Thoughts on the economic outlook of early 2008

Well now that everyone has finished the turkey (minus a few leftover sandwiches), let it digest, and worked off the extra weight running around shopping at every store with a discount sale it’s time of me to get back to work. There has been a lot worth writing about, but let me start with a simple thought. The economy.

The economy is perhaps not the simple part of the thought. It has far too many factors involved, and minds far greater than mine have debated endlessly about what will and does make it move up and down. But as a man who pays attention to the events and has a decent hold on current events I’ll throw my 2 cents in.

I had a friend recently ask me what I thought would be happening to the economy, and my answer was it’s going to get bad. Perhaps recession bad. And I added that the current group of Democratic candidates may only make it worse.

I say this because of several factors. Not the least of which are, the housing crisis, the financial sector, the cost of oil, and potential tax ramifications based on the current plans announced by candidates.

Let’s look at the housing crisis. While there are estimates that state the maximum reach of the crisis is on 5% of homes, I think it fails to take a couple of things into account. While only 5% of home mortgages have failed now, I would expect these are the early defaulters. I would guess that there are another 10-15% of homes in danger of default. Given that the Fed has lowered rates, these homes on the edge have gotten a bit of extra time, but that does not fix their problem.

This leads us to the financial sector. Already several major banks are claiming huge losses due to the bad loans they have made. In order to recoup their losses and in hopes of preventing more credit is being crunched. This means that large- and mid-sized corporations will have less capital available to them, and some short-term loans may be called or canceled. That does nothing to stimulate growth. Plus variable loans to the riskier ventures will invariably go up to offset the losses in the home sector. Thus the purchase of houses must slow, the real estate markets will cease top be a haven for a while and money will have to flow into new areas for investment.

Now when you consider that the corporations are getting higher cost for loans, or being denied, this is happening at the same time that costs for fuel are going up. A lot. That hits profit centers fast. Thus profit margins shrink at the same time that retail is hitting its greatest need for the annual shopping rush of the holidays.

Keep in mind that small companies will be cut off from loans by banks since their credit and assets are too weak in a tight credit market. Add the higher cost of transportation and several small companies will fail to make it thru the end of the year, I expect. That will hit all the businesses that supply and help them operate.

Also keep in mind that as I recall the market virtually never rises, or even maintains its level without the positive performance of the financial sector. As I mentioned that sector is already failing. As the dominoes fall I expect them to perform worse near term. Thus that is direct downward pressure on the market. And while the holiday sales will help retailers absorb the cost of higher fuel, the consumer will likely spend less (or buy items with greater discounts) because the cost of heating their homes and electricity and mortgages are all up.

What’s the last piece of this puzzle? The Presidential race. We have a critical election where several nation defining events will occur. Already several Democratic candidates have expressed expanding entitlement programs. Those programs, like nationalized healthcare, must be paid for via taxes. Those taxes will come from companies making less profit and citizens with less discretionary income. (And a bailout of the mortgage crisis costs even more that needs to me recouped from taxes) This is beyond the fact that when Democratic candidates are elected (which could happen in 2008 – which is a bad thought) the markets normally react poorly initially, when looked at historically.

Add all that up and you have a stagnating market, with reduced sales, higher costs, shrinking profit margins, higher taxes, horrible bond rates, and depressed real estate values. I call that a real problem. Especially if the tight credit, higher fuel costs, and higher taxes cause more home mortgages to fail than just the 15% low-end estimate I posed earlier.

What’s the best plan? Well I used to tell my clients (back when I was a broker, years ago) that we can assume these events as facts and plan for the worse. Set up a plan to sit and wait for a couple of the trends to reverse, and take advantage of market overreactions where possible (the market is more emotional than fact driven even in the best of markets). Is that the best plan for you? I have no idea.

Discuss this with your financial professionals, read what better minds than I say, and make up your own mind. Just remember, it’s all connected, and there is never a perfect answer.

** This can also be seen at Economist Blog where I am an occassional contributing author.**