The outlook for retail just got a little cloudier. The one-two punch of the meltdown in the sub-prime mortgage market coupled with slower-than expected retail sales growth has some economists wondering where the retail sector is going.

Sub-prime mortgages represented 20 percent of all mortgages originated last year and, should their default rates continue to rise, could wreak havoc on the financial health of low- and middle-income consumers. The question for economists is whether the fallout will be felt throughout the retail sector or only at the discount end of the spectrum.

In recent years, homeowners pulled up to $450 billion in equity a year out of their homes through refinancing and second and third mortgages—money that was plowed into retailers’ coffers. That helped keep consumer spending high, with greater than 6 percent retail sales growth in 2005 and 2006, according to data compiled by the National Retail Federation.

“The bursting of the housing bubble has all but eliminated that important prop to U.S. consumer demand,” according to Stephen S. Roach, managing director and chief economist with Morgan Stanley. “In my view, that puts the income-short, savings-short, overly-indebted American consumer now very much at risk. February’s surprisingly weak retail sales report – notwithstanding ever-present weather-related distortions – may well be a hint of what lies ahead.”

NRF, for its part, is projecting sales growth of only 4.8 percent this year.

Market experts are split on how deep the impact will be going forward. Some, including Paul Kasriel, chief economist with Chicago-based banking firm Northern Trust Corp., point to February’s disappointing retail sales numbers. According to Commerce Department figures, retail sales, excluding autos, slipped 0.1 percent. Kasriel thinks the slow sales could be the beginning of a recession that will last well into 2008. Following on the heels of no growth in January, analysts were expecting a retail sales increase of at least 0.3 percent.

According to the Commerce Department, retail sales fell across the board. Furniture sales declined 1.7 percent last month, clothing sales fell 1.8 percent and department stores reported a sales decline of 1.6 percent. Elsewhere, sporting goods sales dropped 0.8 percent. And the housing crunch helped drive sales of building material 1.4 percent lower last month.

Same-store sales also came in weaker than expected, rising 2.5 percent. For now, analysts are not wavering from their retail sales projections and are bullish on March. With Easter falling in early April, retailers will get the full benefit of Easter sales this month, rather than spreading them between March and April. That has ICSC economist Michael P. Niemira projecting same-store sales growth of 4 percent for the month.

Meanwhile, Beth Ann Bovino, senior economist with Standard & Poor’s, still expects consumer spending growth of 3.1 percent this year, 0.1 percent lower than that experienced in 2006, and has revised GDP growth projections only down slightly from 2.6 percent to 2.4 percent.

But things could change depending on how the mortgage picture develops. Delinquency rates are rising on all types of mortgages, according to data compiled by the Mortgage Bankers Assn. And the percentage of loans in foreclosure rose 14 basis points from the third quarter of 2006 to 1.19 percent. Most notably, delinquencies on sub-prime loans have risen to 13.33 percent—up 77 basis points from the third quarter. And a study from the Center for Responsible Lending estimates that 2.2 million American households will lose their homes and as much as $164 billion due to foreclosures in the sub-prime mortgage market. The overall delinquency rate for one-to-four-unit properties has risen to 4.95 percent, according to the MBA.

“The outstanding sub-prime mortgages will certainly affect those retailers that cater to lower-income households and have buyer profiles with higher debt levels [who are also] being hit again with gas prices,” says Dr. Scott Anderson, senior economist with Wells Fargo & Co. “So we are talking Wal-Mart and Target.”

Delinquencies and defaults are not rising as fast on auto loans or on credit card debt, according to Mark Vitner, senior economist with Wachovia Bank, who takes this as a sign that the situation in the sub-prime mortgage sector is not necessarily indicative of a widespread economic slump. In addition, many of the defaults recorded last year may have been the result of fraud, as unscrupulous lenders gave out loans to anyone who asked for them. “A significant number of housing loans that went bad in 2006 didn’t have a single payment on them,” he says.

But a higher default and foreclosure rate in the housing sector might not translate into slower overall growth in retail sales. There is bound to be some fallout for chains like the Home Depot, which deal in home remodeling products and furniture as people won’t be spending money on houses they can’t sell, says Michelle Girard, senior economist with RBS Greenwich Capital, a Connecticut-based trading firm. But having reached the point of foreclosure, many consumers might take their money directly to the mall.

Both Girard and Vitner believe that the low unemployment rate and the 4 percent upswing in income growth will keep most homeowners in good economic shape. “We expect that the majority of people who have a mortgage will [go on] without a problem thanks to a very good job,” Girard says.

The $1.3 trillion sub-prime loan sector, however, is not the only thing worrying economists. A report from First American CoreLogic estimates that 1.1 million of the 8.4 million prime adjustable rate mortgages originated between 2004 and 2006 may end up in foreclosure as those loans begin resetting to higher levels this year. The loans represent $326 billion in total outstanding debt.

The unraveling of the housing bubble might even have the same far-reaching consequences as the dot.com crash did in the early 2000’s, according Roach. In his March 16 research note “The Great Unraveling,” Roach argues that the country’s 2 percent annual GDP growth is being propped up by the resilience of U.S. consumers (personal consumption growth averaged 3.2 percent over the past three quarters). When those consumers can no longer tap their home equity for extra cash, the consequences will be felt through all sectors of the economy.

--Elaine Misonzhnik