Economic Commentaries

06

In recent weeks we revised our range for GDP growth from 1.5%-2.0% to 1% - 2% annually. It appears that growth in the spring quarter will be at the lower end of this range. We always thought the earlier consensus expectation of 2% -2.5% growth was too optimistic, and similarly we think a recession forecast at this juncture is too premature. However, in our view the risks continue to be on the downside and the prospect of an outright decline in business activity is a toss-up.

Guarded optimism is warranted for three reasons in our view. First, it appears that a nascent recovery in residential construction is building some momentum. Homebuilder confidence rose sharply in June as did buyer traffic. And this was during a month when the weather was very hot and consumer confidence was very cold.

Affordability, evidence of home price stability, rising rents, and an improving supply-demand balance are key drivers. Housing starts rose nicely in the spring quarter and residential construction is becoming a key contributor to the paltry economic growth that exists. In line with this, while June was the weakest month of the spring quarter for the overall economy, real earnings actually rose. This was because of declining inflation and not wage increases, but you take whatever you can get. The rise in real earnings was complemented by a rise in the saving rate, so the hope is that these can buffer consumption in coming months. Maybe the back to school selling season will be better than expected.

Finally, Central Banks worldwide will continue to pursue aggressive accommodation which should support asset prices. Additionally we think there will be an effort to pull income into 2012 in an effort to avoid the consequences of the possible expiration of the current tax law as well as the actual tax increases that will go into effect to finance the Affordable Care Act. Some of this income pull should find its way into the spending stream.

These are admittedly not very strong positives and the headwinds are formidable. European sovereign problems will continue to weigh and the European wide recession will continue hurting exports from the U.S. and Asia. Weakening export demand from Asia and the U.S. in turn creates a negative feed back loop on imports into these areas. These are restraining capital investment which also being adversely affected by uncertainties surrounding forthcoming tax law.

Domestically the labor market is weak and recent surveys are suggesting there is an increasing rather than decreasing reluctance to hire. This partially reflects weak demand, but it also reflects the uncertainty surrounding the coming fiscal train wreck (cliff) and the increased cost associated with health care reform. Our fear is that a continually weakening labor market will short circuit the housing recovery. The economy can ill afford this since hitherto strong sectors like energy and agriculture are weakening. A draught is devastating farm income throughout the Midwest and the rig count is down in response to the past several months' weakness in oil and gas prices.

To us it seems the economy is on a knife's edge. If it tips over into recession, the recession will be made much worse if the economy goes over the fiscal cliff of tax law expiration and spending reduction. If a weak economy causes lawmakers to extend current tax law and forego spending restraint, the federal budget deficit will explode and the possibility of a second debt downgrade becomes a distinct possibility. Its a fine fix in which we find ourselves.

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