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Monthly Economic Outlook

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Sub−Par Growth: Economic Workout Continues

Thu, Jul 10 2008, 08:14 GMT
by Wachovia Research Team

Wachovia

U.S. Overview

Sub-Par Growth: Economic Workout Continues

Once again, we are faced with the hard reality that the economic workout continues, keeping pressure on profits and household incomes. There is no easy-out for the economy. We expect continued weakness in consumer spending, residential investment and capital spending in the second half of this year. In contrast, government spending and net exports should maintain positive momentum. Overall, our expectation is that real final sales will slow in 2008 and again in 2009 from the 2007 pace of 2.5 percent.

Inflation, measured by the core PCE deflator, remains at the top end of the Fed’s perceived target range. Higher priced imports, energy and food are all adding to the upward momentum in prices. This combination of sub-par growth and persistent inflation suggests that the Fed will keep the funds rate on hold through the rest of this year. Finally, sub-par growth coupled with rising input prices should deliver a decline in pre-tax profits for the second half of this year.

Our forecast has changed modestly over the past month. Estimates for 2009 have been lowered, reflecting more modest growth in consumer spending, a deeper pullback in commercial construction, and less growth in exports. In addition, the BEA will revise the GDP data for the past three years later this month, which may lower the trajectory of economic growth.

International Overview

U.S. Slowdown Spreading to Other Countries

The slowdown in the United States appears to be spreading to other economies. U.K. economic activity is the weakest it has been since 2001, and growth in the Euro-zone seems to have slowed significantly in the second quarter. Even developing countries, which have enjoyed rapid growth over the past few years, have not been immune to the slowdown. Why has growth slowed abroad? First, exports to the United States from many countries have weakened. Second, credit market dislocations have weakened growth in countries that are extensively financed via capital markets and/or experienced significant run-ups in house prices. Third, the sharp rise in the price of oil is eating into real income in many countries, effectively slowing consumer spending. Finally, foreign central banks have tightened monetary policy in response to rising inflation, engendered by the sharp rise in the price of oil. We have marked down our global growth forecasts for the rest of this year and 2009, which likely will see the slowest year for global growth since 2002. If there is a silver lining, it is that inflation in many countries should come down going forward. Indeed, core rates of inflation in most countries are lower than overall rates at present If oil prices stabilize overall rates of inflation should come back down to the core rates in the quarters ahead. Consequently, central banks in most major economies likely will refrain from tightening further.

Sub-Par Growth: Consumer and Business Restraint

Consumer spending is expected to remain weak after the initial stimulus from the tax rebates. Real personal income growth has slowed this year relative to the prior two years as inflation has picked up while job growth has turned negative. Slower real income growth, combined with losses in real estate and financial wealth have dragged consumer confidence down and should hold consumer spending to just a 1.8 percent pace this year compared to 2.9 percent in 2007.

Over the second half of the year, much of consumer spending will be concentrated in core needs and non-discretionary items. Consumer spending on discretionary items will likely remain pressured. While the tax rebates may help sustain spending short term, we expect an outright decline in real consumer spending in the fourth quarter once those checks are spent.Weakness is also the story for business fixed investment. For the second half of this year we anticipate the combination of slower top line revenue expectations, tighter credit, and reduced corporate profits will lead to slower capital spending on equipment and software. Spending on structures is expected to slow significantly. This weakness will be in contrast to the solid gains we have seen in investment during the prior three years.

Housing Continues to Struggle

On the downside, residential construction likely declined at over a 20 percent annual rate in the first half of this year and is expected to continue to decline at a double-digit pace in the second half. The fundamentals remain negative. Housing demand is limited by sluggish income growth, low consumer confidence, tighter lending standards and a prevailing concern about further price declines. On the supply side, the inventory of homes remains large relative to the pace of sales in many areas. Lower interest rates and falling home prices have led to an increase in housing affordability. However the concerns of buyers and creditors have kept many on the sidelines.

Trade remains a big positive in the economy. We anticipate trade will add one-half of one percent to growth for the second half of 2008. The weaker dollar and stronger growth abroad are the key drivers. Inflation has heated up considerably abroad, however, and central banks, particularly in emerging markets, are beginning to hike interest rates.

Profits Weak & Interest Rates Flat

Pre-tax profits are expected to decline about six percent in 2008 compared to a gain of 2.7 percent in 2007 and 13.2 percent two years ago. The downturn in profits is consistent with slower top line revenue as well as higher input costs signaled by manufacturer surveys and commodity indices.

Short-term rates are likely to remain range-bound as the Federal Reserve balances the dual challenge of below-trend economic growth and above-target inflation. Long-term rates are expected to drift upward once calm returns to the financial markets. Concerns about the dollar and further Treasury financing needs are likely to limit any Treasury rallies despite continued soft economic news.

Credit spreads are not expected to narrow, as event risk remains a concern for investors. 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 remain higher than where it had been during the 2004-2006 period. Risk is being priced back into the fixed income market, but the market is still determining what the equilibrium price will be.

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Published on  Thu, Jul 10 2008, 08:23 GMT