A recession, sooner or later

"In nature, there are neither rewards nor punishments; there are consequences"

-- Robert Green Ingersoll

I am going to go out on the limb and offer my take on what I think might happen in 2008. Take it for what it is -- an opinion only.

The key fundamental principle behind my projections is my core belief in the cause-and-effect relationship of every economic transaction. However, it is also clear to me that because the real world is actually driven by emotion, not logic, not all of my predictions will come to fruition. At least not in 2008.

US economy and inflation

The economy is going to end up recession sooner rather than later. More rate cuts will merely delay the inevitable and exacerbate the damage. The inflation threat is real, and inflation could be on the verge of spinning out of control.

It is certainly true that with a prolonged economic slowdown, prices could and should decline. My fear here is that consumer inflation expectations appear to have been significantly altered by continued rise in food, health care and energy prices, and any declines in commodities will take a long time to feed back into lower wage expectations.

I now think that if and when Fed comes to its senses and stops (or at least slows down) its rate-cutting frenzy, equities around the world might enter another significant downturn. 2008 earnings expectations for most companies still look absurdly high,

Let's not forget that the real damage to most financial companies' earnings, which still accounts for a large share of S&P 500 earnings, did not occur until the second part of 2007. So growing beyond the terrific results of the first part of 2007 will still be tough . Do you actually think Goldman Sachs (GS, news, msgs)can earn as much money in 2008 as it did in 2007?

The private-equity boom that drove the lending frenzy is over, and it won't come back (at least not in 2008). My best guess would be that housing prices have not yet bottomed, simply because of the supply-demand imbalance. Inventories are at all-time highs, builders are still finishing off a lot of projects, and the labor market is not that healthy. I think that we still have a lot more dilution to come in the financial-services sector. We might see more lows here.

The consumer-discretionary sector and anything else that is cyclical (except U.S.-based manufacturing) still seems to have downside potential. Health care has not performed as well as it should have, triggered by weakness in the major drug stocks. Sector rotation could come into play here, with health care outperforming in 2008. I also like consumer staples, large-to-midcap tech stocks, utilities and industrials that have a solid manufacturing base in the U.S. I also think that large-cap and midcap stocks will still hold solid advantage over small caps in 2008.

US dollar

Fears of further dollar declines are greatly exaggerated. The dollar is still a "safe haven" currency, and in combination with potentially more stable interest rates in the U.S. in the short term, I don't see much downside. I am not sure if a sustained rally could be in the works for the greenback, but I certainly believe that the period of severe decline is over for immediate future.

Short oil and other commodities

If you believe in a recession, oil is a clear "sell" here. So are copper and the other basic metals. Gold could hold up slightly better, because many use it as both an inflation and recession hedge.

Short China

I still think that China is a bubble that is going to burst sooner rather than later. Six to 12 months is my best guess. Overinvestment in capacity and obscene prices for real-estate assets and equities, as well as the inefficiency of that government in general, are almost certain to lead to a severe slump. Chinese banks' balance sheets are overloaded with bad assets, and the simple fact that the vast majority of the countries' newly created sovereign wealth fund will go toward shoring up the capital of the three large state banks should have given all rational investors pause. We have seen what happens when loans go bad en masse before (as in the Japan fiasco). And while Chinese currency reserves could help protect the banking system from an eventual collapse, they could also trigger a massive inflation spiral with potential social unrest.

Consider India

I think that India will hold up better than most of other emerging markets because of lesser reliance on the resource sector and higher dependence on the tech sector, which should hold up better in the downside scenario. The banking sector here is of a higher quality but is more concentrated, with only few solid names to play with.

Russia: Be selective

My grim view of Russia turned slightly less bearish due to the fact that Dmitry Medvedev has been in effect named as a "heir" to Vladimir Putin. This is by far the best possible outcome for the West and Russia and will go a long way to supporting the equity markets. Real assets are certainly still way overpriced here, but assuming oil prices do not go back to $40 per barrel overnight, Russian consumers will hold up OK, and thus capital outflows from China could end up supporting Russian markets.

Brazil and Latin America: Be selective

These markets lagged the other emerging-market economies until recently and thus may appear less prone to severe declines. But it is also obvious that the leftist governments of Venezuela and Bolivia will end up destroying what's left of their economies relatively quickly. I would stick with more stable countries like Brazil or Chile. Mexico is likely to underperform due to its heavy dependence on the U.S. in general and on housing-related industries in particular.

Short Japan

I don't know what can help Japan in the next 10 years unless some dramatic shift in popular sentiment occurs. The population is on the decline, the regulatory environment is not friendly to investors, etc. The era of Japan is over, and the economy will continue to contract in lockstep with population decline.

Short Canada

Our neighbors are likely to be punished because of their deep dependence on the U.S. Inflation has been held somewhat in check by stronger currency, but that run is over now.