U.S. Review
The Mid Point In Many Ways
We are now roughly halfway through 2008 and the economic environment has proved to be much more trying than was expected six months ago. While the economy has technically avoided sliding into recession, consumers clearly feel the economy is in deep trouble. Consumer confidence has plummeted and future expectations are at the lowest level we have seen since the Carter presidency.
Whether or not the economy will be able to avoid a recession will have a lot to do with what happens to energy prices. Soaring oil prices are rapidly bringing the economy to the breaking point. At this writing, oil is at $140 a barrel. The recent spike in energy prices has not yet been fully reflected in gasoline prices, which have already topped $4 a gallon.
Consumers have responded to higher gasoline prices by driving less, buying fewer SUVS and large vehicles, and cutting back spending in general. The rebate checks are buying the economy some time, but the rebates will not last forever. Underlying income growth is not strong enough to offset the pain at the gasoline pump.
Rebates Buy The Economy Some Time
Tax rebates provided a huge boost to personal income in May. The Economic Stimulus Act of 2008 boosted personal current transfer receipts by $179.6 billion at an annual rate in May and by a $7.8 billion annual rate in April. The increase reflects payments to individuals who either paid no income tax or whose payment exceeded the amount of income tax paid. The BEA treats these payments as a government social benefit payment. For these individuals the tax rebates truly represent found money. No wonder spending was so much stronger than expected during May.
Consumer spending rose solidly in May, climbing 0.8 percent in nominal terms and 0.4 percent after adjusting for inflation. Nearly all the increase was in outlays for nondurable goods and services, which each increased 0.4 percent. Spending on big-ticket items inched up 0.1 percent, with the gain likely occurring on home electronics. Motor vehicle sales are widely reported to have weakened during the month, another victim of soaring energy prices. With the May increase, consumer spending looks as though it will rise at a 2.5 percent pace during the second quarter. Such an increase should be sufficient enough to keep real GDP growth in positive territory. Our current point estimate is around 2.0 percent.
The good news is that we still have a little more than half of the tax rebates to be played out in the income and spending data. As a result, there is a real good probability that real GDP will remain in positive territory as well. The bad news is that the government can't keep sending out rebate checks indefinitely. Once the rebates end, spending will be driven by wage and salary growth, which has slowed tremendously and is no longer sufficient to cover the soaring costs of gasoline. If oil prices do not drop soon, then real GDP will likely slip into negative territory in the fourth quarter and the outlook for 2009 will have to be scaled back considerably.
Consumers appear to have already scaled back their view on current and future economic conditions. The Conference Board's Consumer Confidence Index declined 7.7 points to 50.4 in May, and expectations for economic conditions six months from now fell 6.3 points to 41.0, which is the lowest level since the Carter presidency. The weakness in consumer confidence reflects deteriorating labor market conditions and frustration over soaring energy prices. The number of households reporting that jobs remain plentiful fell 2 points to 14.1 percent, while the number reporting that jobs are hard to get rose 2.2 points to 30.5. The weakening in labor market conditions raises a warning flag for next week's job report.
U.S. Outlook
ISM Manufacturing Index • Tuesday
Remaining below the expansion/contraction line for the fourth straight month, the Institute for Supply Management's headline manufacturing index recorded a reading of 49.6 as the current domestic economic weakness has limited recovery in the manufacturing sector.
Regional purchasing managers' surveys suggest weakness will continue in June. Both the Empire State and Philadelphia Fed indices recorded lower readings this month, particularly from new orders activity. Higher energy prices will continue to pressure the prices paid index and may eclipse the recent April 2004 peak.
Export activity remains solid on dollar weakness and global growth. While the manufacturing sector certainly has its issues, the sector on whole is holding up relatively well during this economic slowdown.
Previous: 49.6 Wachovia: 48.6
Consensus: 49.0
Motor Vehicle Sales • Tuesday
The seasonally adjusted annual sales rate of total motor vehicle sales slipped to a 10-year low in May at 14.3 million units. As gasoline prices continue to climb, consumers' preferences towards fuel efficient cars and away from gas-thirsty trucks and SUVs has continued to accelerate in recent months. That trend should continue going forward as gasoline prices appear set to climb even higher given global demand and supply concerns.
Surveys suggest consumers remain wary about big-ticket purchases amid today's weak economy. While automakers are likely to increase incentives to grab their fair share of the tax rebate checks, we anticipate auto and light truck sales will continue to remain weak in the coming months as lenders remain restrictive on credit standards.
Previous: 14.3M Wachovia: 14.4M
Consensus: 14.2M
Employment Report • Thursday
Falling for the fifth consecutive month, nonfarm payrolls declined 49K in May. What caught everyone off guard was the half percentage point jump in the unemployment rate to 5.5 percent – the largest one month jump since October 1986. Much of the deterioration came from the 16-19 year old group which could be a seasonal adjustment issue as college students transitioned from school to work.
Another monthly decline is expected in June as initial insurance claims remain elevated. The usual suspects (construction, financial and manufacturing) will continue to show further weakness. We do not suspect the Midwest floods will have a significant impact on the June report but could negatively impact the July employment report. While we expect the unemployment rate to trend towards 6 percent over the coming quarters, we anticipate a short-term pullback in June.
Previous: -49K Wachovia: -75K
Consensus: -55K
Global Review
Euro-zone: Slower Growth, But Higher Rates
Recent economic data in the Euro-zone point in the direction of slower growth. The Ifo index of German business sentiment, which is highly correlated with growth in German industrial production, dropped to a 30-month low in June (see chart at the left). In addition, the purchasing managers' indices for the manufacturing and service sectors in the broader Euro-zone slipped to multi-year lows in June (see top chart on page 4). Although neither the Ifo index nor the PMI's are yet in territory that is consistent with recession, the indicators suggest real GDP growth in the Euro-zone has slowed significantly from the 3.0 percent annualized rate that was registered in the first quarter.
Despite signs of slower growth, most investors expect the European Central Bank (ECB) will hike rates by 25 basis points at its policy meeting next Thursday. Why?
Quite simply, the inflation-conscious ECB seems willing to send a signal that higher inflation will not be tolerated. That is, the ECB, which has the sole mandate to maintain price stability, would rather risk a period of sub-par economic growth, which eventually would lead to lower inflation, than allow inflation to remain at current levels.
As shown in the middle chart, CPI inflation in the Euro-zone has shot up to 3.7 percent. Not only is the current reading the highest year-over-year rate of CPI inflation since European Monetary Union commenced in 1999, but it is well above the 2 percent rate the ECB considers to be consistent with price stability. True, most of the increase in the overall CPI inflation rate is due to the sharp increase in petroleum prices, which the ECB is powerless to control. As the graph makes clear, core CPI inflation has been rather steady since the beginning of 2007. However, the ECB is concerned that the high rate of overall inflation could lead to wage acceleration in the present environment of tight labor markets. (Unemployment in many Euro-zone countries has dropped to the lowest rate in decades.) If wages accelerate, core inflation is sure to follow.
If, as is expected, the ECB raises rates next week, won't the euro strengthen significantly? No, at least not in theory, because the expected rate hike has already been discounted in the euro's price. That said, the euro could certainly strengthen if ECB President Trichet suggests in his post-meeting press conference that more rate hikes are on the way.
A few weeks ago Fed Chairman Bernanke said “we are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations”, and Treasury Secretary Paulson continues to state the United States supports a strong dollar. In our view, these statements are a hint the U.S. government is seriously considering intervention in the foreign exchange market, which it has eschewed for nearly 8 years, if the dollar should weaken significantly further. Moreover, Fed intervention likely would be joined by the ECB as well because a weaker dollar could cause oil prices to rise even further, which is clearly not in the Euro-zone's interest. If the euro should make a run at its all-time high against the dollar, the probability of coordinated intervention to put a floor under the greenback would rise.
Global Outlook
Japanese Tankan Index •Tuesday
The Tankan index, which is a quarterly survey of business sentiment conducted by the Bank of Japan, is widely watched by investors because it is highly correlated with Japan real GDP growth. If the index fell sharply in June, as the consensus forecast anticipates, then it seems reasonable to assume the pace of economic growth downshifted markedly in the second quarter. Indeed, we estimate that real GDP in the current quarter will be essentially flat relative to the first quarter.
In addition to the index of sentiment among large manufacturers, which is the focus of many investors, the Tankan survey contains a treasure trove of data on current Japanese economic conditions that will help analysts forecast the near-term direction of the Japanese economy.
Previous: 11
Consensus: 3
U.K. Manufacturing PMI •Tuesday
Indicators on the present state of the British economy will become available when the purchasing managers' indices for June are released. The manufacturing PMI prints on Tuesday, the construction PMI, which has plunged sharply this year, comes out on Wednesday, and the service sector PMI is slated for release on Thursday. It is likely that each index edged lower in June, suggesting that economic growth slipped further.
The housing market in the United Kingdom has weakened recently, so investors will be very interested in data on mortgage approvals and house prices that will print next week. Recent trends suggest that the housing market will weaken further in the months ahead.
Previous: 50.00
Consensus:
ECB Policy Rate • Thursday
As discussed in the main body of the text, the European Central Bank is widely expected to hike rates at its policy meeting on Thursday. The ECB's hand could possibly be stayed, however, if preliminary data that are slated for release on Monday show a big decline in CPI inflation in June, which does not seem very likely. Data on the Euro-zone unemployment rate in May will print on Tuesday.
Some important economic data in Germany are also on the docket next week including retail sales in May (Monday), the unemployment rate in June (Tuesday) and factory orders in May (Friday). Will these data releases confirm other signs of slower growth in Germany? If so, a series of ECB rate hikes would become less likely.
Current Rate: 4.00% Wachovia: 4.25%
Consensus: 4.25%
Point of View
Fed Leaves Funds Rate Unchanged in Midst of Economic Uncertainty
In an uncertain economic sea the Fed struck its sails and went neutral. Economic fundamentals on growth, inflation, and credit markets suggest a high degree of sensitivity to the next set of indicators. At this razor's edge the call for bold action appears too risky -- better to wait for a clearer vision of the horizon. Looking ahead, we also expect the Federal Reserve to maintain the current two percent Federal funds target at the August and September meetings.
Expectations on Growth and Inflation
Below trend economic growth is our expectation for the rest of this year. While rebates will temporarily boost consumer spending in the third quarter, we expect growth of one to two percent for the next three quarters. Any strength will come from exports and federal government spending. Meanwhile, inflation, as measured by the core PCE deflator, is expected to remain above the Federal Reserve's perceived two percent target ceiling. Therefore, the balance of the growth/inflation outlook suggests that the Federal Reserve will remain on hold for the rest of this year.
Wild Cards: Repairing Credit Markets, the Dollar and Deficits
Three wild cards reinforce the expectation for the Fed to remain cautious on policy. First, credit markets have improved and yet the extent of that improvement remains very sensitive to perceptions of quality in the capital markets. For the dollar, we expect the dollar to appreciate against both the Euro and the British pound but the forecast is highly uncertain.
Meanwhile slower income and profit growth in the U.S. suggest higher federal budget deficits the next two years.
Topic of the Week
High Gas Prices Hurting Auto Sales
As economic uncertainty and rising gas prices continue to strain household budgets, consumers are struggling to find ways to get by. One increasingly popular change is to trade in gas guzzling SUVs for more fuel efficient passenger cars. Automobiles now have a higher market share than trucks for the first time since 2001. Driving habits are also changing and many consumers are consolidating trips, driving less, and turning to mass transportation. As cost conscious consumers look for alternatives, auto sales will continue to weaken with domestic manufacturers feeling most of the pressure. We expect light vehicle sales to moderate further to just under a 15 million unit pace in 2008.
Declines in motor vehicle sales are fairly common during recessions, reflecting slower income growth, increased concerns about job security, and tighter credit conditions. During downturns, consumers pullback on spending for discretionary items and reallocate more dollars to necessities. Big ticket items, like vehicles, are typically the hardest hit. Spending thousands of dollars or obligating yourself to years of monthly payments is the last thing you want to do if you are worried about your job. Instead, consumers are choosing to maintain their existing vehicles. In other words, in recessions, durable goods become more durable.
The consumer is still navigating through major headwinds including a negative wealth effect resulting from the housing slump, a volatile stock market, rising energy and food costs, a tight credit environment, and a weak job market. In this kind of environment, consumers are being extremely cautious. For more, read our special report on auto sales.
Wachovia Corporation
http://www.wachovia.com
Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.
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