by Calculated Risk on 3/20/2010 06:02:00 PM

Last week I reviewed some possible upside surprises for my economic outlook for sluggish and choppy growth in 2010. The most likely upside surprise appears to be coming from consumer spending and the lack of an increase in the saving rate. I still think the saving rate will continue to rise - although maybe not as fast as I originally expected.

Before I comment on downside risks, a quick comment on forecasts: I think a reasonably intelligent person can always make a compelling bearish argument for the economy, and yet most of the time the economy grows and employment increases. Just something I like to remember.

And although I enjoy being a contrarian at times (like calling the housing bubble and bust, or predicting in 2006 that a recession would start in 2007 - or calling the bottom for housing and autos early last year), I try to avoid the mistake of being a contrarian just to be contrary.

Right now my forecast is middle-of-the-road; no V-shaped recovery and no double-dip recession in 2010. Of the two, I think a double-dip is more likely, but I think we will avoid both. Of course the downside to sluggish growth is that unemployment will probably stay elevated for some time.

Don't get me wrong - I'd like to see 6% to 8% GDP growth and the unemployment rate dropping sharply (a "V-shaped recovery") but that seems very unlikely with the two usual engines of recovery, consumer spending and residential investment, both under pressure.

Downside Risks

There are a number of international risks that might impact the U.S. economy in 2010 such as a sovereign debt issues in Europe and elsewhere, and the escalating dispute with China over currency manipulation or a slowdown in the global economy. My guess is the impact on the U.S. this year will be minimal. And there are also long term issues - like the U.S. structural budget deficit and debt - but this will have little impact in the short term.

So I'll focus on domestic issues, and the number one risk remains housing:

Housing Market. The government has been doing everything possible to support house prices - by reducing supply with the modification programs, foreclosure moratoriums, and servicer backlogs - and boosting demand with the homebuyer tax credit and loose lending standards (especially with FHA insured loans).

The next wave of distressed sales is building based on analysis by both Barclays Capital and economist Tom Lawler. Although this wave will probably be somewhat smaller than in late 2008, it might be more sustained (it will just keep flooding the market with distressed homes).

After the expiration of the tax credit, demand will probably decline - and prices could start falling again in areas with significant distressed sale activity. Note: For the tax credit, buyers have to sign agreements by April 30th and close by June 30th. This wave of distressed sales will probably be concentrated in the bubble states, but will be more price diverse than the late 2008 foreclosure wave that was primarily in lower end areas.

If prices fall further than I expect that could have a serious impact on banks (more losses) and consumer confidence (less spending).

Note: Most of the forecasts for residential investment (RI) in 2010 were for moderate growth. My forecast was for RI to move sideways with perhaps sluggish growth. This is especially important for construction related industries and employment. Most of the forecasts have recently been revised down substantially, as an example from Reuters: Fannie Mae slashes mortgage investment forecast

Residential investment is likely to drop 17.2 percent in the first quarter and rebound for the rest of 2010, Fannie Mae economists, led by Doug Duncan, said in their outlook. Just a month ago, they expected the first quarter's residential investment would rise 2.8 percent.

For all of 2010, residential investment will grow 10 percent, slightly below the previous forecast, they said.

The other possible downside risks I mentioned last year were (these all still remain although are less likely):

Consumer Spending and Exports. The flip side to consumer spending is that households might increase their saving rate faster than I expect. And with exports, if the global recovery falters, exports would probably decline.

Unemployment and Wage Deflation If the unemployment rate keeps rising (say to 11% or higher), and CPI goes negative - this could lead to falling wages and even more downward pressure on consumer spending. And deflationary expectations might lead to consumers putting off certain expenditures.

Small businesses. Small business are still reporting poor sales, and these business are key to an employment recovery (although construction is probably over weighted in the small business sector). From Rex Nutting at MarketWatch: Small business optimism falls in Feb., NFIB says

An index measuring small-business optimism fell 1.3 points to 88.0 in February, erasing January's gain, according to a monthly survey released Tuesday by the National Association of Independent businesses.

To summarize: I think sluggish and choppy growth in 2010 is still likely, but the key downside risks are from falling home prices and less than expected residential investment.