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Weekly Economic and Financial Commentary

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Too Many Challenges For The Typical Consumer

Mon, Sep 15 2008, 07:03 GMT
by Wachovia Research Team

Wachovia

U.S. Review

In The Belly Of The Beast

Anyone hoping the Treasury’s takeover of Fannie Mae and Freddie Mac would somehow mark the bottom of the credit crunch is now likely sorely disappointed. There is no question there are still formidable financial challenges ahead for the economy. The second half of this year and first half of 2009 will likely be the most challenging period for the U.S. economy in more than two decades.

Our September 2009 forecast has real GDP eking out modest gains for the next several quarters. The rise is extremely deceiving. Most of the growth comes from continued improvement in the nation’s trade deficit and a smaller drawdown in business inventories. By contrast, consumer spending, which accounts for more than two–thirds of U.S. GDP, is expected to decline in both the third and fourth quarters. Commercial construction outlays are also expected to fall later this year and business fixed investment will almost certainly slow.

This week’s data generally support our more somber view. Retail sales for August came in below expectations and July business inventories increased 1.1 percent.

Too Many Challenges For The Typical Consumer

Retail sales came in slightly weaker than expected during August, with overall sales falling 0.3 percent and sales excluding the volatile motor vehicles sector declining 0.7 percent. The weakness in retail sales is fairly broad based and would have looked even worse if not for a 0.7 percent increase in spending at grocery stores. Sales at building materials and hardware stores fell 2.2 percent and spending at electronics stores tumbled 1.3 percent. Other key areas, including department stores and clothing shops, also posted drops during August, and sales at furniture stores was unchanged.

The weakness in retail sales means that consumer spending will almost certainly decline during the third quarter and could be a harbinger of real trouble this holiday season. When we incorporate the latest numbers into our September forecast they push the third quarter drop in consumer spending to about a one percent annual rate. Back-to-school spending is usually a pretty good predictor of holiday retail sales. If that proves to be the case this year, retailers will almost certainly be disappointed. Holiday sales, however, rarely decline year-to-year. Our early look at the holiday season shows sales rising between zero and two percent from last year.

With retail sales struggling, inventories are beginning to pile up throughout the distribution channel. Business inventories rose an unexpectedly large 1.1 percent in July. Some of that increase likely reflects higher gasoline prices, which soared that month. Inventories of motor vehicles also increased, surging 3.2 percent. If we do not see a reversal in August and September data, inventories could really wreak havoc with the quarterly GDP data. We were assuming inventories would fall by about the same amount they did in the second quarter. That looks less likely today. If inventories fall two thirds as much as they did in the second quarter, they would add 0.5 percentage points to third quarter growth, giving us another deceivingly strong GDP report.

One bit of unambiguously good economic news released this past week was a larger-than-expected decline in the Producer Price Index. The overall PPI fell 0.9 percent in August, which was double expectations but very close to our own forecast of a 1.0 percent drop (way to go Azhar!). Excluding food and energy prices, the PPI rose 0.2 percent. Falling energy prices are responsible for much of the improvement in the August figures. Energy prices fell 4.6 percent during the month, reflecting a huge drop in petroleum prices. Prices for SUVs also continue to tumble. Wholesale prices for light trucks tumbled 1.9 percent in August. Most other prices were also better behaved.

Global Review

Chinese Growth Slows Further

Recent data show that the Chinese economy, which grew at a year-over-year rate of 10.1 percent in the second quarter, appears to have slowed further in the third quarter. For example, the year-over-year growth rate of industrial production slowed from 14.7 percent in July to only 12.8 percent in August, the slowest rate of increase in six years (see chart at left). Does this mean that the Chinese economy is falling apart?

Not really. Yes, the slowdown in industrial production growth in August is consistent with deceleration in exports, which grew 26.9 percent in July but only 21.1 percent last month. However, the slowdown in industrial production growth also reflects factory shutdowns in the provinces surrounding Beijing ahead of the Olympics. (The government ordered a production halt to help clean up Beijing’s polluted air.)

For example, the growth rate of crude steel production dropped sharply from 7.5 percent in July to only 1.3 percent in August, and output of pig iron actually turned negative last month. (The steel and iron industries were targeted by the government for temporary shut downs in August.)

Moreover, other indicators do not suggest the Chinese economy is falling apart. For example, the year-over-year growth rate in nominal retail spending was little changed in August (top chart). Given the decline in CPI inflation that occurred in August (middle chart), unchanged growth in nominal retail spending likely translates into stronger growth in real consumer spending. In addition, the growth rate of fixed asset investment remained very strong at 27.4 percent in August.

So where does this leave the Chinese economy? In our view, the recent slowdown in Chinese economic activity may be exaggerated somewhat by the shutdowns associated with the Olympics, and growth indicators could rebound a bit now that the Games are over. That said, the trend pace of Chinese economic growth appears to have downshifted somewhat. For starters, slower economic growth in the rest of the world has caused export volumes in China to decelerate since the beginning of the year. Also, tighter economic policies that were enacted due to the surge in CPI inflation appear to have depressed construction spending.

In that regard, the marked decline in CPI inflation that has occurred over the past few months is welcome news. Although most of the rise in the overall rate of CPI inflation was tied to food prices, which have subsequently declined, the government was worried that the underlying pace of inflation could shoot higher as well. Although the pace of non-food price inflation has trended higher over the past year, it generally remains benign at only 2.2 percent. The government will probably refrain from tightening policy further, which should reduce the risk of a sharp slowdown.

Another way that the government tightened policy was by allowing a faster rate of renminbi appreciation (bottom chart). However, the renminbi has been largely stable versus the dollar over the past two months. Looking forward, we project the renminbi will strengthen further versus the dollar but at a much slower pace than earlier this year.

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Published on  Mon, Sep 15 2008, 07:09 GMT