U.S. Review
Recession and Recovery
Financial markets are acting as if the recession is ending and recent economic data tend to support that notion. We are now projecting that the recession will end this summer. The strength and durability of the recovery remain very much in question, however, and the economy is expected to have a tough time gaining momentum.
This past week had a light schedule of economic reports and the Treasury auctions took center stage, particularly when Wednesday’s 10-year auction received tepid demand and 10-year yields touched 4 percent. The rise in yields corresponds with continued bad news on the size of the federal budget deficit and weaker dollar. Combined they suggest overseas investors are less sold on near term economic prospects for the U.S. than equity market investors are.
We now believe the recession will end this summer, which is a few months earlier than previously thought. The decision to move up the end of the downturn was largely driven by the timing of motor vehicle assembly plant shutdowns and restarts, which will produce huge inventory swings.
The Economy Still Faces Significant Hurdles
The recent trend in retail sales also lends support to a turnaround in real GDP during the third quarter. After rising in January and February, retail sales fell in March and April, which meant that second quarter sales started at a low base and will likely post a decline for the second quarter even if sales rebound in May and June. Retail sales did pick up in May, with overall sales rising 0.5 percent. The increase means that consumer spending will likely end the second quarter on a stronger note than it started it and will make it easier for real personal consumption expenditures to post at least a modest gain in the third quarter.
The combination of a positive swing in inventories and modest growth in real personal consumption expenditures means there is a high probability third quarter real GDP will be solidly positive. While one quarter of positive real GDP growth does not guarantee the recession will end, we believe that inventories have been drawn down so much that production will rise throughout the second half of this year just to move back in line with sales.
While the recession will likely end in the next few months the economy still faces significant hurdles. Consumer spending is still exceptionally weak and consumers have shown no sign of boosting purchases for big ticket items. To put it bluntly, sales have been horrible for the past eight months and have merely risen slightly from that level. Sales that are a little better than horrible are still pretty horrible.
Consumers will not likely spend freely again until they feel better about their employment and income prospects. On that front, the data are a little better than they have been. First time claims for unemployment insurance declined slightly more than expected this past week, falling by 24,000 to 601,000. The drop also helped pull down the four-week moving average by 10,500 to its lowest level in four months. Unfortunately, continuing unemployment claims continued to increase and the insured unemployment rate was revised up 0.1 percent from the prior week to 5.1 percent, where it stayed this past week. The increase suggests the unemployment rate will rise to at least 9.5 percent in June.
Another huge hurdle for the economy has been the rise in interest rates and weakness in the U.S. dollar. As mentioned earlier, the recent auction for 10-year Treasury notes did not go well. The 30-year auction faired better, but there is a paucity of supply for longer dated issues. The rise in the 10-year Treasury yield has sent mortgage rates sharply higher. Higher interest rates will make it much tougher to engineer a recovery in home sales.
Global Review
Bond Yields Signaling Stronger Growth?
Government bond yields in most major countries have trended higher over the past few weeks (see graph at left). One line of thought claims that the back-up in yields, at least in the United States, reflects reluctance by foreign investors to support the unprecedented budget deficits the federal government is incurring. However, at this week’s 30-year bond auction “indirect” bidders, which includes foreign central banks, bought about one-half of the $11 billion worth of securities on offer, casting some doubt on the notion that foreigners are eschewing U.S. securities, at least at present.
The rise in yields over the past few months, not only in the United States but in other major economies as well, is consistent with the expectation that the global economy will stabilize later this year and resume growing again. However, some recent data releases show that growth has not yet turned positive, at least not in some important economies. For example, industrial production (IP) in the 16-member Euro-zone tumbled 1.9.percent in April relative to the previous month, bringing its rate of decline over the past 12 months to nearly 20 percent (top chart).
In Germany, IP also fell 1.9 percent in April relative to March, which was much weaker than most investors had expected. Germany is an important supplier of capital goods to Eastern Europe, and the economic meltdown in that region is having a negative effect on the German economy. In that regard, the value of Germany’s exports declined 4.8 percent in April from March.
U.K. economic data have not been quite as downbeat recently. British IP was up 0.3 percent in April, the first monthly increase in 13 months. Yes, IP is still off 12 percent on a year-over-year basis, but the rise in the PMIs over the past few months—the service sector PMI is now back in positive territory—suggests that the British economy may be nearing bottom. A widely followed index calculated by a research institution indicates that British GDP contracted 0.9 percent (not annualized) between February and May, not nearly as bad as the 2.2 percent nosedive recorded between December and March. That said, it appears that Britain will record another negative growth rate in the second quarter.
If there is one country in the world where real “green shoots” have popped up—that is, where growth is actually positive again—it is China. Data released this week showed that the year-over-year growth rate of industrial production rose from 7.3 percent in April to 8.9 percent in May (bottom chart). Interestingly, the acceleration in Chinese IP since its nadir a few months ago does not appear to be linked to exports, which were down 26 percent in May, more than the 23 percent decline registered in April. Rather, domestic sources of spending appear to be propelling the Chinese economy higher at present. Growth in retail spending strengthened from 14.8 percent in April to 15.2 percent in May, and investment spending was up 33 percent in May, the strongest growth rate in five years. In response to the global financial crisis last autumn, the Chinese government decided to accelerate infrastructure spending and relax lending restrictions that were put in place when inflation was seen as Public Enemy #1. Its efforts appear to be bearing fruit.
