Surveys continue to show that three-quarters of Americans believe the economy is in recession, yet the latest data continue to show the economy is not quite that bad. Real GDP grew at a 1.9 percent annual rate during the second quarter and revised figures show that growth over the past three years was just slightly less robust than previously reported.
Pessimists can now point to a 0.2 percent decline in fourth quarter 2007 real GDP as evidence the economy is contracting. That decline, however, is too small and too brief to qualify as a recession. The economy regained a modicum of momentum in the first quarter and then bounced back this spring with the help of the economic stimulus package.
Tax rebates clearly helped the economy in the second quarter. Consumer spending increased at a 1.5 percent annual rate. The quarter also benefited from a decline in imports, rising exports and modest gains in business fixed investment. Inventories declined, however, shaving 1.9 percentage points of second quarter growth. Real Final Sales grew at a 3.9 percent pace.
… But Its Not
The smaller than expected headline GDP figure has many people asking what happened to the stimulus. The impact is evident in the numbers but with inventories falling so sharply, some of the benefit from the rebate checks will likely spill over into the third quarter. The next real test for the economy will come in the fourth quarter of this year and first quarter of 2009, when the stimulus will have most certainly run out. Falling energy prices might provide some relief, but they will need to fall even further than they have in recent weeks.
July's employment data came in marginally better than expected. Nonfarm payrolls declined by 51,000, which was about 20,000 fewer job losses than were expected. There was some moderation in the pace of job losses in construction during July but job losses in manufacturing continued at about the same pace as in previous months. Employment at temporary staffing companies, which is a good predictor of future employment trends, also continues to decline. On balance, the employment and GDP reports leave us just where we thought we were earlier. The economy is uncomfortably sluggish but does not quite meet the definition of a recession.
The ISM manufacturing survey declined slightly to 50.0, which is the key break-even level denoting that the number of manufacturers increasing output equals the number of manufacturers reducing output. The ISM notes that in a recession the manufacturing index would be much lower, with a point estimate of around 41.1.
Construction spending fell 0.4 percent in June, with all of the decline occurring in residential construction. Residential construction plunged 1.7 percent in June, following a 1.1 percent drop the prior month and 2.0 percent drop in April. Residential construction has fallen 26.4 percent over the past year and has tumbled 44.9 percent since peaking in the Spring of 2006. Nonresidential construction increased 0.4 percent in June and is up 10.8 percent over the past year.
Weekly first-time unemployment claims rose much more than expected this past week, climbing 44,000 to 448,000. The increase puts jobless claims right around the level we typically see during a recession. There is little doubt layoffs are rising, however the past few weeks likely overstate the gain. The summertime is a volatile period for jobless claims, with the weekly figures bouncing around due to the irregular pattern of annual model year changeovers at motor vehicle assembly plants.
U.S. Outlook
Personal Income • Monday
Thanks to the federal fiscal stimulus package, real disposable income surged to a 11.3 percent pace in the second quarter. The federal government was able to get the checks out earlier than anticipated and consumers' responded in-kind by spending them in March, April and May. Despite sluggish auto sales activity, real personal consumption expenditures (PCE) increased at a 1.5 percent pace in the second quarter, with the bulk spent on non-durable goods.
Real disposable personal income should contract in the second half of the year as deteriorating labor markets pressure nominal income and the temporary impact of the fiscal stimulus package unwinds. As such, we expect real PCE to moderate in the third quarter towards 1.0 percent and then post a loss in the fourth quarter.
Previous: 0.8% Wachovia: 0.4%
Consensus: 0.5%
ISM Non-Manufacturing Index • Tuesday
The Institute for Supply Management's non-manufacturing index (NMI) slipped below the expansion/contraction demarcation line to 48.2 as the economic slowdown has finally caught up with this particular service sector activity measure.
We suspect activity in the service sector will remain below “50” for the second straight month in July as strains from the housing and financial services sectors continue to weigh heavily on service providers. Elevated energy prices will continue to keep the prices paid series near record levels in July. Crude oil has dropped about $20 per barrel over the past three weeks and assuming it holds at current levels we should see a pullback in next month's prices paid reading. With overall growth expected to slow, service providers will find their operating environment very challenging over the coming quarters.
Previous: 48.2 Wachovia: 47.5
Consensus: 48.0
FOMC Meeting • Tuesday
Continuing to deal with sluggish domestic economic growth and a financial market still in a fragile state, the Fed is expected to hold its federal funds target rate steady for the second consecutive month at 2.00 percent.
Earlier this week, the Federal Reserve announced its decision to extend its existing lending facilities to investment banks into 2009. With a declaration that essentially concedes that financial market conditions remain far from ideal, it would be hard to justify interest rate tightening anytime this year – especially in a Presidential election year. This is not to say the option is not on the table but inflation would have to worsen substantially from current levels. We do not suspect that will happen. Commodity prices have retrenched recently, due to the outlook for slower economic growth.
Previous: 2.00% Wachovia: 2.00%
Consensus: 2.00%
Global Review Slowing Global Growth
After the strongest four-year period of growth in decades between 2004 and 2007, global growth is hitting a rough patch. This week's data showed clear signs of slowing in some of the world's largest economies outside of the United States. Indeed, Japan may be slipping into recession. The labor market there showed signs of softening as the jobless rate climbed more than expected to 4.1 percent. The weakness in employment reflects construction cut-backs as the housing market in Japan continues to struggle. Housing starts fell 16.7 percent on a year-over-year basis, after falling just 6.5 percent in May. Some of the acceleration in the pace of decline can be attributed to a statistical payback. Housing starts popped up in June of last year prior to a change in the building code. That said, housing remains a weak spot in Japan, we do not see residential investment picking up in 2008. As export growth in Japan cools amid a backdrop of rising commodity prices and weakening global growth, we would not be surprised to see a negative number for real GDP growth in the second quarter, when that number prints on August 13th.
Misery Loves Company: Signs of Weakness in Britain as Well
Another major economy that managed a positive number for real GDP in the first quarter but may have weakened in the second quarter is the United Kingdom. Preliminary data reported last week showed U.K. economic growth sputtered to an anemic 0.2% rate (not annualized) in the second quarter, but a spate of negative data recently suggests to us that real GDP could contract in the third quarter. The UK does not seem to be immune to the problems in the housing market that have plagued other countries around the world. The rate of deterioration in home prices picked up pace in July, as home prices declined for the ninth consecutive month. The year over year decline of 8.1 percent was the largest since 1991.
With such a lousy housing market, you can hardly blame U.K. consumers for feeling blue. Consumer confidence fell to the lowest level on record (the series goes back to 1981), while consumers' 12-month outlook on their personal financial situation slumped to the lowest level in 14 years.
The Bank of England left interest rates at 5.00 percent at their last meeting, but Governor Mervyn King may find himself between a rock and a hard place when the bank meets next on August 7th. Inflation climbed to 3.8 percent year over year in June, nearly twice the 2.0 percent target rate for the BoE. But at the same time, the negative economic news is raising recession fears. There was little relief when the manufacturing PMI for July fell to its lowest level since December 1998. U.K. Manufacturing is slowing at the fastest clip in decades. The only silver lining is the rate of decline in the output sub index (a measure of actual production) stabilized.
In sum, the pace of global economic activity is clearly cooling. Indeed, global GDP likely will expand this year at the slowest pace since 2003. That said, we do not believe the global economy will experience recession à la 2001 because economic fundamentals in many countries, especially in the developing world, are much stronger today than in previous cycles.
Global Outlook UK Construction PMI • Monday
Many economies face considerable drag from a slowdown in housing, and the United Kingdom is no exception. Construction PMI is falling off a cliff, signaling a continued drag on employment and overall economic growth. The consensus doesn't expect to see improvement when the July data print on Monday.
Services PMI (Tuesday) has also has shown weakness, recently crossing the line from expansion into contraction. Further weakening is expected here as well.
A rate decision from the BoE is expected on Thursday. As mentioned in the Global Review, the BoE is facing a difficult environment of rising prices and slowing economic growth. The Bank is likely to leave rates at 5.00 percent, hoping that slow growth will tame inflation without help from a rate hike.
Previous: 38.8
Consensus: 37.5
ECB Rate Decision • Thursday
The European Central Bank is likely to keep rates on hold at its policy meeting on Thursday. PMI measures of manufacturing and services will print earlier in the week, and both are expected to come in below the break-even 50 level, showing continued slowing of economic activity in the Euro-zone. However a 4.1 percent headline inflation rate makes it hard for the ECB not to raise rates.
Retail sales data for the Euro-zone will be released on Tuesday and will likely reflect that consumers are paring back their purchases.
Also out next week will be data from Germany (Industrial Production & Factory orders)
Previous: 4.25%
Consensus: 4.25%
Canadian Labor Market Report • Friday
Despite slower growth over the past few quarters, the labor market in Canada remains rather resilient; investors generally do not believe it fell apart last month. The consensus forecast anticipates that 5,000 net new jobs were added in July, which would be equivalent to a 50,000 rise in U.S. non-farm payrolls. As long as the labor market remains resilient, Canadian consumer spending should generally remain solid.
Although the labor market report should be the economic highlight in Canada next week, July data on building permits (Thursday) will give market participants more insights into the state of the struggling Canadian housing market.
Previous: -5K
Consensus: 5K
Point of View
Interest Rate Watch
More Tough Talk From The Fed
The Fed is expected to make no change to the federal funds target rate at Tuesday's FOMC meeting. Several Federal Reserve Bank presidents continue to make noise about the need to head off rising inflation expectations. We continue to believe this talk will not result in any action, beyond a few descent votes at the regular meetings. The actual inflation data is not bad enough to warrant any additional action and we continue to believe we are closer to another rate cut rather than a rate increase.
The financial markets apparently take another view. Fed funds futures continue to price in a quarter point hike in the federal funds rate over the next three meetings. In order for such a move to happen we would need to see much stronger economic growth than we currently anticipate or much worse news on core inflation.
Treasury yields continue to bounce around in a fairly narrow range. The 10-year note is ending the week at around 3.95 percent but has been as high as 4.10 percent. The most recent pullback reflects continuing hopes that energy prices are coming down and a growing consensus that the downside risks to economic growth remain formidable. The markets should look past higher headline and core inflation figures this month but will need to see some moderation soon if rates are to remain near current levels.
Money growth has slowed significantly since the Fed stopped lowering interest rates. The broad M2 monetary aggregate is up at just 3.2 percent annual rate over the past 13 weeks and M1 is up at just a 2.8 percent pace. Sluggish money growth along with tightening credit conditions will put a relatively low ceiling on economic growth in coming quarters.
Topic of the Week
How Far Will Housing Prices Fall?
Forecasting a bottom for housing prices is a difficult task. Many of the price measures used today were not available in the 1970s, which was the last time there was a housing cycle close to this magnitude. A comparison of home prices with per capita income and owner's equivalent rent is a benchmark that can be used to gauge the extent to which home prices became overvalued. It also provides some indication of what a normal or equilibrium level would be. Even using these guideposts is limited, however. Owners equivalent rent is only available back to 1983 and many of the popular home price measures began even later than that. There is a wide range of possible outcomes based on various price measures and the per capita income and owners' equivalent rent benchmarks. The S&P/Case-Shiller indices show larger price declines than the OFHEO or NAR measures. One reason for this is that the S&P/Case-Shiller home price indices are more reflective of price changes along the coast, particularly in CA, AZ, NV, FL, and parts of the Northeast, where price gains and subsequent drops were much larger.
So how far will housing prices fall? Our best estimate leads us to believe the S&P/Case-Shiller 10-city composite index will fall 28.6 percent on a peak-to-trough basis. We estimate that the OFHEO purchase only index will decline around 22 percent. Our forecast for the NAR median price series would be for a peak-to-trough drop of around 17 percent. As far as timing goes, it looks to us that at least one-half of the peak-to-trough price decline has already occurred and that we should see an outright bottom either late next year or in the first part of 2010. Please read our full report for more color.
Wachovia Corporation
http://www.wachovia.com
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