I began warning readers about a possible business slowdown in our future back in March of this year.  Now just about everyone who is paying attention to the news has heard similar projections from other analysts and signs of the slowdown are becoming more obvious.

Real estate sales are slumping and the Congressional budget office is planning on an 8% drop in corporate tax revenues next year.  They are not expecting a tax reduction, just less business being done.

As Sy Harding reports in his weekly column, “The debate over the economic outlook changed significantly this week with the release of the Philadelphia Fed Index. It measures manufacturing activity in the mid-Atlantic coast area, and is closely watched because it’s frequently a bellwether for the national index. The Philly Index surprised economists this week by plunging from 18.5 in August to –0.4 in September. Any number above zero indicates manufacturing activity is still growing to at least some degree, while a number below zero indicates not just slowing growth, but contraction.

“Economists expected the number to decline some, as it has been in recent months, to indicate a slowing economy. However, not even those looking for a recession by early next year expected a plunge into negative territory so soon. By the way, it was the first time the index has been in negative territory since April, 2003, when the economy was headed in the other direction, rising from the 2001 recession.  

The consensus is now that we will have a business slowdown.  "How slow will slow be?" is now the question.  If we wait until we read about the degree of slowdown in the news, it will be too late to protect ourselves from the financial impacts.  Just like my warnings in 2005 that it was a good time to lighten up on real estate holdings—if you waited until you got validation by hearing it from multiple sources, you were already too late, and can expect a difficult time selling.

We can look at the Fed’s track record of steering the economy to soft landings.  Unfortunately, when they raise interest rates to “tap the brakes of the economy”, they have a dismal record of over-doing it and pushing the country into recession.  Have they learned their lessons?  No one knows for sure.  But remember—they are from the government and they are here to help us.

Real estate was the 800 pound gorilla of the recent economic expansion, and it may become the Achilles heel of the decline, too.  Real estate accounts for about 10% of all jobs nationwide.  Down the hill in Phoenix, it is closer to 15%. 

Consider what happens when a big builder (used to building 200 homes a year) recognizes the dramatically slower sales and rising inventory of unsold homes and decides to cut back—to build only 100 homes this year.  Half of those jobs disappear.  Half of the roofers, realtors and mortgage processors are unemployed or at least underemployed.  If half of all real estate workers find themselves in this fix, and the nationwide jobs percentage engaged in real estate falls from 10% to ____ (pick your number) the unemployment rolls may grow shockingly large.  This is not soft landing material.

The bond markets provide one of the most reliable indicators of an impending recession.  Bonds are just big IOUs.  When you or I want to add onto our home we get a mortgage.  When Coca-Cola wants to build a new plant they sell bonds.

There is a market for bonds just like there is for stocks, except that the bond market is about nine times as large as the stock market.  It may be hard to believe, but nine times as many dollars change hands every day in bonds than in stocks.  And interest rates determined in the bond market probably affect your life a lot more directly than does the stock market.

Businesses are the largest users of borrowed money.  Interest is merely the price paid for using that borrowed money.  When money is tight, interest rates will get bid up to higher levels until enough lenders are attracted into the market to balance supply and demand. When no one wants to borrow money, interest rates will drop until enough borrowers are attracted. 

Normally, long term interest rates are higher than short term rates. This compensates lenders for the longer period their money will be at risk.  When long term rates drop, it tells us that there are few borrowers out there with the confidence needed to commit to long term expansion projects.  Fewer businesses are willing to expand at the moment.  Why might that be?  Because the amount of business they are doing is slowing down, not growing.

So, long-term interest rates are like our canary in the coal mine.  When they drop it is one of the first signs of a business slowdown.

Long term rates have been below shorter term rates most of this year, and in the past couple of months, long term rates have dropped dramatically.  Right now (October 1^st), overnight “Fed Funds” rates are 5.25%, while 10 year T-Notes pay only 4.60%.  The “inversion” in rates is no longer minor.  Is this a hint of the severity of the possible recession?  I don’t know, but it is certainly one red flag waving.

If the stock market were to stage a strong rally rather than succumb to the seasonal decline many analysts have expected, that would be a strong vote in favor of a soft landing over an outright recession.

How quickly will we know what the future holds for us?  Not right away, unfortunately.  Although the term bubble is used frequently, and bubbles burst in a split second, the markets are not like that.  It took two and a half years of decline for the technology bubble to have its air thoroughly let out by 2002.  Real estate is the latest field to have the word bubble applied to it.  It took several years to get real estate prices this high, and prices may decline for several years before they bottom out again.

          Bubbles rarely just level off.  Most give up almost all of the gains they made in the spectacular run that earned them the "bubble" label.  In the 2000-2002 decline, all of the major stock indexes gave up the gains made since 1997, the hey-day of the bull market mania.  Will real estate give up 5 years of gains like the stock market did?  Only time will tell.

None of these factors tell us whether the economy will have a soft landing and just experience a mild business slowdown or a hard landing that leads to a recession.  My professional opinion?  I can’t say for sure that we will experience a recession, but I’m sure not willing to bet on a soft landing.