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TOM PETRUNO / MARKET BEAT

Decision time for the economy?

August 30, 2008|Tom Petruno

With two-thirds of the year now over, nothing is resolved about the economy, the housing market, the credit markets or the stock market.

What a way to get back to work on Tuesday after summer vacation.

As the curtain comes up on the final four months of 2008, here's a look at some of the key issues that will preoccupy investors:

* The U.S. economy.. Recession? Depression? Recovery? None of the above?

The script that many analysts wrote for the domestic economy at the start of this year was for a first-half slowdown or even contraction (recession), followed by a second-half pickup.

Yet the government this week revised its estimate of real economic growth in the second quarter to a 3.3% annualized pace, up from an initial estimate of 1.9%.

What happened to the slowdown? That actually was the story on the consumer side of the economy. But it was offset by an unexpected surge in foreign demand for U.S. exports in the second quarter.

Excluding trade, the economy grew at a mere 0.2% pace in the quarter, noted Ian Shepherdson at High Frequency Economics in Valhalla, N.Y. "Foreign trade is keeping the economy afloat," he said.

With growth slowing markedly abroad, however, most forecasters see the export boom waning. That will put the onus back on the U.S. consumer.

And with unemployment rising and credit tight, it seems unlikely that Americans can launch a new spending spree. That view was reinforced by the government's report on Friday that consumer spending overall edged up just 0.2% in July.

Asha Bangalore, an economist at Northern Trust in Chicago, forecasts that spending will decline in the current quarter -- which, she says, would be the first quarterly drop since 1991. If she's right, Wall Street in September will have to cope with a new wave of recession fears.

One big wild card: the price of oil. At $115.46 a barrel Friday, crude is down 20% from its July record high. If the price continues to slide, it could underpin the recent improvement in consumer confidence.

* The housing market and the credit markets. The two are inextricably linked. And their next major turn could determine the economy's fate.

There have been some modest signs that the housing market could be beginning to bottom (emphasis on beginning). Sales of existing homes ticked up 3.1% in July from June.

And home prices rose in June, from May, in nine of 20 major cities, according to Standard & Poor's/Case-Shiller market indexes reported this week.

Nobody expects a dramatic recovery in housing soon. But the outlook for the economy could shift significantly if more people begin to believe that the long slide in home prices is nearing an end. That, in turn, could boost confidence that there's an end in sight to real-estate-related bank write-offs.

But the credit markets, which would have to provide the funding for a housing recovery, aren't sending up a message of hope. Just the opposite.

As Wall Street returns to work next week, "investors will be forced to face the facts that things are not getting better on the credit front," analysts at Bespoke Investment Group said in a report this week.

The average annualized yield on high-quality corporate bonds is at a record level compared with U.S. Treasury bonds, a sign of investors' skittishness about providing funding even to financially strong companies, Bespoke noted.

What's more, the troubles of mortgage giants Fannie Mae and Freddie Mac have helped to keep mortgage rates elevated, although they have declined a bit in recent weeks.

And in the Federal Reserve's latest survey of bank lending officers, 65% said they had tightened standards on commercial and industrial loans to small companies in recent months, up from 50% in the spring survey.

Credit is the lifeblood of the economy. If conditions worsen this fall, it's going to be very difficult for the economy to revive.

* The stock market. Investors reviewing the year-to-date performance of their stock portfolios at this point might come away thinking, "It's bad -- but not that bad."

The Standard & Poor's 500 index is down 12.6% since Jan. 1. It had been down 17.3% at its low for the year, in mid-July. Indexes of smaller stocks have held up much better. The Russell 2,000 small-stock index is down just 3.5% for the year.

This has been a disastrous time to own financial stocks, of course. But Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, points out that most of the non-financial stocks in the S&P 500 have suffered much smaller declines. Half of the 10 major S&P industry groups are down less than 8% year to date.

Paulsen contends that non-financial stocks "probably more appropriately reflect underlying economic fundamentals" than the financials.

Either that, or the U.S. stock market is in denial about the risks the economy faces. Most foreign markets have fallen much more sharply than the domestic market this year.

Will they follow us up from here -- or will we follow them down?

--

tom.petruno@latimes.com

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