Thursday, July 26, 2007

U.S. Economy Weakening Again

There have been a lot of economic reports today, which I will return to soon, but the big number for the week is tomorrow's U.S. GDP report. This report will also include revisions of GDP for 2004-2006. The GDP revision for 2004-2006 is likely to slightly -but only slightly- downwardly revise real GDP growth, just like the 2005 and 2006 revisions did.

As for Q2 2007, I basically agree with the average Wall Street forecast of 3-3.2% at annualized rate ( give or take a few tenths of a percentage points) compared to the previous quarter. Personal consumption will likely increase about 1.5% (The decline in June retail sales means however that it could be lower), which is enough to add roughly 1%:point in growth. Meanwhile, both inventories and net exports will each add slightly less than 1%:point. In dollar terms, the trade deficit is likely to be assumed stay roughly unchanged compared to the first quarter, but as import prices (primarily oil prices) rose sharply, this will still mean that net exports will add slightly less than a percentage point to GDP given the prevailing -and illegitimate, but never mind that now- volume methodology. Meanwhile, business investments -particularly private nonresidential construction- will likely add some to GDP, but this will likely largely be cancelled out by continued falling residential investments, so the total net addition from fixed investments will probably be small. Also, increased government spending will likely add a few tenths of a percentage points. If we add this up, we come up with the number of 3% or slightly more than that.

This will represent a significant acceleration in growth from the 0.7% rate of the first quarter, although the terms of trade factor means that the real improvement is not as big as the headline volume number would suggest. Moreover, growth will likely decelerate significantly again in the third quarter. It is way too early to give any exact forecast, but it seems unlikely that growth will exceed 1% and there is a significant possibility of negative growth.

The reason I believe this is that there are a number of strong factors pushing down the economy.

First and foremost, the subprime mess just keeps getting worse and shows signs of spreading to the junk bond sector and to other mortgage borrowers. This implies first of all that residential investments will continue to fall. The sharp decline in new home sales confirms this, as it shows that builders are finding it increasingly difficult to sell newly built homes. Secondly, falling house prices implies that despite higher stock prices, consumers will find it increasingly difficult to expand or even just continue with their negative savings rate. That in turn means that real personal consumption will at most increase (or decrease) at the same rate as real disposable income, and likely be even weaker than real disposable income. Thirdly, higher yield spreads on junk bonds means that M & A activities and business investments will be restrained, as is illustrated by the difficulties for private equity firms to raise the capital needed to buy Chrysler from Daimler. The loose monetary conditions that supported the stock market rally may thus be about to dissipate, which would end the rally and reinforce the effect from lower house prices.

Another factor which will certainly drag down the U.S. economy is the continued sharp increases in oil prices. The sharp increase in oil prices means that real disposable income is likely to be stagnant at most, and it could even turn negative. That also implies for the above mentioned reasons that real personal spending is likely to be stagnant or negative for the third quarter.

Furthermore, business investments aren't likely to increase particularly much, if anything at all. Durable goods orders excluding aircraft and defense orders, a proxy for future business investment spending fell again in June. While tomorrow's GDP release isn't going to say anything about corporate profits, the earnings reports from Wall Street suggest that profits for domestic companies fell as a general theme of the earnings reports was that earnings on average increased only because of higher foreign profits. While absolute profit level remain high, the fact that they are declining and the aforementioned higher junk bond yield means that business investments are likely to be stagnant or negative.

And if final sales are weak, inventories are likely to fall back again.

Somewhat counteracting the above mentioned forces are strong foreign growth and the weak dollar, both of which should imply that net exports at least according to the volume methodology will contribute to growth. The higher oil price means that the dollar trade deficit may fall only slightly or not at all and so this boost will largely be just a statistical illusion. The aforementioned boost in earnings from foreign subsidiaries will likely support U.S. incomes, but not to any significant extent.

All in all, increased net exports and net factor income from the weak dollar and global economy and the stock market rally that is to some extent a result from higher net factor income will provide some support to the U.S. economy. But will it really be enough to counteract the fallout from the subprime mess, the soaring oil prices and the weak domestic profits? That is possible, but it looks increasingly unlikely.


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