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Is the glass half-full or half-empty? If you're an optimist, there are reasons to view this week's batch of economic data in a positive light. Conversely, if you're a pessimist, the same information could just as easily justify a gloom and doom attitude. Not surprisingly, the financial markets spent the week in a state of utter confusion, lurching one way and then the other - a typical response to ambiguity. As one pundit remarked at the end of the week, if you are not confused by the data, you aren't paying attention.
From our lens, the news could have been worse, given the debilitating effects of the housing depression that continue to reverberate throughout the economy. Indeed, the optimists can point to the fact that the powerful headwinds, which also include a severe credit crunch, sky-high energy prices and a deteriorating job market, have not yet brought the economy to its knees. According to this week's GDP data released by the Commerce Department, the economy expanded by a respectable 1.9 percent annual rate in the second quarter, more than double the 0.9 percent pace registered in the January-March period.
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But the government's report also contained the usual annual revisions that revealed a slower growth rate over the 2005-2007 period than was originally reported. What's more, the small 0.6 gain in last year's fourth quarter was revised to an outright decline of 0.2 percent. If that estimate holds up under subsequent revisions, it would mark the first quarterly contraction in GDP since the 2001 recession. Nonetheless, the question of whether the economy has or has not entered a recession remains very much unresolved. The rule of thumb that commonly defines a cyclical downturn, two consecutive quarters of declining GDP, has not been met. But as the chart shows, that yardstick was not met during the 2001 recession either. Quite simply, the economy's cyclical status remains up in the air.
The optimists claim that the economy's second-quarter performance was actually stronger than it looked statistically. One reason the growth rate fell somewhat short of expectations - Wall Street was looking for a 2.5 percent figure -was due to a huge liquidation of inventories, which subtracted nearly 2 percentage points from GDP. Without that drag, GDP would have jumped by an above-trend 3.9 percent rate, and questions about a recession would have been moot. Put another way, if businesses simply hold inventories at current levels and final demand increases at the same pace as it did in the second quarter, the economy will stage a sizeable advance in the summer months.
That prospect, however, is a leap of faith that the pessimists simply will not accept. In their view, final demand will not be sustained at the second-quarter's pace in coming quarters. That's because consumer spending in the April-June period derived most of its strength from the tax rebates mailed out between April and early July. The boost from those rebates are now pretty much exhausted and households are already reining in their spending propensities, thanks to the growing array of forces that are intensifying the squeeze on budgets.. As it is, the 1.5 percent increase in real consumer spending in the second quarter,. while stronger than the first, still fell short of expectations; without the thrust from rebates, the third quarter is likely to see an even weaker increase.
Nor for that matter is the major driver of growth in the second quarter - net exports - expected to retain as much strength going forward. During the period, exports soared by 9.2 percent while imports declined by 6.6 percent. The combination resulted in a net reduction in the nation's trade deficit, which contributed an astonishing 2.42 percentage point to the second-quarter growth rate, more than the increase in GDP. Most likely, imports will continue to decline, reflecting weak economic conditions in the U.S. But the outlook for exports has become dimmer in recent months, as the weakness in the U.S. has spread overseas. Conditions in Europe have deteriorated markedly, with several nations on the brink of recession, growth in Japan has stagnated, and the U.K.economy may already be contracting. Simply put, foreign demand for U.S. goods and services is poised to slow down significantly, undermining an important prop to GDP in recent quarters.
Meanwhile, the housing slump shows no sign of ending. In the second quarter, builders slashed residential outlays by 15.6 percent, subtracting 0.62 percentage points from the economy's growth rate. The latest monthly data on sales, inventories and home prices all point to continued declines in coming quarters, extending a housing correction that probably won't end until sometime next year, if then. There is, however, one encouraging aspect of the ongoing housing slump: Its severity and drag on the broader economy seems to be lessening. The 15.6 percent decline in residential outlays during the second quarter, for example, followed reductions of 25.1 percent, 27 percent and 20.6 percent in each of the previous three quarters, respectively. Likewise, the 0.62 percent drag on economic growth was considerably smaller than 1.12 percentage point and the 1.02 percentage point haircuts snipped in the first quarter and all of 2007.
Quite possibly, the reduction in the housing drag will just about offset the diminished boost from net exports, leaving other sectors to determine the economy's performance over the second half of the year. Although we are impressed with how well the economy held up last quarter in the face of powerful headwinds, it's doubtful that it can show the same resilience going forward. Business investment spending increased by a respectable 2.3 percent in the second quarter, just about matching the 2.4 percent first-quarter showing. But corporate profits are collapsing and companies are finding it increasingly difficult to finance capital spending with borrowed funds, given the tighter lending standards of banks and growing risk aversion of investors in the capital markets.
What's more, the second quarter increase in investment outlays was entirely the result of a 14.4 percent jump in commercial construction. That's not likely to be repeated, as commercial vacancy rates are rising and businesses are becoming fearful about overbuilding in a weakening economic environment. Some of the quarter's strength in commercial construction may also have stemmed from the Economic Stimulus bill, which provided short-term tax incentives for such spending. Like the consumer rebates, that too is expiring and will not be a factor going forward. More importantly, the larger component of business investment outlays - spending on machinery and software - is already contracting. Capital spending fell by 3.4 percent in the second quarter, following a 0.6 percent cutback in the first. Until businesses get a clearer picture of how final demand will shape up in the months ahead, we do not expect investment spending to provide much, if any, contribution to economic growth.
Simply put, the deciding influence on the economy's performance rests, as always, with households, who account for 70 percent of total economic activity. At this juncture, it's hard to be overly optimistic that they will supply enough fuel to keep the economy's engine on a growth track. With the rebates now more or less exhausted, households will have to rely on more organic sources of purchasing power to maintain spending. This means wages and salaries have to grow at a pace that at least keeps up with inflation and the job market has to remain sufficiently strong to keep households in a buying mood. Neither of these vital events are happening.
First, the job market continues to deteriorate, something that Friday's employment report by the Labor Department made abundantly clear. In July, the economy lost another 51 thousand jobs, the seventh consecutive month in which payrolls were reduced. If we are not in a recession, it clearly feels like one to the 463 thousand workers who lost their paychecks over this period. Except for the fact that the monthly job losses are not getting steeper, there is nothing in the latest jobs report that can be viewed in a positive light. All of the cyclically-sensitive industry groups are cutting back staff, and the bleeding shows no sign of ending anytime soon. When companies are in the midst of downsizing as is currently the case, the process rarely ends before the layoffs reach gigantic proportions for several consecutive months - something akin to the final sell-off during a bear market in stocks. We suspect that a blockbuster month of job losses will be reported at some point in coming months.
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