A chaotic stock market, a weak jobs report, a slumping real estate market, a credit crisis and financial commentary that likens current trends to a perfect storm heading to shore — it seems like the month of September has seen wave after wave of indications that spell distress for the U.S. economy and its financial markets.

“There’s a lot of turbulence in the financial markets and that is adding a new layer of stress to the economy,” says Dye. And although it is more fragile than it was just a few months ago, he points out that the U.S. economy is still expanding.

Evidence of a “Still Expanding Economy”
What Dye foresees is a lower-growth scenario, not a recession. “We are expecting real GDP growth to be slower in the second half of 2007 and into 2008 than we did a year ago,” says Dye. The numbers break down like this: The second quarter of 2007 represents the peek of GDP growth for this year; the third and fourth quarter will be slower, probably around 2% or 2.5% real GDP growth for the rest of this year. This will extend into the first half of 2008, followed by a slow acceleration toward the end of the year. “For the year, we are expecting real GDP growth to average around 2% for 2007 and accelerate moderately to 2.8% in 2008,” he notes.

Sound familiar? It should, because growth rates in the 2% to 3% range are what we have been experiencing for some time. According to Dye, “Potential GDP growth, if you look at the rate of change in productivity and the labor force, is putting us on a low-growth track for the next couple of years.”

And the consequences of lower potential growth are pretty straightforward. “If we do start to see above-potential growth, we could see a reversal in the Fed policy back toward a tightening,” he explains. “And if we see continued low-growth, we will see the Fed easing even more.”

The Credit Crisis & the Subprime Market
According to Dye, the subprime markets specifically have caused a worldwide reevaluation of risk, and certain sectors of the financial market have become what he calls “illiquid” because of that reassessment of risk. “The problem there is we need to get liquidity where it can do the most good,” he says. “There are lots of good businesses and lots of good borrowers out there that need and deserve credit, but because of the increased awareness of risk, they are not getting it.”

To facilitate good businesses and good borrowers having access to money for investment, many, including Dye, expected the Fed to cut rates by the end of September. “Because we are seeing signs of a slower growth economy with easing inflation, and given the very weak job numbers that we saw [Sept. 7], I think that gives the Fed ample opportunity to go ahead and lower rates by 25 basis points,” says Dye. The Fed responded on Sept. 18 by lowering rates by 50 basis points.

And, he doesn’t see the Fed stopping there. “We are likely to see another rate cut in October of another 25 basis points and possibly further cuts down the road in 2008,” he says.

A Housing Market Crash?
Dye agrees that equipment lenders and lessors are certainly under pressure, as is every industry that has exposure to residential construction. “I personally do not think the housing market is going to crash. We are certainly in a very weak market, but it’s a buyer’s market. There are people out there with cash and with incentive to buy into the market especially if the Fed does ease. A lowering of the Fed funds rate should help mortgage rates come down and that will bring buyers into the market.”

Dye attributes two fundamental factors that will help turn the market around. “[The U.S. is] continuing to grow in terms of personal income and continuing to generate new households that need housing,” he says.

In the meantime, however, “the bottom of the market for residential construction has not yet been found. Permits and housing starts are likely to sink further into 2008 and we expect sales to remain weak for a while,” he adds.

Yet, there may be light at the end of the tunnel. According to Dye, “later in 2008 … we do expect to see a turnaround, but this is going to be from a fairly low level, so again, any industry that has exposure to housing will continue to see the belt tightening into the end of next year.

“We just have a lot of inventory to work through,” he continues. “We’ve had a speculative bubble that we have to work our way out of, but it will happen.”

Consumer Versus Business Spending
“Households are facing particularly strong head winds now due to the bubble in the real estate market,” says Dye. “Declining home values are throwing some cold water on consumption as home owners are feeling less wealthy, and they are less able to tap into their home’s equity to finance personal consumption.” Combine that with a perennially negative savings rate and you start to see some constraints on consumer activity, which will lead to lower growth in personal-consumption expenditures.

Consumer spending is a big part of the economy, accounting for two-thirds of economic activity in top-line GDP, making it difficult to compensate for if it drops off. Business spending, on the other hand, has better support. “We have fairly healthy corporate profits for a few years running now and that tends to give business investment some forward momentum,” he says. “Healthy profits and strong balance sheets will keep business spending healthy, even if personal consumption falls off.”

However, Dye believes business spending over the next few quarters will not be as high as it would have been in the absence of this new liquidity crisis. “I think we can say business confidence has been rattled, and I do think we will start to see more cautious investment behavior in the months ahead,” he says. “There are an awful lot of projects in the pipeline that are moving forward, there is a lot of momentum in this so it will take more than just a temporary liquidity crisis to significantly drag on investment spending.”

Like any good economist, if for some reason this liquidity crisis extends into the fourth quarter, and there is speculation that it may, Dye reserves the right to reevaluate.

Big Deals Go From ‘Hot’ to ‘Not’
Only months ago, the financial world was talking about high-profile leveraged buyouts like Chrysler. Now, these types of deals, as well as other M&A activity and some stock buyback plans, seem to be a casualty of the credit crunch.

“Highly leveraged deals are getting harder to complete so it looks like we are coming to the end of the cycle for deal making,” Dye notes. “Capital expenditures, by in large, should remain robust, as long as balance sheets remain strong.”

The Bottom Line
The bad news is economic growth will most likely slow down in 2008. “Right now, it does look like downside risks are growing, and an appropriate response to that would be an easing by the Fed and we are expecting to see that,” he says. “I think that will help keep the economy in this slow to moderate growth cycle for the coming quarters.”

So, the good news is the economy, most likely, will not go into reverse. “Residential and commercial real estate markets will be under stress in the coming few quarters, but steady corporate coffers and strong global economy are two sources of support,” Dye explains.

However, even given this healthy global economy the potential ceiling for U.S. GDP growth is lower now than it was a few years ago and, according to Dye, one factor that contributes to downside risk is oil prices. “Given the turmoil in financial markets, one thing that has been slipping under the radar is a steady increase in oil prices,” he says. “So, we are keeping our eyes on that.”

Bottom line, Dye’s view is that businesses should plan for modest expansion through 2008. “That will be fortified by gradual easing of short-term interest rates. But the key word is modest.”

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Darryl Seland worked as an editor and writer for a number of trade publications serving various industries, including software, heavy equipment, home building, insurance and the automotive aftermarket. Previously, he was an associate editor at Construction Equipment Guide. Seland is currently earning his MBA in finance. He can be contacted via e-mail at [email protected].