Register now for a free trial to gain access to
this piece and see how
you can benefit from an RGE subscription.
Global Economic Outlook
United States: Q3 2010 Outlook
By Christian Menegatti and Prajakta Bhide
- The year of two halves – with growth sharply slowing in H2 – is playing out as we speak; the boost from the inventory cycle is over, additional fiscal stimulus support is missing and final demand continues to disappoint.
- Weak labor market and tight credit; sluggish income generation and tight credit will keep constraining the still-leveraged consumer.
- The risk of deflation remains highly relevant; weak final demand and the slack in the labor market will lead the Fed to remain on hold through 2011, if not further.
Outlook Update: Entering the Second Half of the “Year of Two Halves”
RGE’s outlook for a year of two halves in the United States – with growth barely close to potential in H2 and sharply slowing down in H2 - appears to be playing out exactly as we envisioned. The recovery that began in H2 2009 was sustained into Q1 2010 largely relying on temporary effects of inventory restocking and stimulus measures. Final demand is tracking a sub 1% pace as of early 2010, and leading indicators and fundamentals suggest little room for improvement in the rest of the year. While Q1 2010 growth was already revised down from a strong first estimate of 3.7% all the way down to a 2.7% (out of which final sales were growing only 0.8%), our forecasts show further weakening in the remainder of the year with growth converging towards final demand as the inventory cycle flattens out. We forecast Q2 growth at 2.1%, Q3 at 1.6% and Q4 at 1.5%, taking year over year growth in 2010 to 2.6%. With the weak growth momentum likely to continue in H1 2011, a tepid recovery with weak job growth remains our main scenario for the medium term; however, we continue to closely monitor the risks and vulnerabilities that could tip the anemic recovery into a full blown double dip recession.
Figure 1: Contributions to Percent Change in Real Gross Domestic Product
Source: Bureau of Economic Analysis and RGE Estimates
After a brief uptick in consumer spending in Q1 2010, which came at the expense of a fall in the savings rate, consumer spending has predictably moderated in Q2 2010. Weak income from wages and assets continues to constrain spending and the correction in the equity markets in Q2 2010 has certainly lowered household net worth. The weak labor market, tight borrowing conditions, further downside risks to home prices and impaired household balance sheets continue to weigh on consumer confidence and mark the speed limit for the U.S. consumer.
While payrolls turned positive towards the end of Q1 2010, the momentum in the labor market appears to be moving sideways rather than gaining traction. Initial claims remain elevated, suggesting hiring remains cautious. Positive developments of private payroll gains and a pickup in temporary hiring, remain dwarfed by the sluggishness in hourly wages, hours worked, a record high duration of unemployment and the low employment to population ratio. That being said, businesses have cut jobs to the bone during this recession making another round of payroll cut unlikely in the short-term. This is, in RGE’s view, the reason why the economy might not tip in a double-dip.
Figure 2: Non-Farm Payrolls Total—Rebased: First Month of Recession = 100
Source: Bureau of Labor Statistics (RGE Computations)
The manufacturing sector has outperformed in the early phase of the recovery, benefiting from resumption of global trade flows and inventory restocking. The pickup in manufacturing has boosted payrolls, and gains in equipment and software investment boosted growth through H1 2010. As of mid-2010 however, the impetus of the inventory cycle has clearly run its course, with manufacturing surveys showing a predictable tapering off in activity. Going forward, beyond the replacement of outdated equipment, firms will have little incentive to expand capacity as capacity utilization remains low and the record high vacancy rates for commercial real estate suggest that structures will continue to drag down business investment.
Figure 3: Real Residential Fixed Investment—Rebased: First Quarter of Recession = 100
Source: Bureau of Economic Analysis (RGE computations)
Residential investment, historically a key driver of growth in the aftermath of recessions, will continue to disappoint through 2010. Aside brief uptick in Q2 2010 driven by the homebuyer tax credit which “stole” home demand from the future, housing construction will resume a sluggish recovery, until housing inventories are reduced to sustainable levels, which will be a slow and painful process, with demand for housing still severely impaired.
The strength in the dollar will hold back U.S. export growth, and slow growth in major export markets (Eurozone and Japan) will contain demand for U.S. goods. Meanwhile, despite the recent correction, oil and commodity prices will remain elevated. RGE believes that the contribution to growth from trade will be slightly negative in 2010.
Given the substantial slack in the labor market, excess capacity in housing, weak consumer spending and no signs of credit growth, the negative readings on consumer prices come as no surprise. RGE forecasts headline CPI to post a 1.5% gain in 2010 largely driven by base effects of a weak 2009, slowing further to 0.9% in 2011.
As mentioned above, we are not in the double-dip camp, but we recognize that the downside risks to growth are severe. At the beginning of the 2010, bearish and out of consensus economic analysts and commentators were expecting growth to come in at around 3% for H1 2010. While Q1 growth was first estimated well above 3% and then revised down to 2.7%, Q2 growth looks already well close to 2% not 3% (RGE expects 2.1%), even before the negative effects coming from the fading fiscal stimulus expected for H2 kick in. Growth has largely surprised on the downside in H1 2010. We cannot rule out a negative surprise to growth in H2 2010 as well. RGE’s official view is of an average of 1.6% growth in H2 2010, however we would not be surprised to see a number below 1.5% or even closer to 1%. The balance between the negative signals and the positive ones seems to be well skewed towards the negative side.
RGE vs. Consensus: A Too Optimistic Consensus Converging to RGE’s Outlook with a Lag
After bullish consensus estimates for a sharp V shaped recovery issued at the beginning of 2010, downward revision to consensus forecasts are now the order of the day. While still more optimistic than RGE, consensus growth estimates seem to be moving more in line with our forecast of a U-shaped recovery, to which RGE assigns a probability of 60%. Still, compared to our forecast of a weak 1.6% growth in H2 the current consensus – at 3.1% - is still excessively bullish. Interestingly, the string of weak economic data in mid 2010 and signals from leading indicators have renewed discussion on the double-dip recession scenario. As of mid 2010, we assign a 30% probability to a double dip recession. Double-dip risks therefore are present and high, but there would need to be a clear negative shock—such as a disorderly crisis in the Eurozone or a negative feedback loop between the real economy and asset prices—for growth to relapse back into negative territory.
Despite downward revision, consensus still believes that the U.S consumer will continue to boost spending at a 2.5-3%-plus pace through 2010. However, RGE believes that the key drivers of a pickup consumption are clearly missing. The slack in the labor markets implies that income growth will remain sluggish and most of the support to income coming from stimulus-related transfers will fade in H2 2010. RGE expects to see additional correction in home prices that will depress wealth further, and absent a boost to net worth from the stock market, the likes of which we saw in H2 2009, households will be pressed to deleverage further, causing the household savings rate to inch upward. RGE expects consumption to run at a 1.5% pace in H2 2010.
Figure 4: Household Net Worth—Rebased: First Quarter of Recession = 100
Source: Federal Reserve: Z.1 Flow of Funds and RGE Computations
Consensus believes that the unemployment rate has peaked and will trend down in 2010. However, companies have room to delay hiring by raising temporary employment and work hours of existing workers. Any gains in payrolls over coming months will barely match the increase in the labor force, stemming from the large pool of discouraged and marginally attached workers. RGE expects the unemployment rate to continue to hover around the 10% level through H2 2011, though the unemployment rate could fall in spite of weak job growth if enough unemployed become so discouraged that they leave the labor force, as in June 2010 that saw a 650K drop in the labor force.
While consensus expected that home prices had bottomed in early 2010, the sharp falloff in housing starts and sales following the withdrawal of the homebuyer tax credit has highlighted the fundamental weakness in the housing market. With falling demand and the supply expected to rise given the shadow inventory homes of yet to be foreclosed, prices will fall another 6% from current levels before bottoming out. RGE forecasts continue to signal that a sustainable increase in home values will occur only in 2012.
Risks: “V” Increasingly Unlikely, but on the Lookout for “W” Warnings
We continue to monitor the crisis in Europe closely and its implications for the U.S. economy. On one hand, an increase in financial stress in Europe and the consequent flight to safety would lower benchmark interest rates in the U.S.; on the other hand, further Eurozone stress would imply further strengthening of the dollar, which is negative for the trade balance, and increases in credit spreads and interbank spreads, all negatives for the economy. While estimates suggest that the U.S. banking sector would be largely insulated from direct effects of a European crisis, the increase in risk aversion would be negative for financial markets and resultant net worth losses could depress spending further. On the other hand, if European policies manage to soothe market sentiment causing a return of risk appetite, the rally in risk assets could produce wealth effects that could surprise our forecast on consumer spending to the upside.
The increasing emphasis in global policy circles towards fiscal austerity highlights additional sources of risk for U.S. growth, through a worsening of the trade balance and the resurfacing of protectionist policies that are kept high by high unemployment rates and the extremely modest move by China to appreciate its currency. On the positive side, U.S. policymakers have as yet refrained from joining the fiscal austerity camp; however the growing political gridlock in Congress is a source of concern, as passing additional fiscal stimulus is becoming increasing difficult, even towards ends such as the extension of emergency unemployment benefits.
Policy Implications: The Fed Will Be Pushed to Do More
While declines in spending at the state and local level have dragged growth lower in Q4 2009 and Q1 2010, Congress is expected to pass a watered down version of the administration’s proposals for second fiscal stimulus, boosting some federal transfers to states and extending unemployment benefits. This is expected to neutralize the drag on growth from government spending during H2 2010. However, significant additional support from fiscal policy appears highly unlikely even in the event of a sharp growth slowdown; and more fiscal drag will emerge in 2011 as some of the tax cuts of 2001 and 2003 are allowed to expire.
This will put mounting pressure on the Fed to provide additional monetary stimulus to boost demand and alleviate deflation risks. The current relative stability of inflation expectations has clearly worked in the Fed’s favor, but the disinflationary bias is evident in expectations for the coming year. In the event of a marked decline in inflation expectations, the Fed needs to credibly commit to a higher inflation target to escape a deflationary trap.
Figure 5: Inflation vs. Inflation Expectations
Source: U.S. Bureau of Labor Statistics, Federal Reserve Bank of Cleveland, RGE CalculationsRecent statements have shown that the Fed is increasingly wary about recent signs of a stalling recovery and downside risks to inflation. RGE believes this concern is certainly warranted; even today, after accounting for the effects of the Fed’s quantitative easing (QE), the Taylor rule is still telling us that policy is too restrictive, and the Fed Funds rate should be in negative territory. Given our forecast for growth and inflation, not only do we expect the Fed to remain on hold through 2011, but we expect further stimulus from the Fed. Additional easing could be achieved through another LSAP (Large Scale Asset Purchase Program) comprising asset backed securities or long term Treasuries, and/or through verbal intervention, such as the announcement of specific targets for medium-to -longer term yields.