7 economic warning signs

Could a small shock push the economy over the edge?

By Rex Nutting, MarketWatch

WASHINGTON (MarketWatch) -- Everyone knows the U.S. economy is teetering on the edge of recession in the next year, but no one knows if it will tip. Will troubles in the housing market and financial markets spill over enough to halt the economy's growth?

Or will the strength of consumer spending and export manufacturing keep the economy above water?

The U.S. economy is now in the danger zone," wrote Nariman Behravesh, chief economist for Global Insight. "Even a small shock will push the economy over the edge."

Behravesh is not alone. The Blue Chip consensus forecast of 51 economists sees a 40% chance of a recession in 2008, with growth of just 2.1% between now and the beginning of 2009.

Anyone can make predictions. But instead of giving you a bunch of he-said, she-said predictions, MarketWatch thought it would be more useful to help you to watch the economy's vital signs to see which way it'll go.

Here are seven warning signs to watch in the next few months.

1) Credit markets

What to look for: Libor, interest rate spreads.

The spread between the London Interbank Overnight Rate, or Libor, and an ultrasafe 3-month Treasury bill has recently been 75 basis points, but is usually about 10. If the spread returns to normal, the danger from the credit squeeze could be over and the economy might escape without too many scratches.

The biggest unknown in the economy right now is the condition of short-term credit markets that big businesses rely on for their immediate funding needs. Some of those markets are functioning well, but others are clogged up. Some firms, especially those in the mortgage business, can't sell commercial paper at any price. Other companies can't get funding from banks because banks are hoarding their reserves.

The basic problem is fear. After years of accepting almost any kind of collateral, lenders have turned super cautious. Anything that sniffs of exposure to subprime lending is shunned. And because of the way the subprime mortgages were leveraged up and hidden away in special investment vehicles and collateralized debt obligations, the toxic waste could be almost anywhere. Even in Aunt Bea's pension.

The Federal Reserve and other central banks have been trying to Roto-Rooter the system, flushing it with cash too cheap to pass up. The Libor rate should show how successful they are.

2) Capital spending

What to watch for: Investments in core equipment. Profits.

If companies can't borrow money, they'll turn increasingly to their own internal funds from profits to finance expansion projects. The good news is that many companies are sitting on loads of retained earnings and have the capacity to invest, but many others will feel the squeeze as profit growth slows in 2008.

Even if companies have the means to invest, will they have the will? Is it a good time to expand capacity when the U.S. and global economies are slowing? Sure, if you're looking far enough ahead and want to be ready for the next boom. But many managers will opt to cut costs in the short-run and hold off on new plans. That will create a ripple effect as those who produce capital equipment cut back on their own expansion plans.

3) Oil prices

What to look for: Crude oil futures prices. Core inflation rates.

If there's anything worse than recession, it's stagflation, a condition that combines slow growth and rising prices. As well as determining whether inflation remains steady and manageable or explodes out of control, the price of oil could be a major factor in how fast the global economy grows.

The good news so far: Core inflation remains moderate. But inflation hawks on the Fed and in the private sector worry that an inflationary psychology could be taking hold that could push all prices higher.

On the growth side of the equation, the good news is that the global economy has been able to adjust to $80 a barrel oil without killing growth. What we don't know is whether the global economy can thrive under the double whammy of higher energy prices and slower American growth. Would China's growth stumble?

4) Exports

What to look for: Exports, the value of the dollar, global growth rates

If there's one bright spot in the U.S. economy, it's the growth of exports. With the dollar weakening, U.S. producers are once again gaining market share in the global market place. Slowly, the U.S. economy is transforming from a nation that builds too many homes to a nation that makes tradable goods.

The transformation is long overdue, and should help reduce the huge current account deficit. It could be the major driver of growth in the next year.

But export growth is dependent on two variables: Growth rates in America's trading partners, and the value of the dollar.

5) Housing

What to watch for: The number of homes on the markets, housing starts.

Housing has been the big drag on the economy for several years and will probably be so again in 2008.

"We think the housing shock is about half over," wrote Ethan Harris, U.S. economist for Lehman Bros. Foreclosures will probably quadruple to about 1 million in 2008 and 2009, keeping the supply of homes high and putting downward pressure on prices, Harris said.

Home builders have been trying to slash their inventory of unsold homes, but haven't made much progress because sales are falling as fast as new construction is. The official inventory statistics understate how bad it really is for builders because they don't account for canceled sales.

Few observers expect any growth from housing in the next year, although some expect the bottom to come by midyear, while others don't hold out any hope for 2008 at all. If the inventory of homes on the market falls enough, the housing market could stop being such a negative.

6) Consumer spending

What to watch: Consumer expenditures, job and wage growth, and household net wealth

The sharp drop in housing hasn't cut into consumer spending yet, but that could change if home prices keep falling, as many expect. Typically, consumer spending is driven by job growth, which keeps wages rising. Job growth has already slowed to the weakest pace in three years and most economists expect it to slow further in 2008.

As a result, consumer spending could be the weakest in 17 years, according to the Blue Chip consensus.

The wild card for the consumer is home prices. The most pessimistic forecasts call for a cumulative 20% decline in home values and even the most optimistic forecasters don't see any upside for real estate values. There's a big debate over how much the lost wealth will cut into consumer spending.

"House prices are unlikely to plunge," wrote Josh Feinman, chief economist for Deutsche Asset Management in the Americas. "The impact of cooling house prices on consumer spending should be relatively modest."

While some argue that consumers won't be affected by paper losses, Lehman Bros.' Harris argues that it's the growth rate in home values, not the level, that determine the growth of consumption. Rising home values were a real boost to consumption over the past five years and that stimulus has now been removed, cutting about 2 percentage points from the growth rate of consumption.

7) Washington to the rescue?

What to watch: The federal funds rate. Tax and spending legislation.

Timely and targeted actions by government could turn what would be a deep and lasting slump into a minor inconvenience. The Fed is taking the prospect of recession very seriously, having cut the fed funds rate by a full percentage point already.

Some observers think the Fed may be shooting blanks, because consumers have been burnt by taking on too much debt and can't take on much more, even if interest rates plunge. The skeptics think the only effective countercyclical policy could be on the fiscal side.

But the election year won't be favorable for fiscal stimulus, because the two parties have been able to find much common ground, especially on taxes and spending. More government spending is off the table, and a tax cut is unlikely unless Washington can rediscover the lost art of compromise.