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United States: Revisiting our “Year of Two Halves” Theme
By Christian Menegatti and Prajakta Bhide
- We maintain our calls for a subpar recovery in the United States (and in most of the advanced world) and for a V-shaped recovery in much of the emerging world.
- Leading indicators are pointing to a slowdown but not a double-dip recession.
- With no inflation in sight, we expect the Fed to stay on hold for the remainder of 2010.
One of our favorite themes for our U.S. and global outlook continues to be what we call a “year of two halves.” As time goes by, economist musings about a strong V-shape recovery are becoming more and more sporadic; downward revisions to growth and volatility in the markets are the flavor of the day. The latest of those growth revisions came from the U.S. Bureau of Economic Analysis (BEA)—which put Q1 U.S. GDP growth at 3%, down from the previous 3.2%. The revision surprised the consensus, which had expected an upward revision to 3.4%. Now consensus views seem to be slowly converging toward our forecast of an anemic recovery. Personal consumption was revised down and savings rates up; business spending on equipment and software was also revised down; commercial real estate and government spending contracted more than previously estimated; final demand was also revised down to an anemic 1.4%, versus the 1.6% originally estimated.
As it becomes more and more evident that this is not yet a self-sustained recovery, White House advisors are calling for renewed fiscal stimulus—even as the OECD singled out the U.S. for inadequate budgetary retrenchment and called for a rate hike in 2010. The slowdown that we have been expecting for the U.S. economy in H2 2010 is largely justified by the fading effects of fiscal stimulus and the risks posed by the external environment. But let’s take a quick look at recent signals coming from the real economy.
International markets certainly seem spooked by sovereign risk and its implications, but the specter of a sharp slowdown in the U.S. during second half of the year is contributing to a volatile environment. The Conference Board Leading Indicator fell back by 0.1% m/m in April, receding for the first time in 12 months. In the past recoveries, the leading indicator remained positive for a minimum of eight months—with the exception of the double dip experienced in the early 1980s when leading indicator turned negative four months after the end of the recession.
Another leading indicator that deserves attention is the ECRI weekly index, which leads economic activity by about six months. That indicator now points to a significant slowdown (GDP growth between 1% and 2% in H2 2010) in the second half of 2010—but not a recession. The ECRI leading indicator (growth rate) averaged -25% in Q4 2008 and Q1 2009 (when the economy contracted heavily), bottoming out at -29.7% the week of December 5, 2008. Aggressive policy measures brought growth in economic activity back to positive territory in Q3 2009 and the ECRI indicator peaked at 28.5% in October 2009 before descending back to 5.1%, where it now sits. As a side note, the last time ECRI touched those levels (June/July 2009) the SPX Index was over 150 bps south of where it is right now. ECRI usually points to a recession when it crosses the zero mark and heads into negative territory; a sharp descent from peak like the one that we have witnessed since October 2009 signals a sharp slowdown ahead and, if history is any guide, very poor equity market performance.
In line with our central scenario, this prescient indicator is not pointing to a double-dip recession. However, a sharp slowdown in the second part of 2010, consistent with our “year of two halves” theme, is very much in the cards.
Figure 1: ECRI Weekly Leading Index Growth Rate
Manufacturing activity has been a source of strength in Q1 2010 and has helped payrolls. However, the first regional manufacturing surveys for May—the Empire State manufacturing survey, the Philly Fed Survey and the Richmond Fed Survey—are showing signs of stress in the details. The indexes showed a decline in growth of new orders and a stabilization of inventories in May. Additionally, the NY Fed survey noted that optimism regarding future business conditions was “noticeably lower” in May, while both the employment as well as workweek gauges fell back in the Philly Fed survey. The Chicago PMI showed an easing in the pace of business activity in May, with the employment gauge showing contraction for the first time in 2010. These early warning signs seem consistent with RGE’s Q2 2010 outlook. We highlighted that support from the inventory restocking cycle would fade in H2 2010, and restocking would proceed cautiously. We noted that the slowing of fiscal stimulus at home and abroad would lead manufacturing to weaken. And if the outlook for production is sluggish in H2, firms will have little reason to aggressively expand payrolls and boost investment spending.
Figure 2: Regional Manufacturing Indexes: New Orders
Source: Federal Reserve Bank of New York and Federal Reserve Bank of Philadelphia
Housing data have turned predictably weaker. Mortgage applications collapsed following the April 30 expiration of the first time homebuyers’ tax credit. The week ending May 21, the index for purchase mortgage applications stood at its lowest level since April 1997, suggesting home sales will retrace gains over recent months, just as we saw in November 2009 before the tax credit was extended.
Figure 3: MBA Weekly Mortgage Applications
Source: Mortgage Bankers Association, Bloomberg
Housing starts data were positive for April, but housing permits, an indicator of future starts, fell 11.5 % in April. Interestingly, homebuilders’ confidence held up for May, even as the Conference Board survey of consumers showed a fall in consumers’ home buying plans over the next six months.
Figure 4: Housing Permits, SAAR
Source: U.S. Census Bureau
While payrolls have turned positive in recent months, jobless claims are stuck at a high level—after coming off the peak of 643,000 they reached in April 2009. In recent weeks initial unemployment claims have disappointed, in contradiction with payroll gains. Clearly, that is an indication that hiring is not picking up as hoped. The four-week moving average of initial claims ticked up to 456,500 the week of May 22, up from 454,250 the week before—a level that in the past has generally been accompanied by net job losses.
Figure 5: Initial Unemployment Claims, Four-Week Moving Average
Figure 6: Initial Unemployment Claims, Four-Week Moving Average
Source: U.S. Bureau of Labor Statistics, Bloomberg
The stabilization of wealth losses toward the end of 2009, due to the rebound in equities and the stabilization of housing values, offered some respite to households. In our Q2 2010 outlook, we noted: “Assuming that equities won’t repeat their H2 2009 performance, consumption can grow at best apace with income. RGE expects a weaker pace of consumption in H2 2010, with the risk of a climb in the savings rate.” While it may be premature to read too much into the surprise flattening of consumption in April, the current stress in the financial markets and expected weakening of home prices only bolsters our view of a slowdown in consumption in H2 2010.
The recent increase of the unemployment rate falls in the “bad news” category, though in fairness, it is not a sign of deterioration of labor market conditions as much as a sign of the large slack still present in the markets. This slack will prevent strong wage growth (U.S. average hourly earnings for all employees were flat in April after declining 0.1% in March) and might affect personal consumption negatively.
Figure 7: U.S. Average Hourly Earnings (All Employees)
Source: Bureau of Labor Statistics
Current external factors also pose a risk for growth in the United States. While we suggested that the contribution from net exports would remain flat in 2010, we highlighted the risks of a slowdown in the Eurozone (EZ) for growth in the U.S. and continue to do so. Fiscal austerity measures in the EZ will imply lower U.S. exports to EZ, but more importantly a strengthening of the dollar vis-à-vis the Euro will negatively affect U.S. exports to the rest of the world.
Credit markets in the U.S. have certainly thawed over the past 12 months, but are nowhere near pre crisis levels. As a result, the risk of a financial crisis stemming from Europe can have significant repercussions on U.S. growth. In a recent speech, Federal Reserve Board Governor Daniel Tarullo noted “a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for U.S. trade and economic growth.”Recent Fed statements also signal general caution. The April 28 FOMC meeting minutes noted: “Participants expected the economic recovery to continue, but, consistent with experience following previous financial crises, most anticipated that the pickup in output would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion, in turn, would imply only a modest improvement in the labor market this year, with the unemployment rate declining gradually.”
Given the slack in the labor markets, still sluggish consumer spending, and excessive housing inventories, we noted in our Q2 2010, that core CPI inflation would post a sluggish 1% pace in 2010—with downside risks to that forecast.
Indeed, the decline in inflation witnessed across all gauges of inflation is striking. Core CPI, trimmed mean and median CPI all continue to show that weak pricing power is not restricted to a few sectors of the economy, but is significantly broad based. This confirms our view that the risk of deflation continues to outweigh the risk of inflation, and that the Fed will remain on hold till at least the end of Q1 2011.In the April FOMC meeting, members revised estimates for inflation lower for 2010, implying that the first expected rate hike will likely be pushed back further, certainly lowering the odds of a hike by December 2010, which is what markets are currently pricing in.
Figure 8: Consumer Prices: Alternative Measures
Source: Federal Reserve Bank of Cleveland