[ U.S. Economy: The Weak Spots for '07 ]

If everything goes right in 2007, Standard & Poor's expects the U.S. economy to slow, but not precipitously. Our forecast is for growth to slide to 2.3%, from 3.3% in 2006. Inflation will drop gradually from its current level, while the unemployment rate creeps upward toward 5% from 4.4% now. However, these projections, as always, could change depending on external or internal surprises—that is, if something goes wrong.

When looking for things that can go wrong, four risks jump out, but the top contender always seems to be the Middle East. The recent drop in oil prices has helped convince us that the economy is unlikely to dip into recession in 2007. But oil prices are very volatile, and a supply shock from Iran or elsewhere could easily send them right back up to the $78 per barrel dollar level of last summer, or even higher.

The continued dependence of the U.S. on imported capital is another weak spot. For the moment, markets are calm. Although the dollar has slipped, bond yields remain low. Our expectation is that the dollar will continue to decline in an orderly manner, and that bond yields will edge up in response to tightening overseas and to a reduction in inflows.

Home Price Uncertainty

But if the dollar's drop becomes disorderly because foreign investors try to yank their money out quickly, the greenback could fall faster and bond yields could rise more sharply.

The housing market adds a third uncertainty. Median home prices are already down 3.5% from a year ago, and we expect them to drop by a total of 7%, with housing starts and sales 25% lower than their 2005 peaks. But higher bond yields could make the correction more severe, in turn damaging household wealth and consumer spending more than we anticipate.

The fourth fear is that productivity growth could slow. It has slipped in the last year, with nonfarm productivity flat in the third quarter. We believe that the slowdown is cyclical and that output per hour will grow at a 2.2% trend going forward—its average over the last 47 years. But there's a risk that the falloff will be more severe. And slower productivity growth would lead to higher inflation, since productivity is the cushion between wage growth and price increases.

To examine how significant these four risk factors are, we ran two alternative projections to our current baseline U.S. economic outlook. In the first alternative, called High Oil, we assumed that oil prices rebound to the $78 peak hit last summer, while trend productivity growth slows to 1.5% from the 2.2% assumed in the baseline.

In the second scenario, Dollar Crisis, not only do oil prices rise but foreign investors try to take money out of the U.S., sending the dollar down and inflation and bond yields up. The productivity trend is assumed to be only 1%. In part because of the higher interest rates, home prices drop more than in the High Oil or baseline scenarios. Both alternative scenarios imply a mild recession in 2007; in the second, the recovery is also extremely weak.

The Baseline

In this projection, oil prices remain in the $60 to $65 range for the next four years. Growth slows in 2007, to 2.3%, almost entirely because of the weakness in the housing market. Consumer spending declines, partially because of the impact of housing on wealth and employment, but also because consumers simply can't continue to spend more than they're earning. However, business-fixed investment remains strong, and the trade deficit, which has been a drag on growth in recent years, stabilizes.

Housing drops sharply, with starts falling to 1.5 million in 2007 from 2.1 million in 2005. Prices also decline, with the median home price down 7% by the end of 2007 from its recent peak, the largest drop in postwar history. By mid-2008, housing begins a slow recovery.

Core inflation (which excludes food and energy prices) slides gradually from its current peak. The headline inflation number drops more quickly, because of lower oil prices. Wage growth is balanced by steady productivity increases, averaging 2.2%. The unemployment rate rises from its current 4.4% to 5% by the end of 2007.

The Federal Reserve cuts interest rates in mid-2007. However, bond yields edge higher, because of continued rate hikes in Europe and Asia. The dollar drops 5% next year (trade-weighted) as the interest rate differentials between the U.S. and other industrial economies narrow. The federal budget deficit widens slowly from the $247 billion of fiscal 2006, as expenditures begin to rise with the early retirement of the Baby Boom's leading edge.

Overall, the outlook is rather benign, with a moderate slowdown similar to the 1995 correction. The recovery after the "soft landing" is moderate, but steady. Growth returns to near 3% annual rates, with the unemployment rate stabilizing near 5%.

Scenario 1: High Oil

This scenario is based primarily on a rebound in oil prices to the $78 per barrel peak hit this summer. In addition, it assumes a slowdown in productivity growth to a 1.5% trend rate from the 2.2% assumed in the baseline. Actual productivity is even lower, because of the weak real growth.

The lower productivity growth results in a higher core inflation rate, in spite of the weaker economy, with the core consumer price index rising more than 3% through the forecast period. As a consequence, the Fed raises the federal funds rate to 7%, despite an unemployment rate that exceeds 6% in 2008. The higher short-term interest and inflation rates push the bond yield up to 6.4% and mortgage rates to 8.3%.

Housing is further damaged by the higher mortgage rates, with starts dropping to 1.3 million. Lower home sales and weak wealth cause consumers to cut back, although spending continues to increase through 2010. The saving rate rises to 2.5% by 2010, compared with 1.3% in the baseline, because of weaker consumer spending. Car sales suffer disproportionately, hurt both by the higher oil prices and the weaker economy. Sales of light vehicles drop to 14.1 million in 2008, down from an estimated 16.5 million this year.

In the High Oil scenario, the economy enters a recession in the second quarter of 2007 and begins to recover in the first quarter of 2008. Although residential construction leads the downturn, higher interest rates also hurt business-fixed investment. The recession is moderate by historical standards, with the unemployment rate reaching 6% in 2008. The lower productivity growth balances some of the impact of the weaker GDP growth on payroll employment, which keeps the unemployment rate relatively low, but at the expense of more inflationary pressure from the higher unit labor costs.

The recession sends corporate earnings down in 2007. Lower profits and higher bond yields result in a weak stock market, with the S&P 500 stock index dropping to 1,250 by early 2008 from its current level of 1,400, but then recovering with the economy.

The result of this scenario is a mild recession, followed by a sluggish recovery. The pattern is similar to the 2001 downturn, except for the higher inflation rate, which prevents the Fed from lowering rates aggressively, as it did in 2001.

Scenario 2: Dollar Crisis

In this projection, the lofty energy prices of the High Oil scenario are accompanied by a sharp drop of 10.5% in the U.S. dollar in 2007. Foreign investors, trying to close out positions before they lose too much money on currency translation, pull out of the bond market, sending yields up sharply. The 10-year Treasury note reaches 8.5% in 2008. Productivity growth slows to a 1.0% average, about what it was during the 1970s and 1980s.

The 2007 recession under the Dollar Crisis is deeper than in the High Oil scenario, and the recovery slower. Much of the damage is done by a sharper decline in housing activity, with starts dropping to 1.0 million in 2008, about the average of the recessions before 2001. The mortgage rate climbs into double digits for the first time in 20 years. Nonresidential fixed investment declines in 2008, because of higher capital costs and weaker output.

Consumer spending is hurt by higher oil prices, lower wealth, and weaker home sales. The weaker consumer spending means the saving rate rises above 3% in 2009—still low by historical standards. Car sales again are a large part of the weakness, tumbling to 13.4 million units sold in 2008. Paltry U.S. demand, especially for consumer goods, and the lower dollar cut imports, hurting other world economies. That in turn slows exports, which, together with higher import prices, keeps the trade deficit near the baseline level despite the much weaker imports.

Being Prepared

Lower productivity helps employment stay higher and the unemployment rate lower than might be expected. The jobless rate peaks at 6.4% in 2009, only 0.3 percentage point higher than in the High Oil scenario. The negative side, however, is higher inflation: Core CPI inflation averages 3.3%, compared with 2.0% in the baseline.

Profits are also hurt. Operating earnings for the S&P 500 drop to $56.41 per share in 2008, compared with $64.70 in the baseline, and recover only to $69.71 in 2010, compared with $95.57 in the baseline. The combination of lower earnings and higher bond yields implies a much weaker stock market. The S&&P 500 drops to 867 in 2009, barely half the baseline level of 1,637.

The Dollar Crisis scenario implies that several things go wrong at once. Even so, the recession is mild by historical standards. And the weak recovery is a tamer version of the 1970s' stagflation, although its impact on the stock market is just as severe.

Mild recessions, however, are still worse than no recession. Although we expect and hope nothing goes wrong, being prepared for surprises remains the best policy.

Source - BusinessWeek / S&P Direct Ratings