No Boom, but Maybe a Bust: The Consumer and Sub-prime Hold the Cards to Economic Growth in 2008

As we shortly close out another year in the markets, it’s fair to conclude the best of America’s economic growth cycle lies behind us. Growth peaked in the second quarter along with broader stock market aggregates later on July 19th. On November 21st, Dow Theory triggered a bear market sell signal as more stocks continue to break down and hit new lows.

The next few months will confirm whether the world’s largest economy is now contracting or mired in a slowdown. That’s a key trend-setter because it’ll determine how to position investment portfolios in 2008.

Small is Struggling, Sub-prime Spreading

Smaller companies, the backbone of corporate America, have already peaked since last spring and are cutting back on capital spending. Signs also point to a reduction in hiring as slower growth forces more companies to shed redundant labor. But labor trends, a lagging indicator, typically shows up late after a recession has already started. In late 2007, the unemployment rate is still historically low; as the New Year progresses, however, more job losses will mount as sub-prime spreads to the non-financial economy.

One major source of instability that threatens to delay a recovery in broad economic growth remains housing. And not just in the United States.

Residential investment is falling hard since mid-2006 in America but has only started to decline in ”bubble” markets in Europe, mainly Spain, Ireland and the United Kingdom.

Housing in the United States is still hemorrhaging with no signs of a bottom, bank lending is contracting amid the worst credit crisis since 1998 and with the exception of exports every facet of the economy is now in a downtrend. The economic picture doesn’t look too pretty for the first half of 2008.

Over $1 Trillion – and Counting

In addition to housing, the sub-prime crisis is deepening with over $1 trillion dollars now committed to money-markets by the world’s central banks since August 9th. The European Central Bank (ECB) is responsible for more than half of that total, attacking the inter-bank lending freeze across the euro-zone with $500 billion alone on December 17th. Although Euribor and Libor rates have declined as a result, spreads remain well above central bank targets as banks are reluctant to lend overnight.

To the casual observer, Libor and Euribor might not matter much. Yet, in reality these inter-bank lending rates -- still in a virtual freeze since August, affect global lending rates and trends in institutional and corporate borrowing; even if rates were to normalize tomorrow, the lasting impact has already been felt across the global economy, especially over the last 30 days.

The Consumer and Employment are Wildcards

The United States might escape a severe recession in 2008, defined as two consecutive monthly declines in output. But one more major shock and a real bust might tip the scales into a deeper economic contraction.

With domestic consumption in the United at 70% of gross domestic product and big business providing another serious chunk of change to economic growth, the odds are rising that a soft recession has already started in late 2007. Corporate earnings are too optimistic for 2008 as capital spending stagnates and consumption faces a temporary freeze following the Christmas retail sales jolt. Once the holidays are over, domestic consumption is likely to stall combined with weak GDP data for the fourth quarter denting already fragile consumer confidence.

The Fed Fighting Stagflation and Deflation

Meanwhile, the Fed is fighting a toxic cocktail of rising inflation and growing deflation in housing – a major policy challenge for any central bank. The Europeans also face the same problem as the ECB remains reluctant to cut short-term lending rates amid high inflation, mainly in energy and food prices.

In an environment where global economic growth is slowing, especially in the United States, Japan and the United Kingdom, the time to hedge your investment portfolio is now. It’s not too late to add alternative investments like reverse-index funds, Japanese yen and other Asian currencies, and hedge funds specializing in distressed debt and busted credits. Plus, commodities, though likely to face some downward pressure (oil and the base metals) still offer great hedges in the grains, soft commodities, livestock and the precious metals as supplies continue to tighten.

Join me at the Sovereign Society’s Emergency Money Summit in St. Kitts (February 20-23) to learn how to hedge your global portfolio, access some world-class money-managers for All-Weather markets and protect your wealth ahead of the next bear market.