Turning the Corner
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Dr. Martin Regalia
Although it may be some time before we get the official word from the National Bureau of Economic Research, the U.S. economy finally appears to have turned the corner, and an end to the recession is in sight. The S&P 500 broke the 1,000 level, the Dow Jones Industrial Average rose above 9,000, housing sales and starts have increased of late and prices are stabilizing, and credit market spreads are down significantly from the levels seen six months ago.
While we are still experiencing job losses, they, too, are down sharply from the peaks of a few months ago. And the recently released GDP report showed a much smaller decline than in the previous two quarters. While these are all positive signals pointing to an end to the downturn in the third quarter of this year, we still expect the recovery to be somewhat subpar and the unemployment rate to remain elevated through much of next year. Let's take a closer look at some of the numbers. But in the newfound spirit of optimism, we'll cover the best first and save the negatives for later.
Rate of Decline Is Slowing
The economy continued to contract through the first half of the year, but the pace of decline has slowed dramatically. Real GDP declined at a 1% annual rate in the second quarter of 2009, a clear improvement from the first quarter's revised 6.4% drop and a 5.4% drop at the end of last year. This improvement is consistent with our expectation that the economy will rebound over the second half of this year.
Consumer spending, which had shown a bit of life in the first quarter, declined moderately in the most recent data. Business and residential investment, inventories, and exports all declined as well, but at a less steep pace than earlier in the year. Imports and government spending helped offset this weakness.
Last month we wrote about the bottom in housing, and the most recent data have not only confirmed our expectation but have shown further improvement. Existing home sales increased 3.6% in June to a 4.89 million unit annual rate from 4.72 million units in May. New home sales jumped 11% in June, rising to a 384,000 annual pace from 346,000 units the previous month. Both series remain down from a year ago but point to a gradual recovery over the coming year.
The improvement in sales was reflected in declining inventories where the months' supply of existing homes for sale declined in June to 9.4 months from 9.8 months in May, and the months' supply of new homes for sale in June fell to 8.8 months from 10.2 months in May. Price movements reflected some ambiguity in June with existing home prices up and new home prices down slightly. Even the S&P/Case-Shiller composite index showed less steep declines than in the past.
Inflation remains low and is not currently a threat. With weak global demand, it is unlikely that price increases will be a problem for the remainder of the year and through at least the first half of next year. Looking beyond the next year and a half, inflation may pose a greater threat. The Fed's unprecedented balance sheet expansion must be unwound at some point. If it waits too long, inflationary pressures will begin to build.
In addition to the rebound in the stock market, recent improvements in credit markets have continued to erode the significant risk spreads that existed late last year. And even though long-term interest rates have risen a bit, the credit markets have a more positive "feel" about them. The Fed is expected to maintain its current policy for the foreseeable future, keeping the Fed Funds rate close to zero through the middle of next year. However, the Fed may begin to remove some of the balance sheet stimulus sooner than that.
Industrial production declined over the past eight months, but the declines are less steep now than before, and businesses have been working through their existing inventories and, at some point, will likely begin to restock. Business confidence is also showing some improvement. The Institute for Supply Management's Purchasing Managers Index (PMI) remains below 50, its threshold for growth, but has increased to 48.9 from 35.6 in January. Several components of the survey are above 50, suggesting that firms are expecting future growth.
Storm Clouds Still Abound
While the aforementioned indicators are all positive signs, we don't want our optimism to become euphoric just yet. There are a few dark clouds still on the horizon that suggest the recovery may be a tough slog.
Business confidence may be improving, but consumer confidence in the state of the economy is deteriorating. The Conference Board's measure of consumer confidence has declined for the past two months. It is still up from recent lows because of two large jumps in April and May, but it has given up some of those gains. A similar survey from the University of Michigan has been on an upward trend but also declined in July.
It should not come as much of a surprise that consumers are not very upbeat about the economy. While we can see some signs that the economy is improving, household wealth is down, there is downward pressure on wages, and the economy continues to shed jobs, creating worry and uncertainty about the future.
Household net worth has been hit by a combination of falling home prices and the decline in the stock market. Since the recession began, household net worth has fallen by more than $12.2 trillion. While we have already seen some signs that housing prices are stabilizing and that the stock market has rallied a bit, we have a long way to go before we see a rebound in wealth.
Personal income fell 1.3% in June, and disposable personal income also fell by 1.3%. One partial reason for the decline was the end to some of the stimulus transfer payments, but the decline in income was broad and likely reflected the weak labor market.
With income and wealth down and confidence gone, it was no wonder that personal consumption expenditures declined 1.2% in the second quarter after increasing in the first by 0.6%. Consumption should regain some momentum in the second half of the year as the economy improves and income stabilizes. The personal savings rate has been rising since early 2008 but declined on a monthly basis in June. Rebuilding savings is an important long-run goal for consumers, but it slows GDP growth in the short run. What we need here is balance.
In the labor market, employment declines have remained sizable, and the unemployment rate will continue to rise even as the broader economy stabilizes. The unemployment rate is expected to rise well into next year, likely peaking above 10% in the first half of 2010. The economy has already lost almost 6.5 million jobs since the start of the recession. More than half of this decline has occurred in the past six months, but the pace of job loss has slowly declined. In the first quarter, the economy shed an average of 691,000 jobs per month. In the second quarter, the average rate of job loss slowed to 422,000 per month. July saw a decline of 247,000 jobs. So the losses are diminishing, but they are losses nonetheless.
With the economy recovering slowly and capacity utilization at a very low 68%, businesses are unlikely to begin an investment boom anytime soon. Because of inventory accumulation, capacity utilization rates have been on a downward spiral since December 2007, when the capacity utilization rate was 82.6%.
Equipment and software investment declined at a 9% annual rate in the second quarter after declining more than 36% in the first quarter and falling in every quarter since the recession began. We expect the rate of decline to slow over the next few quarters, but we are not anticipating growth until sometime next year.
Investment in structures fell at almost a 9% annual rate in the second quarter, after dropping almost 44% in the first quarter. We see no appreciable growth in this component of GDP until we use up the excess capacity. Private inventories declined by $141 billion in the second quarter after a drop of $114 billion in the first quarter. But with sales so weak, the inventory-to-sales ratio remains elevated, and thus we are not expecting any inventory rebuilding until the second half of 2010.
The storm clouds are abating, and we see clearer skies ahead. However, this economy remains unbalanced and susceptible to policy miscues, so we are not out of the woods yet. Some things just don't come easy.