Goldman Sachs sees recession in 2008

NEW YORK (Reuters) - Goldman Sachs on Wednesday said it expects the U.S. economy to drop into recession this year, prompting the Federal Reserve to slash benchmark lending rates to 2.5 percent by the third quarter.

In a note to clients, Goldman said real gross domestic product would contract by 1 percent on an annualized basis in both the second and third quarters. For all of 2008, the investment bank said GDP would rise by 0.8 percent.

The unemployment rate will rise to 6.5 percent in 2009 from the current 5 percent, it said.

The weakening economy will force the Fed to lower policy rates by an additional 1.75 percentage points from the current 4.25 percent. Starting in September, the Fed cut rates at the last three meetings of the Federal Open Market Committee, reducing the target rate on loans between banks by 1 percentage point from 5.25 percent.

Goldman strongly advises fund managers to overweight health care, consumer staples, energy and utilities. They are significantly underweight consumer discretionary, financials, industrials, materials and information technology.

The three most significant changes to their sector recommendations are the reduction in the financial sector weighting by 300 basis points to 14 percent, the information technology weighting by 400 basis points to 15 percent, and the increase in their health care weighting by 300 basis points to 17 percent, the firm said.

Their reduced allocation to financials reflects weak fundamentals and their declining weight in the S&P 500. The reduction in information technology reflects that the group has been the second-worst performing sector in both the six months leading up to a recession and during the first phase of a recession, Goldman said.

The health care weighting change reflects strong performance of the group during the six months leading up to and during the first phase of a recession in addition to an attractive valuation, Goldman said.

On Monday, Merrill Lynch economist David Rosenberg said the jump in U.S. unemployment in December confirmed that the economy was entering a recession.

Reporting by Daniel Burns and Nick Olivari; Editing by Tom Hals