U.S. Review
Change Yes, But Not Very Comfortable
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This will not be your typical economic recovery. September’s employment report brought home the harsh realities of the forces of cyclical weakness with soft consumer incomes and spending for the second half of this year.
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Secular change will be most evident in a slower pace of consumer spending and residential construction in this recovery.
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Globalization of production will continue as emerging markets grow faster than the U.S.
Harsh Job Realities Greet Simplistic Recovery Hopes
This will not be your typical economic recovery. The September employment report brought home the harsh realities of the forces of cyclical weakness, structural change and the globalization of the production cycle.
Cyclical weakness is evident from the employment report for both income and production. Household income will be weaker than usual in this economic recovery as job losses are accompanied by diminishing gains in average hourly earnings. In addition, the average work week has declined over the past three months. Fewer workers working fewer hours for more modest wage increases is a prescription for subpar consumer spending in the second half of this year and likely a disappointing start for early next year.
Industrial production, a coincident economic indicator, has also not fared well. A decline in the manufacturing workweek and a drop of 51,000 jobs suggests a decline for industrial production to be reported later this month. This view is reinforced by the flattening out of the gain reported in the ISM manufacturing index. The ISM data for September suggest that both production and new orders decreased in September. Moreover, prices paid rose suggesting rising input cost pressures—especially on metals—for manufacturers. Our outlook remains for only modest gains in industrial production of one to two percent for the rest of this year. This outlook received further reinforcement from the decline in light vehicle sales in the aftermath of the cash for clunkers program. The weakness in vehicle sales, both cars and trucks, is consistent with weak consumer income and low levels of consumer confidence. Our outlook remains for subpar consumer spending of just below one percent compared to two percent prior to the financial correction.
One positive to the outlook is the stabilization that appears to be happening in private residential construction spending. Here too the test will be the response in the market once the first-time home buyer credit lapses—if it lapses at all. Unfortunately, nonresidential construction does not appear to have found a bottom and we expect that this sector of the economy will continue to be a drag on growth going forward.
Secular Change and Global Production
Beyond the business cycle, the strength of the expansion will be tested by secular forces that will damper, in our view, the pace of growth in consumer spending and housing starts for the year ahead. A more cautious, higher saving consumer will limit spending. The financial incentives to invest in housing are more limited. Moreover, job opportunities will increasingly favor college-educated workers and this will flavor life-time income expectations for many households in our society.
Production will continue its global outreach as U.S. growth will remain moderate compared to growth in Asia and other emerging markets. Production will follow sales. Moreover, production will continue to move up the value chain as lower value-added production, and its associated employment, will move offshore.
Global Review
Tankan Survey Signals Further Expansion in Japan
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The Tankan index of Japanese business sentiment, which is highly correlated with real GDP growth, suggests that the Japanese economy expanded further in the third quarter. Indeed, recent “hard” data are consistent with another increase in real GDP in the recently completed quarter.
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Yen appreciation represents a risk factor to the nascent Japanese economic recovery. The yen has strengthened nearly 10 percent against the dollar since early August, and export growth could slow if the Japanese currency were to rise significantly further.
Tankan Survey Signals Further Expansion in Japan
Although the Bank of Japan’s Tankan survey is only conducted on a quarterly basis, it is widely followed by investors because it contains a treasure trove of information about the Japanese economy. For starters, the “headline” index, which measures business conditions among large manufacturers, has a high degree of correlation with real GDP growth (see chart on front page). Therefore, the rise in the index from -48 in June to -33 in September suggests that the economy expanded further on a sequential basis in the third quarter. Indeed, “hard” data show that industrial production (IP) through the first two months of the third quarter rose more than 6 percent relative to the second quarter. Although IP remains 18 percent below its level of a year ago, it has risen 20 percent since its nadir in February (top chart).
Japanese businesses reported in the Tankan survey that overseas demand improved considerably in the third quarter, and “hard” data, which show a 9 percent rise in export volumes through August, corroborate the anecdotal evidence. But domestic demand is also starting to do its part. Data on machinery orders suggest that capital expenditure may be in the process of stabilizing, and growth in consumer spending has turned positive. The value of retail sales is up more than 2 percent relative to the low set in March. (That said, retail spending is still down on a year-over-year basis—see middle chart.)
Speaking of retail sales, consumer spending may strengthen further over the next few quarters. The new government that took power a few weeks ago promised in its campaign platform to significantly increase tax deductions for families with dependent children. If this policy proposal is passed into law later this year, as seems likely, the boost to household real disposable income could lead to stronger consumption expenditures, at least over the next few quarters.
In sum, the Japanese economy fell off a cliff in the wake of last autumn’s worldwide financial crisis, and most indicators suggest that economic activity remains below the levels of a year ago. However, an incipient recovery appears to be taking hold. Is there anything that could cause the recovery to stall? Clearly, there are a number of shocks that could cause the economy to lurch lower again, but a notable risk to the recovery is significant yen appreciation. The Japanese currency has strengthened nearly 10 percent versus the dollar since early August (bottom chart). Moreover, the yen has appreciated against most major currencies as well recently.
Very low interest rates in the United States relative to Japan—the 3-month dollar LIBOR rate is currently 6 basis points below the comparable yen rate—has contributed to the yen’s rise vis-à-vis the greenback. In addition, the new government has hinted that it will essentially take a hands-off approach to the exchange rate because yen appreciation helps consumers by reducing import costs. However, export growth could slow in the quarters ahead if the yen were to strengthen significantly more, which could put a damper on overall economic growth in Japan.
