Tuesday Outlook: Europe's Ills May Hit US Economic Growth

It wasn't just your stock portfolio that got banged up by Europe's sovereign debt crisis—the U.S. economy may also be a little bruised.

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Goldman Sachs economists said the impact of the havoc in financial markets has probably already knocked 0.25 percent off of U.S. growth, and that is if the damage to financial conditions were to stop now and European import demand were to slow just slightly.

That estimate also takes into account the positive impacts from lower oil prices and lower bond yields, they said in a note.

However, if there were to be a significant tightening of financial conditions and credit availability gets tighter in a big way, there is risk the economy could fall back into recession, according to the Goldman economists.

For now, they are sticking with their previous forecast that GDP growth would slow to below trend in the second half, before picking up in 2011.

J.P. Morgan economists are also looking at their forecast for 4 percent GDP growth in the second and third quarter, with an eye toward downgrade, depending on how markets behave.

Economists have been worried about tightening in interbank lending markets and widening of other credit spreads, as well as the loss of household wealth due to equity market losses.

Three-month dollar Libor, the London interbank offered rate, crept up again on Monday, rising above 0.5 percent for the first time in 10 months.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

Credit market experts say while the level has been inching up daily recently, there is no panic in the move and it is still well below the levels of the peak of the credit crisis.

"I think if things turn around in the next few weeks, the impact would be manageable. The longer we fester here, the worst the outcome will be because of the greater uncertainty," said J.P. Morgan economist Michael Feroli.

Feroli notes that from the drop in stock prices alone, household wealth declined nearly a trillion dollars from the March S&P 500 average of 1152, through Friday's close.

Based on an estimated decline in spending of 3.5 cents for every lost dollar of wealth, the decline in annual consumption would be about $33 billion or 0.3 percent of consumption.

As the euro has teetered, the dollar has risen 3.2 percent from its March average and 4.7 percent from its first half lows. Each 1 percent increase in the dollar historically restrains exports by 1.5 percent and boosts imports by 0.3 percent.

Feroli points out that would imply a drag on GDP of between 0.7 percent and 1 percent, with the impact being felt over about two years.

Positives would be the drop in gasoline prices and decline in mortgage rates.

Gasoline prices are now $0.27 below their March average, and that would translate to a boost to the consumer of about $30 billion at an annualized rate. 30-year fixed rate mortgages are downbetween 10 and 40 basis points.

According to Feroli, each 100 basis point move up in mortgage rates results in a decline in home sales of about 10 percent, so the current decline in rates could support home sales by 1 to 4 percent.

Corporate borrowing rates have also declined significantly though corporate spreads have risen.

"It's probably making corporate a little bit uncertain right now," he said.

Investment grade corporate debt widened by 2 basis points Monday, while high yield actually tightened by 10 basis points after last week's thrashing, according to data provided by Credit Research.

Several companies successfully priced debt offerings Monday.

Abbott priced $3 billion in a three-part deal; Georgia Power priced $600 million, and Empire District Electric priced $100 million in the investment grade market, according to Thomson Reuters IFR.

Investment grade issuance has picked up slightly since a period of extreme drought in late April, early May, due to unease about the European sovereign debt crisis. But the pipeline for high yield deals continues to be constricted, with few coming to market.

Allegiant Travel's plan to issue $250 million Monday was shelved, according to IFR. No new deals in that market were announced Monday or Friday.

Dave and Buster's did manage to $200 million last Wednesday, with an 11 percent yield.

Goldman Sachs chief U.S. economist Jan Hatzius, in a note, said there would be little enthusiasm for a new fiscal stimulus package if the economy does start to head south. But the Fed is still able to take action and it could restart its asset purchase program if there's a return to recession in the second half of the year.

What to Watch

Consumer confidence is reported at 10 a.m. Tuesday. The S&P/Case-Shiller home price index is released at 9 am, and FHFA home price data is released at 10 a.m.

Treasury Secretary Tim Geithner attends the Strategic Economic Dialogue summit in China, and was to meet with Premier Wen Jiabao and President Hu Jintao. He will speak with CNBC's Erin Burnett early Tuesday morning.

Fed Chairman Ben Bernanke speaks in Tokyo at 8:30 p.m. New York time. He will take questions.

Traders are watching tomorrow's 1 p.m. auction of $42 billion in 2-year Treasury notes. After a frenzy of buyers last week, Treasury prices were mixed Monday. The 2-year was unchanged, with a yield of 0.755 percent. The 10-year came under selling pressure, as its yield rose to 3.231 percent.

Euro Trashed

The euro lost more than 1.5 percent against the dollar Monday, finishing the day at $1.2380.

Stocks traded relatively quietly most of Monday but took a dive at the close, in a move led by financial and energy stocks. The market started the day weaker on worries about the rescue of a Spanish bank.

The Dow finished down 126 at 10,066 and the S&P was at 1073, down 14.

"I don't think people are putting money to work. That's one of the problems," Michael O'Hare, managing director at LaBranche Financial. "There's no buyers on this tape because everyone's so fearful. Eventually, if there's no bad news, you'll see people going back in slowly, but surely."

"We're not in a credit crisis and that's a big factor. Corporate earnings are there," said O'Hare.

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