U.S. Review
On The Road To Recovery
The past week’s first quarter GDP report likely marks the end of the economy’s free fall, which began when Lehman Brothers declared bankruptcy. A similar fall is unlikely to follow yesterday’s announcement that Chrysler is seeking bankruptcy protection and the economy should be able to handle whatever resolution unfolds for General Motors.
Real GDP declined at a 6.1 percent annual rate during the first quarter, with a huge $103.7 billion plunge in inventories accounting for 2.8 percentage points of the drop. Consumer spending rebounded slightly during the quarter but business fixed investment was astonishingly weak. Government spending was another surprisingly weak sector and net exports added 2.0 percentage points to the first quarter figures. Imports fell more than exports during the quarter.
While the first quarter’s decline nearly matches the fourth quarter’s 6.3 percent plunge, the composition was very different. The huge drop in inventories helps pave the way for a rebound in orders and output and puts the economy firmly back on the road to recovery.
The Road To Recovery Will Likely Have a Few Potholes in It
Being on the road to recovery is not the same thing as being in a recovery. Excesses that developed before the recession still need to be corrected and this will take more time. Progress is underway. Inventories are coming down and planned shutdowns by Chrysler in May and General Motors this summer should go a long way toward clearing out the oversupply of cars and light trucks.
Government spending is also poised to rebound now that the stimulus package is rolling out. The pace of government spending may prove to be less than many are expecting, however. Federal outlays fell at a 4.0 percent annual rate in the first quarter, with spending for national defense falling at a 6.4 percent pace. Apparently, the unwinding of the Iraq War has led to cutbacks in equipment purchases and the planned buildup in Afghanistan is not large enough to offset them. Further cutbacks in military procurement are likely, although part of these cuts will be offset with increased outlays for military construction.
State and local government outlays fell at a 3.9 percent pace, with cutbacks in construction, equipment purchases, and manpower accounting for the drop. Many municipalities are facing severe financial challenges and are limited as to how much they can raise taxes or issue debt. As a result, many state and local governments have dipped into rainy-day funds, trust funds and maintenance accounts. Spending for actual maintenance and repairs is being deferred. As a result, increased funding from the federal government may not provide as much of a lift as many people expected. Instead of building new highways and bridges, federal money may end up going toward fixing potholes.
Another potential challenge for the economy is the consumer. While spending rebounded at a 2.2 percent annual rate, it ended on a weak note, with spending falling 0.2 percent in March. That means we will have to see hefty gains in April and May just to keep outlays from falling in the second quarter. While there is some anecdotal evidence that the tax cuts are helping we do not expect it to be enough. Our first look at the second quarter calls for outlays to fall at a 1.5 percent annual rate, which will make it tougher to bring inventories completely back into balance.
The ISM manufacturing survey, as well as most regional manufacturing surveys, improved during April. New orders and order backlogs have increased and inventories continue to decline. The indices remain firmly in recession territory but are moving in the right direction and show the factory sector is actually a little further down the road to recovery that the economy as a whole.
Global Review
Euro-zone in Deep Recession
Unlike the United States, the Euro-zone has not yet released official GDP data for the first quarter of the year. However, preliminary estimates from some individual countries suggest that the official outturn will not be pretty when it is released on May 15. As shown in the chart at the left, real GDP in Spain plunged at an annualized rate of 7 percent in the first quarter relative to the fourth quarter of 2008, the sharpest rate of contraction in years if not decades. A breakdown of Spanish real GDP into its underlying demand components is not yet available, but the 10 percent drop in nominal retail sales in the first quarter (year-over-year change) suggests that consumer spending was a major reason overall GDP growth dropped as sharply as it did. The Spanish labor market has fallen completely apart. From the eight percent or so rate that prevailed throughout 2006 and 2007, the unemployment rate in Spain has surged to more than 17 percent recently.
Spain is suffering from a housing market bubble that has subsequently burst, a fate that has also befallen Ireland. As shown in the top chart, unemployment in Ireland has shot up to its highest rate in more than a decade. In its recently released World Economic Outlook, the International Monetary Fund projects the Irish economy will contract 8 percent this year following the 2.2 percent decline in real GDP that occurred in 2008.
The overall Euro-zone economy should continue to contract in the second quarter, but the rate of decline likely will not be as extreme as in the first quarter. As shown in the middle chart, the purchasing managers’ indices for both the manufacturing and service sector remained in recession territory in April. However, both indices have improved over the past two months, suggesting that the rate of decline in the economy is starting to slow. In addition, the economic confidence indicator that is compiled by the European Commission rose in April, the first increase in the index in nearly a year. Although we wouldn’t want to proclaim yet that the “green shoots” of recovery are staring to show up in the Euro-zone, recent economic data have not been as universally bad as a few months ago.
Against this backdrop, the European Central Bank (ECB) holds its next policy meeting on May 7. Most analysts (ourselves included) expect the ECB to cut its main policy rate by 25 bps, which would bring it to 1.00 percent. However, most ECB policymakers seem reluctant to take the policy rate below 1.00 percent. Unless the economy goes into freefall again, which we do not expect, the ECB will probably keep its policy rate unchanged at 1.00 percent well into next year.
As shown in the bottom chart, the euro continues to move sideways against the dollar. However, because American authorities have taken more aggressive steps to stimulate the U.S. economy than their European colleagues have done to the Euro-zone, we expect that the “green shoots” of recovery will become more apparent sooner on this side of the Atlantic. Therefore, we look for the greenback to strengthen vis-à-vis the euro in the quarters ahead.
