Analysis: Plunging stock prices a sword over U.S. economy

By Lucia Mutikani

WASHINGTON (Reuters) - Plunging stock prices in the wake of Standard & Poor's decision to strip the United States' top-tier AAA credit rating may threaten consumer confidence and could push the frail economy into recession.

While analysts say the direct impact on the economy from the credit rating downgrade itself is limited, a sustained drop in share prices would have a negative impact on wealth, and likely force both consumers and businesses to hunker down.

Consumer spending accounts for about 70 percent of U.S. economic activity and analysts at Albion Financial Group estimate the domestic stock market has dropped by about 14 percent since July 25, wiping off $1.93 trillion.

"This massive move in the equity market does dim the economic outlook for the next six months," said Carl Riccadonna, senior U.S. economist at Deutsche Bank in New York. "We would put the recession odds at about 40 percent and about two weeks ago they were at about a 10 percent chance."

U.S. and global shares have come under relentless selling pressure since late July as investors took a dim view of a nasty fight in Washington over raising the country's debt ceiling and a string of weak economic data around the world.

Adding to the stock market's woes, S&P on Friday cut the long-term U.S. credit rating by one notch to AA-plus on concerns about the government's budget deficit and rising debt burden. Stocks on Wall Street tumbled more than 5.0 percent on Monday, their worst day since December 2008 during the worst of the banking crisis.

Last week Wall Street firms, including Goldman Sachs, lowered their third-quarter growth forecasts to an annual rate of about 2.0 percent. Third-quarter GDP growth had been previously forecast in a 2.5-3.0 percent range.

Economists said the steep decline in share prices could have a psychological impact on households, causing them to cut back on spending, and force businesses to defer hiring and spending on capital.

U.S. consumer spending barely grew in the second quarter, while business investment in equipment and software slowed a bit from the first three months of the year.

Businesses stepped up hiring in July, adding 154,000 jobs after holding back in the prior two months, but declining equity prices could see them wanting to conserve cash.

"We had already been flying too close to the ground and clearly the risk of a crash is no longer negligible. I don't suggest that we will go into a double-dip, but I would no longer consider it a laughable scenario."

The stock market rout comes at a time when there is limited monetary and fiscal policy ammunition to shore up the economy.

"When a negative feedback loop emerges in the economy, typically the central bank can jump in," said Deutsche Bank's Riccadonna. "Market participants are wondering what tools are available to break that negative feedback loop."

The Federal Reserve has already cut overnight lending rates to near zero and spent $2.3 trillion on buying bonds to try to spur the economy by keeping interest rates low.

There still are some analysts who are hopeful the stock market sell-off will abate and help the economy avoid a dreaded double-dip recession.

Many were encouraged that U.S. Treasury bonds rallied despite the credit rating downgrade, allaying fears that interest rates might spike upward. Yields on benchmark 10-year Treasury notes fell to 2.34 percent on Monday, their lowest level since January 2009, as investors looked for the safe haven of the world's largest and most liquid debt market with stocks plunging.

"So long as the downgrade does not trigger higher costs of borrowing over the next quarter or two, we will probably be in the same place as we were before the downgrade," said Albion Financial Group analyst Jason Ware. "It's an anemic recovery."

(Reporting by Lucia Mutikani)