From the December-January 2008 issue of Treasury & Risk magazine

Recession? Inflation? Choose Your Poison

By most measures, 2008 is not presenting a pretty economic picture. The downside risks are profuse--from the collapse in home prices, to the potential for additional trauma from the subprime market, to the supply and price issues in energy and raw materials. For the first time in years, the U.S. is the principal global slacker in terms of economic growth. While the weakness in the dollar can ultimately help our export imbalance and deter some of the movement of jobs overseas, it also significantly reduces our buying power as a nation and diminishes our leverage in global markets. Although a measured response from the Federal Reserve may avert recession, the nation could still face a politically uncomfortable economy--feeble growth in consumer income and assets as home values contract, salaries grow minimally and the markets gyrate, while simultaneously prices on such essentials as energy, medical care and now even food are trending upward. Treasury & Risk has asked economists M. Cary Leahey of Decision Economics, Milton Ezrati of Lord Abbett and John Lonski of Moody's Investors Service to suggest strategies for weathering the unfavorable economic clime.


Watching Overseas Grow
M. Cary Leahey
Senior Managing Director,
Decision Economics Inc.

Worries about recession risks abound when talking about the economic outlook for 2008. Real energy prices are high, the two-year-old housing recession shows few signs of quitting, and the financial markets are in
turmoil. Is there a ray of sunshine in what otherwise portends to be a disappointing, if not dismal, 2008? Surprisingly, yes--but one that companies need to prepare for if they are to benefit.

The overseas economic backdrop is the strongest in 35 years. (See chart) Since 2006, the U.S. has gone from the G-7 economic growth leader to growth laggard. GDP growth dropped to 2.1% in 2007 from 2.9% in 2006, while overseas GDP growth is expected to remain unchanged at 6%. Next year, U.S. GDP growth should fade a bit more to 1.9%, while overseas GDP growth fades to only 5.7%. At the same time, the dollar has been in decline for five years and has now more than reversed the previous seven years of appreciation to confine it to its lowest level since 1995.

This "decoupling" of U.S. and overseas growth is an important development, with serious implications for U.S. companies. Thanks to the dollar's feebleness and the economic strength overseas, one would expect U.S. exports to rally, and indeed they did rise almost 10% in the past year--the most significant surge since the late 1980s. Manufacturers with strong international presence--particularly in rapidly growing regions--might hope to weather the expected slowdown in domestic demand for their products and services by shifting their attention and sales abroad.

But there are no guarantees. Take, for instance, the export history with Asia. The share of U.S. exports more than doubled to India and China in 2006, to 6.3% from 2.6%, but was offset by a sizable drop in the rest of Asia's share from 23% to 18%. About half of that dip in export share came from the reduced importance of Japan and about a quarter came from Asian tigers like South Korea.

Mexico remains a wild card, despite its NAFTA status and proximity. In 2006, The Mexican share of U.S. exports fell marginally to 13% from 14% the year before. The reason is simple: Mexico's economy has been losing out to the rising tide of exports to the U.S. from the burgeoning Chinese and Indian economies. Even with the weak dollar, it leaves Mexico with less money to buy more from the U.S.

OPEC nations provide another somewhat ironic bright spot. The massive jump in petrodollars from higher oil prices is being partially recycled back to the U.S., with the share of U.S. exports to OPEC rising to 3.9% in 2006 from 2.4% in 2000. Experiencing an infrastructure boom similar to China, OPEC is buying capital goods--although some U.S. companies have hopes that the consumer side will also take off as living standards rise in China, India and OPEC.

Of course, stronger U.S. export numbers are the bright side of globalization--increasingly a dirty word among the many, even highly educated, Americans who have lost jobs to overseas competition. The entry of India and China amounts to a 70% increase in the global labor force--roughly three times the impact of the entry of Japan, South Korea and the other Asian tigers in the 1970s and 1980s. While companies can comfort themselves that expansion of the Chinese and Indian economies will continue to open up new marketplaces for U.S. goods and services, there are no assurances--as we are seeing this year--that their strength will translate into a robust U.S. economy.


Diving for Dollars
Milton Ezrati
Partner, Senior Economist and Strategist, Lord Abbett & Co.


The dollar certainly has confronted investors with some scary viewing of late, falling against just about every currency and prompting many to reconsider the greenback's position as the world's reserve currency. For all the excitement and the attendant doubts, however, there is reason to con-
clude that the worst for the dollar is probably over and 2008, if it does not see an upward correction, will at least see relative stability and little further dollar depreciation.

Though the currency agita is of relatively recent vintage, the dollar has actually been losing ground for quite some time. It hit its highs against most major currencies near the end of 2001, and by the end of 2006, it had lost 50% against the euro, 35% against sterling and 15% against the yen. What has exercized market participants is that after this ongoing dollar erosion, the pace of depreciation accelerated this year, with the dollar down in the last 11 months alone by another 10% against the euro, 9% against sterling and 7% against the yen.

But for all this relentless dollar depreciation, the Eurozone's still heavy reliance on exports gives one reason to look for stability at the very least going forward. Past euro appreciation has already hurt the competitive position of European exports. Order books in Italy, France, and even Germany have shown the strain. With the latest euro surge this export pressure should intensify. And though recent quarters have seen something of a recovery in the domestic Eurozone economies, the strain on exports from a strong euro ultimately could so threaten European growth prospects that investors would have to reappraise currency values, a step that could itself stop and likely reverse the trend in dollar depreciation.
China's currency policy simply raises the chances of dollar appreciation and stability going forward.

Contrary to popular talk these days that Beijing will abandon the dollar as a currency guide, China's need for job creation and Beijing's keen recognition of the contribution to growth from exports to America argue forcefully for a dollar link. Beijing then will likely continue to manage the dollar-yuan rate, as it has for some time, to keep the yuan cheap to the dollar and thereby make Chinese goods exceptionally price competitive. To be sure, this year Beijing has allowed more yuan appreciation than in the past. The move is not because China is shifting from the dollar, but rather because euro appreciation and the inroads it offers Chinese sales into Europe have simply allowed China room to accept less of an export advantage in the U.S. market. But while welcoming this European edge, Beijing knows that a switch away from the dollar to a yuan-euro link would lose much of the U.S. consumer market to Chinese products, hardly an attractive tradeoff given sluggish trends in European consumer markets.

All that said, currency markets are known for developing a momentum that frequently defies the underlying fundamentals, at least for a while. In the absence of such irrationality, however, the interaction of Chinese policy and European export dependency should slow and likely reverse the dollar's depreciating trend.


Will the Fed Cut Enough?
John Lonski
Managing Director
Moody's Investors Service

Few imbalances argue more persuasively for additional reductions in the federal funds rate as the recent deep discounts in the rates of the three-month Treasury bill and two-year Treasury yield relative to the 4.25% fed funds rate target. In order to assure an adequate supply of private-sector credit, the fed funds rate probably needs to be no greater than 3.5% by the end of 2008's first quarter. But whether it sinks that low--and for how long--may depend upon what the Federal Open Market Committee (FOMC) focuses over the next months.

On Dec. 11, the FOMC moved to close the spread by cutting the rate by 25 basis points, indicating that the U.S. central bank is definitely more concerned about elevated macroeconomic risks from home price deflation, slower consumer spending and subpar corporate profits than on the potential for inflation--and rightly so.

As long as downside risks loom large, businesses will proceed cautiously with capital spending and hiring. Provided that a contraction of employment is avoided, consumer spending ought to grow by enough to keep the U.S. out of recession. However, if employment shrinks as home prices fall, the retrenchment of consumer spending could be severe.
Despite recent spikes in energy and raw material prices, the Fed seems to be concluding that the inflation in the consumer price index (CPI) will be held to 2.2% in 2008 by subpar growth in consumer spending and a massive overhang of unsold homes, which should rein in the 38% of the core CPI consisting of shelter costs, excluding energy, maintenance and taxes. In fact, recent Treasury yields would suggest CPI inflation should average near that tolerable 2.2% over the next 5 years.

While the Fed's top priority has most often been combating inflation, only an aggressive easing of U.S. monetary policy will boost the supply of credit to the private sector by both improving the economic outlook and by widening the net interest margins of financial service companies. All else the same, wider net interest margins would also boost the earnings capabilities of banks, which will at least partly offset recent and forthcoming write-offs owing to exposure to troubled subprime mortgages and CDOs.

If the fed funds rate drops as low as 3.5% during 2008's first half, three-month LIBOR may sink to 4.25% provided that debt repayment problems do not mount throughout the U.S. business sector. The housing market outlook is apt to improve by mid-year, thanks to what would be the lowest 30-year mortgage yield since September 2005, substantially discounted home prices in much of the country, government efforts to freeze interest rates on sub-prime adjustable rate mortgages and the economy's successful sidestepping of a recession.

But the Fed's work will not be done. Once the economy has gained some momentum, there is a risk that the labor market, which has not seen a marked softening, could quickly tighten by enough to boost inflation risks. Coupled with the supply pressures in the commodities markets, investors should not be surprised by a relative quick turnabout by the Fed on rates. Thus, the first six months of 2008 may offer a unique opportunity to lock in attractive fixed-rate borrowing costs.

As shown by November's surprisingly strong showing by retail sales, U.S. economic growth just might surprise on the upside. However, it's difficult to envision a decisive firming of economic activity without a definitive stabilization of housing, which probably will require a longer stay by comparatively low interest rates. Similar to what occurred last summer, market forces will ultimately reverse any rise by borrowing costs that makes matters worse for an already badly weakened housing industry.

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