GDP forecast moves lower

We would like to suggest an algorithm to reduce the effort required to digest this month’s commentary:

1. Resurrect last month’s commentary.
2. Make all pessimistic comments more so.
3. Ignore most traces of optimism.

In fact, nearly all of the economic data during the past month have been bad. Perhaps even worse, in most cases they have fallen short of already low expectations, and their trend points downward. Not surprisingly, this has moved our forecast toward even slower growth.

First quarter data
The third release of first quarter NIPA data left real GDP growth for the quarter at just 1.9%. Aside from two notable exceptions changes to components were small. Growth in household consumption and business equipment purchases were each reduced slightly, offset by increases in construction – small for residential investment, quite large for business structures investment, which moved from negative to positive.

The other large revision was that both sides of the trade account were lowered sharply. For exports the growth estimate was reduced from 7.2% to 4.2%; for imports the change was from 6.1% to 2.7%. Given the difficulties in Europe and the apparent growth slowdown in Asia, a negative change was not surprising, but the magnitude is disturbing.

Monthly indicators
As the third quarter begins, revisions to the first quarter data are less informative than monthly data, which reflect how the second quarter has been unfolding. Unfortunately, the story they tell is bleak. Personal consumption fell in March and then just inched upward in April and May. Over the three months it grew at only a 0.4% annual rate. There may be some bounce in June from lower gas prices, but probably not much. Auto sales did move back above a 14 million rate in June, but retail sales data from large chains were mostly disappointing. Even falling gas prices didn’t improve consumer sentiment. Consumer confidence fell in June for the fourth straight month, as did their expectations. The latter is down 18% since February, the former by 13%.

On the business side, after solid gains during December through February, industrial production fell in March and again in May, before improving modestly in June. The ISM reports for June were both weaker than expected. Their manufacturing sector reading dropped into contraction territory at just 49.7, down nearly four points from May and over five points from its most recent peak in April. The non-manufacturing index is also down over five points from its February peak, although at 52.1 it still indicates expansion.

Finally, the most recent report on the labor market was again dismal. Total employment in June rose by only 80 thousand, the third month in a row well below the 125 thousand or so needed just to keep up with normal labor force growth. Almost a third of the increase was in temporary workers. Sometimes, increases in temps can be a prelude to permanent hiring, but it is always a sign of hesitancy by business. There were a few positive scraps in the payroll report – average hours worked ticked up, as did average hourly earnings – but overall mostly more bad news. The household survey was only a little better. Unemployment held steady at 8.2%, but there was some labor force growth, and the household measure of employment rose by 128 thousand.

Outlook
All this downbeat news has had a negative effect on our forecast out through next year. For the just completed second quarter we now expect growth to be below 2.0%. The major source of change is a reduction in our expectation for growth in exports both near-term and through 2013. For all of 2012 we now put growth at just 2.1%.

Moreover, we feel that there is significantly more downside than upside risk in the current situation. We don’t see the latest news from Europe as containing much fundamental change. A deterioration of the situation there could push U.S. growth down to very close to zero. Combine that with a “fiscal cliff” game of chicken or with problems in China, and renewed recession next year is quite conceivable.

Our GDP forecast calls for slow improvement over the next few years. GDP dropped 3.5% in 2009 and rebounded 3.0% in 2010. Growth slowed in 2011 to just 1.7%. We expect to see a small improvement in growth to 2.1% in 2012 with further gains of 2.2% in 2013 and 2.8% in 2014. All three years of this forecast are below the historical average for the U.S. economy.

Risks
As stated above we believe that our baseline forecast has more risk to the downside than the upside. Our baseline forecast is that the U.S. economy will continue to muddle through the next year. The downside represents mainly the possibility of a negative shock – there is currently no indication of a specific industry or event that would lead to a better economic outcome.

The list of potential negative shocks includes the same suspects as in recent months. The probability of one of these occurring has increased over the last couple of months. These events cannot be ignored:

1. Euroland collapse
2. Middle East (Oil or Syria – take your pick)
3. Chinese slowdown (not a near-term issue)
4. U.S. political/policy meltdown.

We believe that the European situation is most likely to be a muddled affair, but they will do all they can to stave off an economic collapse. That should help keep us out of recession but does not indicate stronger growth for our export numbers. In fact, the Euro-zone is in recession and that is a big constraint on our export sectors.

We assign a probability to the main economic scenarios to highlight where your concerns and efforts should be most concentrated. Once more, our downside potential increased this month at the expense of the base forecast. We have broken out the possibility of a recession since it is now a reasonable outcome. We are still confident in our moderate growth outlook for 2012, but the headwinds continue to gather additional steam. Below are our current thoughts. Note that there is now a greater than 1-in-4 chance of seeing slower growth:

• Stronger Growth (GDP better than 3%): 10% probability
• Current Forecast (GDP between 2% – 3%): 55% probability
• No Growth (GDP under 1%): 25% probability
• Recession (GDP under 0%): 10% probability