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To be sure, the U.S. economy is in the midst of a painful structural adjustment process.  And, not surprisingly, the consumer is at the epicenter of the crisis.  After years of excess consumption, overextended consumers will have to significantly reduce consumption and increase savings to restore their financial health.  Moreover, since consumer spending constitutes 70% of GDP, many economists fear that this “deleveraging” process may plunge the U.S. economy into a deep and protracted recession.   

There is, however, much speculation among economists as to precisely how sharp the pullback in consumer spending will be and when it will recover.  Stepehen Roach, Managing Director and Chief Economist, Morgan Stanley Asia believes that a global economic slump has just begun and that the U.S. is on a “recession trajectory”.  Mr. Roach further suggests that people are still in denial with regard to the severity of the problems confronting the U.S economy. Given this grim outlook, Morgan Stanley has lowered its S&P 500 2008 year-end target to 1300 from 1400.

By contrast, Dick Green, Chief Economist of Briefing.com believes that the U.S. economy will continue to defy the skeptics.  In his view, the headwinds stemming from the bursting of the housing bubble will recede without any significant impact on consumer spending. He notes that consumer spending has not declined in any month since the peak of the housing bubble and therefore expects it to continue to hold up going forward.  In fact, he predicts that the economic data in the next two months “will be good, if not great”, which could set the stage for a solid year-end rally.

Which assessment is more likely?  Will falling home prices plunge the U.S. economy into recession or are the headwinds already receding?

In my view, the correlation between the housing market and consumer spending is widely overstated.  I would argue that consumer spending is driven more by consumers’ expectations regarding the labor market (i.e. employment and wage growth) than by the housing market.

Many observers believe that the current weakness in the labor market will further contribute to the expected pullback in consumer spending.  Admittedly, the labor market has weakened relative to the year-ago period.  But this weakness reflects a cyclical trend, not a secular one.  In my view, consumers are more likely to base their spending decisions on their long-term income expectations.  That is, I believe that the secular, rather than cyclical, labor market trend is more important in terms of understanding consumer spending behavior. 

Significantly, the secular trend points to a strengthening labor market. For example, the average unemployment rate has declined from 7% during the 1975-1998 period to 5% during the 1999-2008 period.  If this trend were to continue then perhaps the U.S. unemployment rate will touch 3% by 2020.

To be sure, the secular decline in the U.S. unemployment rate is likely attributable to the ageing of the U.S. workforce, which will accelerate over the next two decades as the baby boomers retire.  Surely, existing workers are well aware of the unprecedented opportunities that will likely be derived as a result of the continued ageing of the U.S. workforce.

In my view, consumer spending will be well supported as a result of workers’ expectations surrounding the continued strengthening of the labor market over the long-term.  And, as previously noted, because consumer spending constitutes 70% of GDP, I believe that the U.S economy will manage to avert a recession despite the turbulence stemming from the collapse of the housing bubble.

Moreover, I believe that the housing market is beginning to stabilize.  For example, the latest data from the S&P Case Shiller Index indicates that home prices in 20 metropolitan cities declined by a mere 0.5 percent.  More significantly, home prices in 9 of the 20 cities surveyed increased for the third consecutive month.  Karl Case the co-creator of the index believes that the housing market is returning to normalcy and will likely begin to recover by the end of 2008.  I share his optimism, given the continued U.S. population growth of 1% and increasing home affordability.  In addition, the recently enacted housing bill, sharp decline in new construction and accommodative monetary policy will further bolster the housing market.

If accurate then the most ominous headwind confronting the U.S. consumer will likely recede in the near future.  As home prices stabilize, the housing market will exert less of a drag on consumer spending.  In addition, declining gas prices at the pump will also boost consumer confidence.

In short, I believe that the fears surrounding the U.S. economy are overstated.  While I do not see a quick return to long-term trend growth, much less the 3.2% growth rate of the previous 13 years, I do expect the U.S. economy to remain resilient. 

Specifically, here is my forecast for U.S. economic growth:

• 2008 1.5%
• 2009 2.0%
• 2010 2.5%

At this time, the S&P 500 is priced at 12 times forward earnings, which is well below historical valuations.  In my view, the underlying resilience of the U.S. economy has been clouded by the headwinds stemming from the collapse of the housing market.  I expect these headwinds to recede by the end of 2008, setting the stage for a sustainable rally in U.S. equity markets. To that end, my mid-2008 S&P 500 Price Target is 1500.

Raju Agarwal