Economic forecast from Allen Sinai

Some politicians have suggested that the global credit crisis could push the US economy into another Great Depression. Those warnings are overblown, although we will likely face a deep, long and painful recession.

The economy will suffer its worst downturn since the 16-month recession that occurred in 1981 and 1982, which was triggered when the Federal Reserve boosted its key short-term interest rate to 20% to rein in rampant inflation. During that slump, the unemployment rate peaked at 10.8%.

This time I expect that the unemployment rate will rise, but not higher than 7.5%, compared with the recent rate of 6.1%. That’s partly because the aging workforce has reduced the number of people looking for work.

Also, certain sectors, such as health care and education, still are booming and represent a much bigger component of the economy than ever before, helping to prevent a higher unemployment rate.

The Gross Domestic Product (GDP), a key measure of US economic output, is likely to show a decline for the third quarter of 2008, then a more significant drop of somewhere between 2% and 5% in the fourth quarter and a drop of 0.5% to 1% for all of 2009. That GDP statistic, however, understates the severity of the decline, because the housing and financial sectors will essentially be in a depression. The inflation rate — including prices for food and energy — is likely to be a good deal lower in 2009 than in 2008, but that won’t boost consumer purchasing power and retail sales until 2010.

RESCUE PLAN IS FLAWED

The federal government’s $700 billion financial rescue package, while better than no plan, is flawed and does not address the economy’s central problem — continuing declines in home prices. Still, the plan, including $250 billion to buy stakes in banks, and other steps should eventually help unfreeze credit markets. They will likely stabilize sometime in the first half of next year.

At the moment, financial institutions have stopped lending to one another because of concerns about repayments. As a result, loans to businesses and consumers have been scaled way back. Only consumers with the highest credit scores are able to borrow for such purposes as buying a home or a car, in contrast to the lax lending conditions and explosion of credit that led to today’s crisis.

Without financing, consumers have cut back on purchases, and normal levels of spending by businesses are dropping sharply.

The Federal Reserve is trying to avoid the policy errors of the 1930s by aggressively providing lending capacity and cash to beaten-down financial institutions and encouraging mergers of banks to strengthen those institutions that survive.

The rescue program is meant to use taxpayer money to help unclog the financial system by injecting capital into the banks that can survive and guaranteeing their new debt. Also, the government will help remove bad loans from the balance sheets of financial institutions that have seen the values of their risky loans and loan-backed investments plunge, especially those related to housing.

With the new capital in place and the “toxic” loans and investments put aside, the balance sheets will improve… institutions and investors will be better able to judge the risk levels of various loans… and the risk for defaults will decline. As financial institutions become more stable, they can step up lending to one another, as well as to consumers and businesses.

HOUSING BUST CONTINUES

The problem is that the government program does not deal directly with the underlying problem — falling values of assets, such as homes, that serve as collateral for loans. So the bad loans still can get worse, and credit may remain tight.

Housing prices likely will decline further, foreclosures will rise and the ability to refinance will lessen, contributing to the ongoing recession. Of course, the crisis eventually will pass and the recession will end, but the financial system will be changed fundamentally. In recent years, the financial sector boomed, aided by sales of mortgage-backed securities and other complicated and risky instruments to investors. That helped boost housing activity, housing prices, the economy and the stock market.

Now we face a bust. There will be fewer commercial banks, investment banks, hedge funds and private equity firms. Instead of buying stocks and complicated bonds, many investors will put their savings in insured bank deposits. The financial industry will begin to resemble the system that existed decades ago, when deposit-taking banks rather than capital markets played the dominant role.

RECOVERY IN 2010

Stock markets anticipate changes in the economy months in advance. Shares often rise before the economy shows clear signs of improvement. The greatest bull market in history began in August 1982, a month when unemployment was rising and the gloom was too thick to see through. In the current cycle, the bear market in stocks should end sometime in 2009 even though the economy still will be sluggish then. Stocks and the economy should begin showing real progress in 2010.

For now, investors would be wise to exercise a high degree of caution.

Try to avoid taking on more debt, and pay down what debt you have as much as possible using current income.

Aggressive risk-taking will have its day again but not now. New allocations to stocks should be minimal. Instead, favor safe fixed-income investments with above-average but not unusually high yields, such as top-quality municipal bonds, especially short-term ones, and maintain a strong cash position.

No matter how bad it all looks now, patience will pay off because opportunities and bargains will emerge.