Tuesday, June 14, 2011

Key Question: Is the slowdown temporary?

by Bill McBride on 6/14/2011 12:18:00 PM

The recent economic data indicated a slowdown in May: only 54,000 payroll jobs were added, auto sales declined significantly, retail sales were sluggish even excluding autos, growth in manufacturing slowed sharply, house prices continued to decline to new post-bubble lows (as of March), and home sales slowed.

This raises a key question: Is the recent economic slowdown temporary or is the U.S. heading into a "double dip" recession?

Some of the recent slowdown was related to the tragic events in Japan that started with the earthquake on March 11th. These events impacted the supply chain, especially for the automakers, and these disruptions negatively impacted manufacturing output in the U.S.

Also the sharp increase in oil and gasoline prices - partially attributable to events in the Middle East and North Africa - has impacted consumer sentiment and retail spending. Oil and gasoline prices have fallen in recent weeks, but are still up sharply from the end of 2010. (WTI futures averaged $85 per barrel in Q4 2010 and are now at $98 per barrel).

A third possible temporary impact has been the severe weather this year. Although there is always severe weather somewhere, the weather has been especially extreme this year from the massive snowstorms in the east, to the recent flooding along the Mississippi river.

But are these impacts temporary?

The supply chain disruptions are clearly temporary, and the good news is the supply issues are being resolved ahead of schedule. From Edmunds.com:

“Manufacturing disruptions appear to have peaked in April and May, and recent news points to steady improvements moving forward,” said Lacey Plache, chief economist at Edmunds.com. “Toyota said it expects North American production of its top-selling Camry and Corolla models to be back at 100 percent [in June], and Nissan’s key engine plant in Japan is returning to full production [in May]. Even Honda, which was the hardest hit of the big three Japanese automakers, is making optimistic statements about its recovery."
Also the recent decline in oil and gasoline prices will help, although $100 oil is still a drag on the economy. The weather is unpredictable, but hopefully it will be less severe.

There are also several other ongoing drags on the economy. These include:

• Less Federal stimulus spending in 2011. The American Recovery and Reinvestment Act of 2009 (ARRA) is winding down, and will be a drag on GDP growth.

• The ongoing cuts in state and local spending.

• The festering financial crisis in Europe. Although the direct impact on U.S. trade would be minimal, there could be a significant financial impact on the U.S. if Greece (and other countries) default.

• The slowdown in China impacting U.S. exports.

• Another downturn in house prices.

Note: Since it appears that most of the impact from QE2 is due to the stock effect (as opposed to flow), the end of the buying program will probably have little impact on the economy.

And of course this is all on top of the generally fragile economy. My general outlook since mid-2009 has been for a sluggish and choppy recovery. Usually the deeper the recession, the steeper the recovery - however recoveries following a credit bubble-financial crisis tend to be sluggish.

There is still too much excess capacity in most of the economy for a large contribution from new investment (except in equipment and software). We see this excess capacity in housing, and in overall industrial production. As an example, domestic auto production is still only about 2/3 the level of 2006 - so there is no need to expand production. There is also excess capacity in office space, retail space, and other categories of commercial real estate. In addition, household debt, as a percent of income, remains very high and household deleveraging is ongoing.

Of course a sluggish recovery following a financial crisis is not unusual. From "The Aftermath of Financial Crises", Reinhart and Rogoff, 2009:
"An examination of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. ... Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt."
To answer the key question we need to distinguish between the impact of these short terms issues (supply chain disruption, oil prices, weather), and the ongoing drags.

Although we can try to model the impact, it is hard to separate out the various factors. Note: Cleveland Fed economist Kenneth Beauchemin argues that "the shocks we experienced in the first quarter of 2011 have had measurable effects on both economic activity and consumer price inflation. However, as long as energy and other commodity prices do not continue to rise sharply, these effects are likely to be temporary and modest." See: Shocks and the Economic Outlook

I think the data will help us over the next month or two. If the impact was temporary, auto sales and manufacturing should rebound by July. If there are more severe issues, the weakness will persist.

We have to also remember that Residential Investment (RI) will probably make a positive contribution to the economy this year, for the first time since 2005. The five years of drag on GDP from RI (2006 through 2010) is the longest period on record, breaking the previous record of four years from 1930 to 1933. The positive contribution this year will mostly be due to a pickup in multifamily construction (apartments) and in home improvement. Of course single family housing starts will continue to struggle.

Since RI is the best leading indicator for the economy, I think a pickup in RI suggests the recovery will continue. This isn't perfect - nothing is - but RI is usually a strong leading indicator for the business cycle.

So for now I'll stick with my general forecast for 2011: growth will remain sluggish, but I expect 2011 to be better than 2010 for both employment and GDP growth.

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