Capital Commerce

One the smartest guys I know is Bruce Kasman over at JPMorgan, and he still doesn't think the economy is going to fall into recession, much a less a severe, 1982-style downturn. (Neither, by the way, does the Fed.) Rather, he sees the economy muddling along with 1 percent GDP growth in the second half. Here are his three reasons:

1) Profit margins at nonfinancial companies remain healthy. "This is a testament to the fact that firms have produced strong productivity gains—estimated to have risen at a 2.5% pace in 1H08."

2) Trade remains strong. "This is related to the decline in the dollar and the composition of US exports which is concentrated in agricultural products, industrial supplies, and capital equipment—items that remain in demand by rapidly growing emerging market economies."

3) Businesses will have to rebuild their inventories. "Apparently, retailers and manufacturers are using the lift to demand from rebate spending and strong exports in 2Q08—in which final sales grew at a faster than 3% clip—to clear their shelves. In addition, the agricultural sector is experiencing a forced inventory drawdown due to floods and bad weather conditions. This destocking is holding back our estimate of 2Q08 growth to 2.2%. But it will add significantly to growth in the coming quarters. It should be noted that only twice in the last three decades—at the end of 2001 and 1982—did firms destock at the pace seen in 1H08. In both these previous cases, a stabilization in stockbuilding contributed more than 1.5 percentage points to growth over the following two quarters."

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More and more, it looks as if the next president will inherit a weak economy at best. I think public pressure would force a President Obama to junk the economic platform of his campaign and "go for growth." It seems that superstar bond manager Bill Gross's idea to create a $500 billion stimulus package could happen, since it's hard to imagine Obama proposing dramatic tax cuts. Nor does Obama probably want to follow Bill Clinton's "bond market strategy" of boosting the economy by cutting the deficit. (Liberals hate that idea because it knocks out all their pent-up spending plans.) Anyway, here is the gloomy economic outlook from the usually bullish economist Michael Darda:

June retail sales failed to live up to consensus expectations, indicating that the bounce from the rebate checks now hitting household mailboxes will be shallow and short-lived. Given the latest "wave" of the credit crisis, business and household caution will almost surely continue to slow growth though yearend, which is undermining payroll employment and income gains. High headline inflation, declining home values, and falling stock prices are pressuring household balance sheets and permeating a high level of economic pessimism.... If there is any good news here, it's that the stock market appears to have priced in a prolonged period of weakness already, meaning there isn't the kind of fluff in valuations or sentiment that characterized the last bear market in equities. Hopefully this means the bulk of the weakness in stock prices is behind us.

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The 2008 presidential race has gone weirdly nonlinear. The latest Rasmussen poll has Barack Obama with a 2 percentage-point lead over John McCain (Obama had been consistently leading by 5 points for the past six weeks). And Newsweek has Obama ahead by just 3 points—within the margin of error—after putting him up by a whopping 15 points last month. (After seeing that first Newsweek poll, a McCain adviser told me, "If that poll is somehow right, I may as well call it a day and go home right now.")

Up until now, the electoral equation seemed pretty straightforward. The more the economy weakened, the better it was for Democrat Barack Obama and the worse for Republican John McCain. Certainly the expectation of Washington know-it-alls has been that a weak economy, when combined with frustration with the ongoing war in Iraq, would doom the GOP nominee. That's definitely the prediction of all those sophisticated presidential election forecasting models. And out-and-out recession, according to the model of economist Ray Fair of Yale University, would give Obama at least a 10-point landslide.

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Some observations on the Paulson-Bernanke bailout of Fannie Mae and Freddie Mac:

1) This crisis will ensure quick passage and signing of the Frank-Dodd foreclosure bill. My sources tell me the Fannie-Freddie emergency package will be wrapped into that bill with full action by month's end.

2) With the government guarantee of the two companies now explicit rather than implicit, I am not sure what the rationale is for keeping up the financial fiction that they are private companies. End the masquerade. My guess is that they will be explicitly nationalized because they have already been implicitly nationalized. One possible outcome is that their portfolios will eventually be shrunk and their mandate perhaps restricted to low-income borrowers.

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