Economic Trends and Risks

GDP Surge Drives Confidence, Expect Q4 Slowdown

The press did a good job summarizing the 3.5% jump in third quarter gross domestic product (GDP) -- the big kahuna among the economic indicators.  The stronger than expected rise seems to confirm that the recession ended in mid year though there are some looking for a "W" shaped recovery with the risk for another downturn in growth.

As the press noted the bulk of the gain was due to specific stimulative factors.  Car sales (and total consumer spending) was strongly boosted by the "cash for clunkers" sales incentive as we already saw the fall off as the incentives ended in September.   The incentive for first time home buying also helped to leave a strong rise in residential investment (the first since late 2005) which is likely to soften if Congress allows it to run off as seasonally soft activity arrives in a few months.

The chart above shows the real dollar contributions from the six key components.  The forward risk in predominant consumer spending (70% of GDP) comes the broader factors determining the spending force -- unemployment and income growth, credit availability and the strong drop in household wealth. 

Business investment has vastly improved over the last two quarters but the accelerating downturn in commercial real estate will continue to be a drag.  Residential investment appears to have turned stronger but the cold season ahead will provide regional softening and may extend buyer hesitation with out the buyer incentives.  The drag from trade came from double-digit percent gains after over a year of declines from both imports and exports.  The weaker dollar will help limit the forward damage here.  

Inventories continue to fall but at a slower rate boosting its positive contribution as government spending will remain a very clear positive factor in the year ahead.

My U.S. growth expectations are for modest growth near 2% over the next two quarters as a modestly stronger upward trend arrives in mid-2010 which will trigger the long awaited Fed rate hikes.  Given the near zero level of the policy interest rate, expect a more aggressive tightening than seen after the 2001 recession.

Record Smashing $1.4 Trillion FY09 Budget Deficit

The Treasury reported the record shattering fiscal year 2009 budget deficit with out much attention from the press.  September's $47 bln deficit left the fiscal year with a $1.417 trilion budget shortfall -- more than three times the size of the prior year's record size and at 10% of GDP the record setter by far in that measure as well. 

For those looking for one there is a bright side.  The deficit was $424 bln smaller than May expectations and $163 bln smaller than the deficit the government forecast in August -- a month before the fiscal year ended.  The miss was largely attributed to the lower than anticipated outlays from the Troubled Assets Relief Program (TARP).  Most of the $82 bln TARP miss will be shifted to FY10.  For the conservatives the deficit rings up to over a $10,000 bill for each of the current U.S. workers.  More is on the way.

Tax receipts fell -17% from FY08 -- the largest decline in my 40 year history.  Outlays surged 18%, the largest hike since 1975.   The Administration's chief economic stabilization and recovery efforts -- TARP and the outright stimulus titled the American Recovery and Reinvestment Act (ARRA) accounted for 24% of the deficit total.  Or, the deficit excluding TARP and ARRA amounted to a truly tremendous $1.1 trillion.

The costs were funded from public borrowing of $1.7 trillion as total outstanding is now nipping at the $12.1 trillion debt limit (which stands at 85% of nominal annual GDP).  Now Congress has to raise the debt limit to allow the funding its already cleared through the ARRA.  The show continues.

The August estimates from the bi-partisan Congressional Budget Office puts the FY10 budget deficit at a similar $1.38 trillion as the annual deficit isn't expected to fall below a half trillion over the next decade.   For obvious reasons, the public debt -- the amount we tax payers owe -- follows the same path.

 

Inflation Fears

There is no putting to rest the markets' inflation fears given the Fed's ultra-easy policy stance.   Experience shows that in the long term inflation is a monetary phenomenon.  The Fed seems comfortable in the current environment as the accelerated reserve growth came with plenty of economic slack as the chief business cost -- labor -- is lower than a year ago.

First let's touch on the pace of monetary growth given its long term influence on inflation.  While the Fed has pumped a massive amount of money in to the reserve market, the broader M2 money supply has shown declines in both of the last two months and just a 1% annualized growth over the last 6 months from the heady 15% pace early in the year. 

Reserves are not included in M2 money supply and can not be transferred outside the banking system.  While the Fed was bulking up bank reserves, banks were simultaneously slowing deposit growth given the heightened risks of lending.  Now, as the search for higher yields returns, money is actually flowing out of banks to the stock market, corporate debt or higher real yields abroad. 

Underlying the inflation fear is the risk that the Fed will drain off those added reserves too slowly.  The Fed clearly understands the risk of overstaying its welcome with low policy rates and is likely to boost them fairly rapidly from their near zero level when it deems the economy is strong enough.

The tremendous slack in the economy is expected to provide a period of very modest inflation gains.  The quarter century high in the unemployment rate and industrial capacity utilization below 70% leaves a large gap between potential and actual growth.  Its when those measures draw close or when actual growth exceeds potential that inflation pressures build.

 

Others see a rise in commodity costs or the falling dollar value as indicative of higher inflation ahead.  To that I'll remind you that 2/3 of business costs are labor and that unit labor costs fell -6% in the second quarter to leave a -1% decline over the last year -- no inflationary implications there. 

And don't let the run off of last year's fourth quarter plunge in energy prices convince you that inflation is returning.  Modest 0.2% CPI gains in the current quarter will leave a 2.5% annual growth rate at year end from the -1.3% annual decline in September.  Exclude the volatile food and energy components and the underlying pace of core consumer inflation is a comfortable 1.5% from a year ago.

Consumer Credit Continues to Plunge

The decline in annual personal income growth owed to the quarter century high unemployment rate adds to the severe plunge in household wealth to help hold back the demand for consumer credit.  Consumers are currently frightened to spend beyond their means.  Meanwhile the risk-wary lenders continue to restricting borrowing as the result is seen in the record decline in consumer credit.  

Consumer credit fell another $12 bln in August after the revised $19 bln plunge in July.  Moreover, given the surge in auto sales over July and August the expected rise in auto loans  helps disguise the size of the underlying decline.  The trend pace will be easier to recognize in a few months as the jump in auto sales was followed by a 35% September plunge given the end of the cash for clunkers buying incentives.

Given the timing of the lift in auto sales, August non-revolving credit fell just $2 bln after a $14 bln average decline over the prior two months.  Revolving credit fell $10 bln in August. 

 
  

The peak in consumer credit was reached over a year ago in July 2008 as the declines show no sign yet of deceleration.  Over the last 6 months consumer credit has fallen nearly $100 bln given a slightly stronger decline in revolving credit (i.e.  credit cards) than other household non-mortgage loans (such as for autos, tuition, etc.).   About a third of the $2.5 trillion of consumer credit is composed of revolving credit as non-revolving makes up the majority.

The annual decline is the largest on record as will be the eight month string of monthly declines if September shows the expected fall off.  Consumer retrenchment continues to be a worry for the economy given the strong headwinds .  With consumer spending making up about 70% of GDP it carries a dominant role in the outlook for future growth.

Unemployment and Recovery

Payroll employment fell -263,000 in September, a larger decline than the revised -201,000 August fall off and the -175,000 or so expected in the market.  The unemployment rate rose to 9.8%, its highest level in a quarter century.

The slow trend movement isn't all that surprising given the lagging nature of employment to the economy and the more obvious read from leading employment indicators.

 

Payroll employment following the last two recessions turned to gains when the weekly initial claims for unemployment benefits fell to about 400K, they reached 550K last week.  The unemployment rate peaked when continued unemployment claims fell below 3,500K, they stood at 6,090K last week.

Unemployment claims still stand well above the peaks of the last two recessions and foretell the slow trend movement in payroll growth and unemployment. 

 

Nonetheless, the economy has turned out of recession.  In the third quarter which ended yesterday GDP growth could exceed 3% given the data already released.  Many simply see this as a return of the "jobless recovery" the press emphasized during the last recovery.  A more accurate read is that companies only seek to expand the employee count (i.e. expenses) when demand has clearly stretched its capacity -- employment is a lagging indicator.

While there's plenty of room for surprise as more third quarter data rolls in, here's what we've seen.  Consumer spending may reach 3% growth given the sharp rise in spending partly tied to the cash for clunkers funding.  Business investment is recovering strongly seen in the rise in durable goods shipments, housing should show the first rise in over three years as inventories will also provide some lift.   I expect to see slightly softer positive growth in the fourth quarter given the fall off in auto spending.