Wednesday, March 28, 2007

Risk Of U.S. Recession Increasing

New information this week implies that the risk of a U.S. recession increases further.

First, oil prices are increasing as traders are putting an increased risk premium on oil after Iran's abduction of 15 British sailors and the increasing tension over the Mullah's nuclear weapons program. Fundamentally, it is difficult to justify an oil price over $60 per barrel given the fundamental supply and demand conditions over the world. But in the case of an armed conflict between Iran and the U.S. and/or Britain and/or Israel, oil shipments from Iran, and possibly if Iran decides to attack oil tankers from Arab gulf states, the entire Persian Gulf region, oil would rise to $100 per barrel or more. As the perceived risk of this increases, oil prices will increasingly have a significant risk premium. Higher oil prices implies that the purchasing power of U.S. consumers will be reduced which in turn means that consumer spending will be reduced.

Second, new home sales fell to a 7 year low. And as Nouriel Roubini points out, new home sales are what matters for construction activities. And as home sales reach new lows and prices fall while inventory levels rises, this means that residential investments are likely to continue to fall.

Thirdly, orders of core (Non-defence, non-aircraft) capital goods continue to fall. As this is a proxy of future business investments this means that business investments are likely to fall in the second quarter.

All in all, this means that growth will be below 2% during the first quarter, perhaps as low as 1%. And with the leading indicators of both business investments and residential investments indicate future declines and with higher oil prices ,as well as the increased fear of the ramifications of the subprime mortgage mess, indicating that consumer spending will be stagnant or declining, there is now a significant probability of negative growth in the second quarter.

UPDATE: I see the markets are interpreting the upward revision of fourth quarter GDP from 2.2% to 2.5% as a bullish sign. But this number in fact implies increased risk of a recession as it was based on an upward revision of inventories. This means a higher risk of reduced inventories in the future. Meanwhile, business investment was downwardly revised while corporate profits fell, also bearish indicators.


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