Wednesday, June 06, 2007

U.S. Economic Outlook

The tone of economic reports from the U.S. during recent weeks has been decidedly more bullish than in the previous month. This makes it a virtual certainty that economic growth during the second quarter will be higher than the mere 0.6% recorded during the first quarter. It also means that the probability of the bearish scenario that I've argued for have fallen. Strong optimism still dominates Wall Street and to a lesser extent most other parts of the economy except housing. And if this sentiment remains in place, then a recession is highly unlikely.

However, if it falters, then the economy is likely to fall into a recession due to the following weaknesses:

-Residential investments as a share of GDP remains above the historical average and far above the lows reached in previous recessions (except the 2000-01 recession). This means that there is a lot more room for decline in this sector.

-The household savings rate remains negative, at -1.3%. With housing prices being stagnant or falling (depending on which survey you use), this means that consumer spending depends on a continuation of the stock market rally. A stock market correction would mean that consumer spending would have to fall.

-Profitability in the domestic nonfinancial sector fell between the first quarter of 2006 and the first quarter of 2007. The entire increase in profits of U.S. companies was in the financial sector and in the foreign operations of U.S. companies. But what matters for the U.S. investment outlook is the domestic nonfinancial sector, where profits are falling. While the absolute level of profits are still high, and certainly high enough to support investments if corporate executives are sufficiently optimistic, this means that investment spending could falter quickly if optimism wanes.

So, in conclusion. The increased optimism means that I am less bearish on the U.S. economy than I was two months ago, at least with regard to the short term outlook. But the economy remains highly vulnerable to any swing to a more pessimistic sentiment on Wall Street and among corporate executives.


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