What's in store for 2008? Stagflation and Recession.

Year 2007 is almost over and a lof of people are wondering what will happen in 2008, for the US economy, stock market, job market, housing market, global economy etc. Here is what I think will happen for US economy in general. Stagflation and Recession.

Stagflation (economic stagnation coupled with out-of-control inflation) is an interesting phenomenon. Not only it is hard to fix stagflation (from the Fed perspective on whether to cut or raise interest rate as it often will fix one side of the problem but make the other problem worse), but also it is hard to understand why stagflation even exist at the first place.
Eventhough most lending institutions are trying to clean up the mess before entering 2008 (with massive write downs), the housing issue is not over and will continue throughout the year 2008. Other loans (such as auto loan and unsecured loan) will also get impacted (higher delinquency) in 2008 which will contribute to the slowing down of the economy. New sales (Home and Auto) will also likely to stay the same as 2007 level if not getting worse. Too bad that we are having this housing bubble issue (that impact the whole economy in general), because the tech sector was just about to come back strong this year.

Warren Buffett and Charles Munger (from Berkshire Hathaway) have said several times before that the US economy system is strong and can handle a lot of abuse, but it doesn't mean it is bulletproof. In the case of the housing bubble issue, I think people get too creative with ARM, Interest only mortgage, Option ARM etc, and forget about basic common sense as house price goes above and beyond the normal level. No one can predict the top as price is regulated purely by supply and demand (as the traditional and conforming mortgages started to get ignored by many), but there are some basic metric that people can use to monitor affordability level. No, it's not the mortgage payment to income ratio. It's the house price to income ratio (think it of like P/E ratio for stock) for example .

Inflation will continue in 2008 and not only for oil/gas price but other goods as well (mainly basic goods). Check out the current price for eggs and milk for example. Items imported from the third world countries and China (clothes, toys, furniture etc) probably will still be cheap but with the trade deficit continue to increase in 2007, the US dollar might continue to weaken and prices of those imported goods might increase. In some ways, weak US currency might reduce the trade deficit in the long run. I've mentioned before that continually having trade deficit is akin to selling parts of our country to others.

By the end of 2008, recession will happen in my opinion, and it is not necessarily bad. It's just part of the economic cycle and it will come back. But it is important to let nature takes its course and let it correct by itself (some intervention is ok but the Fed must be careful not to invervene too much and create more damage to the system)

Obviously, no one know for sure when or if recession will happen. The market/economy also tend to overreact to situation (both bad news and good news). The important part is knowing when there is a good chance that recession is going to happen and how we should prepare for it. There will be a lot of opportunities in the market during recession and we can start building reserve systematically for those opportunities. Don't panic during this downturn, and if you are already long on many solid companies, just hang tight and ride it out. Keep your spending and debt level in check. And always learn from your (and other) mistakes and be financially responsible.

All the best for 2008!

Sidarta Tanu