(Recasts; adds more analyst comments, background, share price details)
By Tenzin Pema
BANGALORE, April 9 (Reuters) - Merrill Lynch warned that the United States faces the prospect of a severe and prolonged recession as consumers cut spending, and credit-card stocks could be hit as current valuations and market estimates for the U.S. consumer finance sector assume only a moderate downturn.
Recently released economic data suggests debt-laden and cash-strapped U.S. consumers are becoming increasingly more cautious on spending and falling further behind on debt payments, analyst Kenneth Bruce said.
The U.S. consumer finance sector will likely face credit and spending-related headwinds in the first quarter, and credit-card and travel-services firm American Express Co (AXP.N) may be hit hardest due to slower revenue growth and higher credit losses, Bruce said.
Weak first-quarter results at American Express and rival Capital One Financial Corp (COF.N) could lead to earnings outlook cuts and valuation downgrades, reversing the stocks' recent rally that was triggered by aggressive moves by the U.S. Federal Reserve, the analyst said.
Shares of American Express has risen more than 10 percent since the start of March, while Capital One shares have jumped about 16 percent as the Fed eased interest rates and green-lighted several plans to cushion the blow from the turmoil in credit markets.
American Express' stock was down almost 2 percent at $45.45, and Capital One's stock was down more than 3 percent at $51.79 in midday trade on the New York Stock Exchange.
Although most card issuers boosted their loss provisions in the fourth quarter of 2007, Bruce expects the current reserve level will fall short if the credit downturn deepens.
"The worst is yet to come, in our view," Bruce wrote in a note to clients.
Consumer lending is starting to feel the pinch of the credit crunch, Bruce said. The rate of auto loan defaults recently hit a 10-year high of 3.4 percent and the nationwide repossession rate was up 15 percent so far this year.
With oil prices rapidly rising and the economy in a downturn, many consumers find that their car loans exceed the value of their cars, he said.
"There is also the spillover effect from the mortgage crisis as cash-trapped consumers choose to default on their car loans rather than mortgage payments."
But the analyst expects auto loan providers to recover more quickly than mortgage lenders as vehicle repossessions can occur within 90 days after a loan is past due. (Editing by Pratish Narayanan)