20 July 2008

Gary Schilling: U.S. In Recession Now

The U.S. is already in a recession that’s unfolding in four stages — and it’s going to get a lot worse, investment advisor Gary Shilling says.

“We’re between the second and third stages right now,” Shilling told a Bloomberg interviewer.

“The first phase was the collapse in housing market, led by subprime slide last year;, the second phase was Wall Street, where there was a tremendous amount of over-leverage and investment in assets of questionable if not unknown value and highly illiquid.”

Shilling believes the third phase — a big nosedive in consumer spending — is about to unfold.

“Once people work through their tax rebates, they’ve run out of borrowing power,” Shilling notes. “Their home equity has disappeared. They’ve been relying on that and on income growth that isn’t happening. With high energy bills and maxed out credit cards, I think consumers are about to go off the cliff.”

“I look for the biggest decline in consumer spending since the 1930s,” Shilling says — and after that, it’s on to phase four, when recession spreads to the rest of the world.

Looking on the bright side. Shilling says that as consumers really hit the skids, concerns about inflation will fade, foreigners will once again look to the U.S. as a safe haven, and the dollar will rise.

“I’m looking for a rally in the dollar and basically selling stocks short now,” Shilling says.

For investments in this market, Shilling likes long Treasuries. “I think they’re going to rally as people look for a an alternative, a safe haven, as inflation worries turn to deflation worries as I think they will do by the end of this year and as the Fed eases further, which I think it will.”

Shilling also expects the unemployment will reach 7.2 percent at the bottom of the recession, which he thinks will be in the second quarter of next year. He disagrees with the Fed's assertion that inflation is a concern.

“To make a bold prediction, I think towards the end of the year we'd be back to worrying about deflation and not inflation,” Shilling says.

Shilling points out that in the past, housing cycles construction as a percentage of GDP normally fell from around 5.5 percent to 3.5 percent. In this super cycle, he expects a decline from the 6.3 percent peak to below 3.0 percent for a cumulative negative impact on real GDP of more than 3 percent.

According to Shilling, a 3 percent drop in GDP constitutes a major recession. He points out that only twice in the post-World War II era — the 1957-1958 slump and the 1973-1975 retreat — were there peak-to-trough declines in real GDP of over 3 percent.

“Unless strength in some other sector offsets it, the normal cyclical drop in housing is enough to register a recession, and the collapse in the current super-cycle implies a major recession,” Shilling says.

Without any follow-on effects or other negatives such as high fuel prices and falling stocks, Shilling says the 25 percent decline in house prices he foresees could slash consumer outlays by 3 percent, creating a 2 percent drop in GDP.

This, added to the 3 percent or greater drop Shilling expects will occur from slower residential construction, will result in the worst recession in the post-World War II era.

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