U.S. macro outlook: Watch for second half headwinds

As the calendar approaches the mid-year mark, the economy through the first half appears on track to exceed earlier expectations, thanks to increased spending by consumers and the willingness of businesses to build inventories and invest in new equipment and software. But headwinds are on the horizon, including the end of the stimulus program, stubbornly weak housing markets, and persistently high unemployment.

As the calendar approaches the mid-year mark, the economy through the first half appears on track to exceed earlier expectations, thanks to increased spending by consumers and the willingness of businesses to build inventories and invest in new equipment and software. But headwinds are on the horizon, including the end of the stimulus program, stubbornly weak housing markets, and persistently high unemployment.

GDP on modest growth path

The latest forecast for inflation-adjusted growth in the nation's Gross Domestic Product (GDP) is consistent with the subdued gains seen in our most recent recessions, 1991 and 2001. GDP is projected to increase by 3.5 percent in 2010 and by a more modest 3.0 percent in 2011.

The current outlook is actually somewhat stronger than the recovery periods after the 1991 and 2001 recessions. After falling by 0.2 percent in 1991, GDP rose by 3.4 percent in 1992 and downshifted to 2.9 percent in 1993. Following the recession year of 2001, GDP grew by only 1.8 percent in 2002 and 2.5 percent in 2003.

Although 2010 growth of 3.5 percent would represent a 5 percentage point swing over the 2.4 percent decline in 2009, the expected increase is well below the growth rates posted in the first recovery year after other severe drops in GDP. In 1976, GDP jumped by 5.4 percent, following two years of decline. In 1983, GDP was up by 4.5 percent on the heels of a 1.9 percent downturn in the previous year.

Beating earlier expectations

While growth in the 3.0 percent range is not spectacular, it would be an improvement over earlier projections made at the beginning of the year. In January of 2010, the consensus among economists was that GDP would be up by less than 3.0 percent for the year, due to the absence of private sector spending strength. Among the developments pushing up more recent GDP forecasts are the following:

1. Consumers unexpectedly loosened their purse strings in the first quarter and fears of a "new normal" marked by increasing frugality began to abate. Spending in Q1 increased by 3.5 percent (the largest gain in three years) as the savings rate fell from 3.7 percent in January to 3.1 percent in March.
2. Businesses have been slow to add workers, but are pushing ahead to modernize equipment and software. Such spending grew by 12.7 percent in the first quarter, continuing the double-digit growth (19.0 percent) of Q4 2009.
3. Rebuilding of inventories and increased exports led to three consecutive quarterly gains in industrial production, after five quarters of decline during the gloomiest part of the recession.

Second half headwinds

Moving into the second half of 2010, analysts are waiting to evaluate the impact of reduced spending from the Federal stimulus program, as well as a slowing down of additions to inventories. These are only two factors of several that raise questions about the strength of the economy in the next few months. Some of the potential drags on growth in the second half are listed below:

1. If government transfer payments are netted out, personal income is barely growing at all. With reduced stimulus support, a healthy private sector is needed to boost consumer spending. But the latest monthly jobs report showed only 41,000 new private jobs and over 400,000 Census jobs. If labor markets don't improve in the second half, with private job creation and even minimal reductions in unemployment rates, consumer confidence and spending will be undermined. The consumer saving rate in April was back up to 3.6 percent and personal consumption showed no real growth.
2. The housing market is a negative, rather than a positive force for the economy. Single-family housing starts fell in May by nearly 100,000 units (from 565,000 to 468,000), after several months of gains. Further, home prices are now expected to fall by 3-5 percent this year, a reversal of the gains in 2009. Housing markets cannot recover until prices stabilize. And consumers will be reluctant to spend on big ticket items while their personal housing wealth is deteriorating.
3. Exports contributed strongly to GDP growth in the first quarter, but the rising value of the dollar means that U.S. goods will be less competitive in global markets in the months ahead.

But indicators are a mixed bag

As always, the indicators available to analysts make up what at one time was called "a mixed bag." To be sure, there are some emerging bright spots in the economy. Hours worked are up, even if job creation is not surging, and this means paychecks are growing larger, which should spur consumer spending. The downturn in nonresidential construction may not be as severe as expected.

Spending on nonresidential structures is projected to be up in the current quarter, due to increases in energy-related building (for electric, oil and gas), mining structures, and manufacturing. While a double dip (negative quarter of GDP growth) is not expected, the headwinds on the horizon suggest that the second half is likely to bring weaker gains than seen in the first two quarters of 2010.