Economic data released this week corroborated our view of sub-par economic growth in the second half of this year. Overall GDP growth should slow during the second half of 2008 as growth in both consumer spending and business investment should be flat to negative. For the consumer, June income and spending data were impacted by the tax rebate checks that have been distributed to the majority of Americans. Over the last three months wage & salary growth has slowed to 3.3 percent compared to 5 percent plus in the prior two years. Meanwhile, real consumer spending has slowed to just 1.5 percent compared to roughly 3 percent in the first half of last year.
For the third quarter much of the benefit from the economic stimulus checks will be siphoned away by higher energy prices. Moreover, low levels of consumer sentiment and tighter credit standards are slowing spending for big-ticket discretionary items. Motor vehicle sales declined even further in July, hitting their lowest level in 15 years. The net result should be an outright decline in consumer spending during the third quarter, marking the first drop in 18 years. We expect another drop in the fourth quarter.
Years ago we developed a concept called core GDP, which measures private final domestic demand. Core GDP includes three items: consumer spending, business fixed investment and residential construction. The concept excludes swings in inventories, net exports and government spending. The net result is a measure much closer to how Main Street views the economy. Core GDP is expected to decline at a 1.2 percent pace in the third quarter and fall further at a 1.1 percent pace in the fourth quarter. The weakness in core GDP helps explain why three-quarters of Americans believe the economy is in recession even though the GDP data remain solidly positive.
Capital Spending: Modest Growth in June
Non-defense capital goods orders ex-aircraft, a key leading indicator for capital spending, rose 1.2 percent in June and is up 2.9 percent year-over-year. However, this is much weaker than the ten percent plus pace we experienced during the 2004-2006 period. Shipments for non-defense capital goods ex-aircraft were unchanged at 0.7 percent in June and up 2.7 percent over the last three months. This suggests a business spending environment that remained positive in the second quarter but does not hold out much promise for the second half of this year. Weaker corporate profits, tighter credit lines and reduced expectations for growth all suggest that business investment in the second half of this year will be in-line with our outlook for smaller gain.
Service Sector Outlook Slowing
For the broad service sector, this week's ISM non-manufacturing index came in at 49.5, just a touch below neutral. This suggests the service sector, particularly retail, remains in a no-man's land of neither expansion nor contraction - just treading water. The most forward-looking components of this survey, new orders and employment, still remain below the key "50" level. This suggests to us that the economy, while not technically in recession, remains uncomfortably sluggish. The near-term outlook should remain challenging for service providers as prospects for growth in coming months are limited.
Two elements of the service survey highlight the conflict in the economic outlook. First, the employment index at 47.1 is below par and suggests that hiring remains weak and thereby is a negative signal on the consumer. Meanwhile the price index is over 80 suggesting that input prices could lead to upswing for inflation.
U.S. Outlook
Trade Balance • Tuesday
While imported petroleum products should rebound significantly in June, we should see growth in non-petroleum imports begin to wane as domestic demand has turned sluggish. Exports should continue to post another monthly increase with notable gains in capital goods and industrial materials. On balance, we expect the trade deficit to rise to -$61.9B.
The real trade deficit, which is important in the calculation of real GDP, continues to narrow. This is a positive for economic growth as a narrowing of the trade deficit is counted as a contribution to overall growth. It appears net exports are on track to provide further positive contributions in the third and fourth quarters, albeit less contribution than in previous quarters. For an economy that is currently struggling, this continued contribution is key to keeping overall growth in positive territory.
Previous: -$59.8B Wachovia: -$61.9B Consensus: -$61.5B
Retail Sales • Wednesday
While weak motor vehicle spending will weigh heavily again on total retail sales in July, we expect to also see modest declines about everywhere else as the majority of the economic stimulus package has likely played out. Retail gasoline prices declined about four percent on the month which should result in lower gasoline station sales. One bright spot, however, should be online store sales. Online shopping should post another significant gain as consumers continue to look for ways to offset elevated gasoline costs.
Consumer spending held up admirably in the second quarter rising at a 1.5 percent annual pace - thanks largely to the economic stimulus package. However, that momentum will fade in the second half of the year. We now expect consumer spending to decline at a 0.7 percent annual rate during the third and fourth quarters. The Grinch may play an important role this holiday shopping season.
Previous: 0.1% Wachovia: -0.3% Consensus: 0.1
Consumer Price Index • Thursday
Primarily due to rising gasoline and food prices, headline inflation has been accelerating in 2008. In June, headline CPI was up 5.0 percent over the past year. Despite rapid increases in energy and food prices, the core CPI, while uncomfortably elevated, has remained fairly stable - up at a 2.4 percent pace over the past year.
Fortunately oil prices have back off record highs over the past few weeks and that has resulted in lower prices at the pump. If this trend continues we should see year-over-year headline inflation begin to move lower in the coming months. In addition, there have also been a few signs of easing in food inflation. Core CPI is expected to remain better behaved as softer motor vehicle prices, apparel and shelter costs help offset increases in medical care and airline tickets.
Previous: 1.1% Wachovia: 0.4% Consensus: 0.4%
Global Review
Aussie Dollar Takes a Hit
After reaching a 25-year high last month, the Australian dollar has declined almost 10 percent versus the U.S. dollar (see graph at left). The slide in the value of the Aussie dollar accelerated this week in the wake of the policy meeting at the Reserve Bank of Australia (RBA). The RBA kept its policy rate unchanged at 7.25 percent, which was universally expected. However, the RBA surprised investors by stating in its policy statement that the "scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing." In other words, rate cuts appear to be on the horizon down-under.
A few months ago, the RBA had an implicit "bias" to tighten policy further. What happened? The short answer is that the economy is slowing quickly. This point was underscored last week when retail sales data for June printed much weaker than expected. As shown in the top chart, growth in retail sales has been weakening most of the year. Moreover, real retail sales dropped 0.6 percent in the second quarter relative to the previous quarter. Although services probably continued to expand, it looks like growth in real consumer spending may have been relatively weak in the second quarter. Recent data on business and consumer confidence are also consistent with slower growth. Australian real GDP, which expanded at a year-over-year rate of 3.6 percent in the first quarter probably slowed further in the second quarter.
But with the CPI inflation rate well above the Bank's target range of 2 to 3 percent (see middle chart), would the RBA really entertain a rate cut in the near term? Yes. As shown in the bottom chart, monetary policy in Australia is rather restrictive at present and it will take a number of cuts to bring policy back to a more accommodative stance. Given the long and uncertain lags involved in monetary policy changes, it could take some time before rate cuts are actually felt in the economy. In the meantime, growth could weaken even further. If recent drops in food and oil prices are sustained, then the overall CPI inflation rate should decline going forward. Moreover, slower growth should put downward pressure on inflation.
Another factor that may be weighing on the Aussie dollar at present is the recent decline in commodity prices. Australia is more dependent on the production and export of commodities than are most other economies, and an increase in commodity prices raises the country's terms of trade. That is, Australia can buy more imports from a given quantity of exports, which effectively raises national income. The decline in commodity prices, especially if it continues, would contribute to slower growth in the Australian economy. Moreover, slower economic growth in the rest of the world would also weigh on economic activity down-under via weaker growth in export volumes.
Looking forward, we project further losses, at least on a trend basis, for the Aussie dollar vis-à-vis its U.S. counterpart. (For details, see our Monthly Economic Outlook, which is posted at www.wachovia.com/economics.) We think the slide in the Aussie dollar will become more pronounced later this year and early next year as the RBA actually begins to cut rates.
Global Outlook
Japanese GDP Growth • Tuesday
The Japanese economy grew at a brisk pace in the first quarter, paced by strong growth in domestic demand as well as in net exports. However, monthly indicators suggest growth was quite weak in the second quarter. Indeed, the consensus forecast looks for a sizeable contraction in the recently completed quarter.
Japanese GDP growth has a tendency to bounce around from quarter to quarter, so the second quarter's expected outturn may overstate the weakness of the Japanese economy. That said, Japan has probably slipped into a mild recession. The outlook for the Japanese economy depends in large part on the pace of global growth going forward. If global growth weakens significantly then Japanese exports will turn down, which would weigh further on Japanese GDP growth.
Previous: 4.0% (quarterly annualized rate) Consensus: -2.3%
U.K. CPI Inflation • Tuesday
CPI inflation has shot well above the 2 percent rate the Bank of England is mandated to maintain in the "medium term." And it appears the bad news is not over yet for policymakers at the Bank as the consensus forecast anticipates that the year-over-year rate of CPI inflation breached 4 percent in July.
Most of the increase in inflation reflects the sharp rise in energy prices earlier this year. Core CPI inflation is more benign. However, the Monetary Policy Committee (MPC) will have its hands tied cutting rates, although the U.K. economy is weakening at an alarming rate, until CPI inflation starts to recede. If oil prices stay at current levels, then inflation should come down going forward. However, it may be a number of months before the MPC can ease policy. The labor market for June, which will print on Wednesday, should shed some additional light on the current state of the U.K. economy.
Previous: 3.8% (year-over-year) Consensus: 4.2%
Euro-zone GDP Growth • Thursday
Real GDP in the Euro-zone grew at a decent clip in the first quarter. However, warm weather, which helped construction, may have flattered the results. Most analysts had looked for slower growth anyway in the second quarter, but recent economic data from the Euro-zone has been weaker than expected. Indeed, the consensus forecast looks for a mild contraction in real GDP in the second quarter.
Data on Euro-zone industrial production in June will print on Wednesday. Although the data won't really increase our knowledge of the second quarter, it will tell us how much momentum the economy had entering the current quarter. Weaker than expected data could cause the euro to break into a new (lower) trading range.
Previous: 0.7% (not annualized) Consensus: -0.2%
Point of View
Interest Rate Watch
Range Bound Rate Outlook Offers No Easy Out for Credit Adjustment
There is no easy out for creditors or debtors in our outlook. A difficult workout remains ahead. Short-term rates are likely to remain steady as the Federal Reserve faces the dual imbalance of below-trend economic growth and above-target inflation. For the second half of this year we expect average real growth around 1.5 percent with weakness centered in the domestic economy - consumer and business investment. Meanwhile, inflation, as measured by the core PCE deflator remains at or above the top end of the Federal Reserve's target range.
As for long rates we expect inflation stability will keep the ten-year rate in a tight 3.8 - 4.0 percent range. Yet there is significant uncertainty on both the dollar and federal deficit outlook that suggests that rates could rise above our outlook. On the opposite tack, our concerns about the dollar and further Treasury financing issues are likely to limit any Treasury rallies towards lower rates.
Credit Spreads: Wide and Volatile
Unfortunately, credit spreads are not expected to tighten in the near term. They have not only tightened over the last month, they have widened anew as negative financial news reminds creditors of the event risk in company announcements. Capital markets continue to search for a new risk/reward tradeoff. At present, the trend in the TED spread (three month futures contract for U.S. Treasuries less the three month Eurodollar futures contract) suggests the new equilibrium spread will be higher than what it was during the 2004-2006 period. Risk is being more fairly priced - we just haven't seen what the new equilibrium price is quite yet.
Topic of the Week
Get Ready for Lower Inflation
There was a stretch in early spring where it seemed like all we heard about was the rising price of food and energy. In late April the news media was full of reports of the run-up in rice prices which had doubled in a matter of weeks. At the time, warehouse stores began to impose limits on rice purchases, as consumers and small business owners rushed in to buy 20 lb. bags of the staple grain.
Rice had become the prime example of over-heated food prices. Higher costs for food passed through to the consumer and were ultimately manifested in sharp increases in components of the Consumer Price Index (CPI). In June, the "food" component of CPI was increasing at a 3-month-annualized rate of 8.5 percent.
In recent weeks however, there has been considerable cooling in the red-hot commodities market. Since April when rice peaked, prices have come down more than 34 percent. Other food staples are also down from their peak in the spring. Corn is down 33 percent, while wheat is off 36 percent.
Energy prices have also shed value. Crude oil has come down more than 20 percent from its peak in early July. And while prices at the pump are still far from cheap, retail gasoline prices have eased as well.
We are beginning to see anecdotal signs of food costs coming down. This week King Arthur Flour announced a price reduction for its line of premium flours. If recent price declines stick, we would not be surprised to see month-over-month declines in CPI.
Some market-watchers thought the Fed should have hiked rates to address rising inflation. Maybe the FOMC members are looking at those 20 lb. bags of rice in their pantries.
Wachovia Corporation http://www.wachovia.com
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