August 22, 2011 – By Lucia Mutikani
WASHINGTON (Reuters) - Nobel Laureate Paul Samuelson is famous for saying the stock market predicted nine of the last five recessions.
This joke by the first American to win the Nobel Memorial Prize in Economic Sciences is not lost on economists as they repeatedly downgrade U.S. growth forecasts in response to the exceptional turmoil in financial markets.
Others have also joined in the fray and many Wall Street firms now see the odds of a second recession in the world's largest economy as high as 50 percent.
"The main driver is the hit that confidence is taking because of the market volatility and the belief that the hit to confidence is going to start showing up in real economic data in the next couple of months," said Tom Higgins, global macro strategist at Standish Mellon Asset Management in Boston.
The Standard & Poor's 500 Index <.SPX> has dropped 17.6 percent from its most recent closing high on April 29 through Monday's close. That's a bruising decline but one that Standish said was not a clear recession signal, based on a reading of history.
Still, the plunge in stock prices is scaring consumers -- and Higgins and other analysts say it bears watching. The Thomson Reuters/University of Michigan consumer sentiment index hit its lowest level since 1980 early this month.
Business confidence is also eroding, a fact underscored by the Philadelphia Federal Reserve Bank's index of business activity, which dropped to a near 2-1/2 year low in August.
Goldman Sachs on Friday slashed its estimate for third-quarter economic growth by a full percentage point to an annual rate of only 1 percent. It sees growth in the fourth quarter at a 1.5 percent rate instead of 2 percent.
"The survey data could potentially have been biased downward by volatility in financial markets and the contentious debate over the debt limit," said Zach Pandl, an economist at Goldman Sachs in New York.
ALREADY IN RECESSION?
Pandl said updating the firm's forecasting model with the latest data on equity prices, housing starts and an estimated value for the Institute for Supply Management's index of August factory activity due on September 1 gave a probability of about one-third that the economy was currently in recession.
JPMorgan on Friday cut its fourth-quarter GDP forecast by 1.5 percentage points to a 1 percent rate and lowered its growth estimate for the first three months of 2012 by a point to 0.5 percent.
While economists agree recession risks have increased, many warn the stock market may be overreacting.
"In any period when you have volatility in financial markets, these periods tend to be accompanied by changes in expectations in the economy," said Standish's Higgins.
He said that was what happened in 2008. But there's a big difference between then and now: In August 2008, financial markets were starved of liquidity. Now, he says, they are functioning normally.
Economists say the four main variables watched by the National Bureau of Economic Research, the arbiter of U.S. recessions, point to slower growth rather than an outright contraction in output.
Industrial production rebounded in July as the effects of the supply-chain disruptions wrought by the Japanese earthquake faded. Personal income and corporate profits are holding up.
"Payrolls figures for July were not great, but they weren't terrible, the sales data wasn't gangbusters, but it wasn't bad either," Higgins said.
"So what we can say is (that) as of the current month, we are not in a recession. What the market is doing is extrapolating that the trend in these variables is going to deteriorate in the second half of this year because of the hit to confidence we have seen as result of the market volatility."
Nonfarm employment increased 117,000 in July after a combined 99,000 gain in May and June, while retail sales posted their largest gain in four months, suggesting the economy was beginning to find somewhat better traction.
However, some economists warn a self-reinforcing cycle could take place in which eroding confidence undermines markets, which leads to a further hit to sentiment.
"The stock market movements are creating these swings in the indicators and then the stock market is reacting again to the weakness. It's a metric response," said Harm Bandholz, chief U.S. economist at UniCredit Research in New York.
"This poses the risk of a negative feedback loop between stock prices, business surveys, and ultimately, the overall economy. A particular concern is the negative impact of both lower stock market valuations and a gloomier mood among companies on capex spending and hiring activity."
(Reporting by Lucia Mutikani; Editing by Jan Paschal)