in a conference call in mid-November. The company posted a rise in quarterly profit but cut its fiscal-year earnings forecast and scaled back its expansion plans.

The Conference Board's survey of consumer confidence fell in October for the third month in a row, sending the index to a two-year low. A similar monthly survey conducted by Reuters and the University of Michigan reported that consumer sentiment in November fell to a two-year low and, excluding the months after Hurricane Katrina hit in 2005, reached its lowest point since 1992. The survey's sponsors warned that "the risk that a recession develops is uncomfortably large."

That makes this year's holiday shopping season all the more important. Holiday sales got off to a stronger-than-expected start on Friday, rising an estimated 8.3% from a year earlier to $10.3 billion, according to ShopperTrak RCT Corp. But retailers, fearing a weak season, quickly began offering specials to keep the momentum going. More-definitive data will be out this week -- and closely watched by investors as a possible harbinger for the broader economy.

"I don't think the consumer is going to pull back for a quarter and then rebound again," says portfolio manager Ed Maraccini, of Johnson Asset Management in Racine, Wis. "This is something that is going to be longer term," especially in light of consumers' reduced ability to borrow against the value of their homes to purchase big-ticket items.

Financial stocks have fared even worse than consumer discretionary stocks, down more than 20% this year. Financial institutions of all stripes -- from Citigroup Inc. to Merrill Lynch & Co. to Freddie Mac -- have taken huge hits to profits because they have had to write off soured mortgage-related holdings.

Merrill Lynch analysts dissected third-quarter earnings and found financial institutions recorded an average 19.7% drop in profits, the worst quarter since the fourth quarter of 1990. The U.S. was in a recession then, following the savings-and-loan crisis.

[Turning Point?]

Financial profits are likely to be down more than 20% again in the fourth quarter, Merrill says. Share prices in the sector seem especially vulnerable. Consider what happened to congressionally chartered home lender Freddie Mac last week. Its shares were down 7.9% in trading ahead of its quarterly profit report. Then they fell another 29% when Freddie announced its quarterly loss had more than doubled to $2 billion.

Other market indicators are worrisome. Instead of stocks and other risky forms of debt, investors have been buying up Treasury bonds lately. Short-term Treasury yields have plummeted, signaling that many investors believe the Fed will have to cut its own interest-rate target again when policy makers meet next month. Such a move would lower borrowing costs throughout the economy and could help to spur growth.

There are signs the housing and credit crises might be starting to affect business confidence. In a survey of manufacturing from the Institute for Supply Management, the activity index dropped last month to 50.9 -- barely staying above the 50 that indicates growth. "It does appear that the impact of the slowdown in the financial, housing and transportation segments has spilled over into manufacturing, with the exception being continued strength in new export orders," noted survey chair Norbert Ore.

James Wiltz, the chief executive of Patterson Cos., a St. Paul, Minn., distributor of dental products, is seeing it in his business, too. "Problems with the housing market and high gas prices may have introduced a note of caution into the minds of many dentists, causing them to temporarily delay new investments in their practices," he told investors on a conference call last week, while also revising down the company's earnings guidance.

Many economists are looking abroad as a growth alternative. Thanks to a weak dollar and strong growth overseas, U.S. exports grew at a 16.2% annual rate in the third quarter, making them an increasingly important contributor to economic growth.

"The world in 2007 and early 2008 is very different from what it was in 2001," says Brian Bethune, U.S. economist at Boston-based research firm Global Insight. "A strong overseas economy including a strong Asia, Latin America and a lot of demand from Middle East is enough to keep the economy from shrinking."

--Greg Ip and Justin Lahart contributed to this article.

Write to Peter A. McKay at and Kelly Evans at

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