Reality Bites 'Economic Fairy Tales'

By DAN DORFMAN | July 14, 2008

An increasing number of signs suggest the widely projected recession — as officially heralded by two consecutive quarters of negative economic growth — may be finally under way. Likewise the deteriorating economy is poised to soften even more, with no end expected to the swelling job losses, 438,000 of which have been recorded so far this year.

That's what I hear from Wall Street's economic fraternity. As a result, their bevy of cheery economic forecasts earlier this year — notably, for a significant recovery later this year or in early 2009 — are rapidly going the way of the SUV.

According to veteran investment advisor Charles Allmon, these forecasts included a number of "economic fairy tales," including:

A quick end to financial problems.
A significant housing recovery.
A solid pickup in jobs.
No real inflation worries.
A much livelier tone to business spending.

Because of such expectations, economic soothsayers envisioned a robust stock market in this year's second half.

With all of these predictions turning out to be economic fantasies, gone is the sunny forecast that 2008's gross domestic product could grow as much as 3%, compared with a 2.2% rise in 2007.

The Organization of Economic Cooperation and Development recently cut its GDP growth forecast for the year to 1.8%, which would be the slowest pace of growth since 2002. Morgan Stanley says even that projection is excessive: Its outlook calls for only 1.2% growth this year, followed by a puny 0.9% gain next year.

"Forget the fairy tales and come back to the real world," Mr. Allmon says. "What's real is we face what could be the roughest economic era since World War II."

Mr. Allmon, who manages about $200 million of assets and is editor of the Growth Stock Outlook newsletter in Bethesda, Md., adds, "A credit crunch of unknown severity looms large as the real estate mess rolls on." He says he expects a worsening economy that could lead to a jobless rate of more than 7.5%; the current unemployment rate is 5.5%.

Recent comments from some prominent business figures give credence to Mr. Allmon's economic concerns. For example, the Treasury secretary, Henry Paulson, has said that problems in the housing and financial markets may last longer than expected. The president of the San Francisco Federal Reserve, Janet Yellen, observed that banking problems would likely get worse before they get better and that housing would not improve until 2009. Likewise, the Federal Reserve chairman, Ben Bernanke, last week described the financial turmoil as "ongoing."

Some economists says it will be business as usual for the American economy within a year, or two years at the longest. Economist J.C. Spender ridicules such thinking: "One or two years is too soon," he says. An economics professor at Britain's Open University School of Business in Milton Keynes, Mr. Spender says he figures it will take the economy "at least eight years, if not more," to recover from the enormous damage it incurred in recent years.

Reflecting that damage, Mr. Spender argues that "the American dream is receding from view; America no longer dominates the global economy as it did in the 1950s, and, like France, it's becoming industrially irrelevant."

When I challenged his suggestion of an eight-year wait for an economic rebound, Mr. Spender retorted that between 1929 and 1940, there was no meaningful economic recovery in America. "So a period of eight years is really nothing," he said.

Earlier this year, Raymond James Financial's chief economist, Scott Brown, told me he expected a second half rebound. No More. Now, he's saying, "No second half recovery." His key reasons: Higher food and energy prices will restrain consumer spending growth; aggregate wage income growth has slowed, and the Fed, reflecting higher inflation, will raise rates before the economy recovers.

In June, the government distributed $32.7 billion in income tax refunds and rebates, which should be a major economic stimulus. The problem, as noted by the economic consultant to TrimTabs Research, Madeline Schnapp, is that skyrocketing fuel prices — more than 44% in the past three months — are offsetting any positive impact on consumption.

A Morgan Stanley strategist, Richard Berner, estimates that real economic growth in the first half ran at a 1.25% annual rate. But he believes tighter financial conditions, high energy prices, higher global inflation, and weaker global growth will soon promote a mild downturn, with America's economy contracting at a 1% annual rate both in the fourth quarter of 2008 and first quarter of 2009. He says he expects this year's GDP growth to run 1.5%, followed by a puny 0.7% gain in 2009.

The bottom line: Say goodbye to economic fairy tales.

dandordan@aol.com