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Wednesday, January 17, 2007

The US Economy In Perspective

by Edward Hugh : Barcelona

The future of the US economy is a topic which is the focus of considerable debate these days, what with all the talk of hard and soft landings, customers of last resort, global uncoupling etc etc etc. In part Claus Vistesen has addressed some of the underlying structural issues in the previous post, and in part, as Stephen Roach suggests in this post earlier in the week, the future outlook for the US economy is in large measure also a question of whither the global economy, in the rather novel sense that growth in the US now depends to some significant extent on economic performance elsewhere. Indeed it is perhaps the central message of this forum that global conditions now influence national economic performance to a greater extent than has ever been the case in the past.

That being said, there is also some considerable value to be found in examining the evolution of the US economy in its own terms, to try and get a measure of where exactly it is headed, and what the general outlook for 2007 is likely to be. This is the topic I will directly address in this post, whilst a subsequent post will examine the underlying dynamic of housing, the labor market and productivity, which are arguably the three fundamental drivers of the forward path of the US economy.

With this objective in mind Ted Wiesman's Monday post on the MS GEF certainly forms a useful starting point (United States Review and Preview). Weiseman's response to the question “Is the US ‘Growth Recession’ Ending?” would appear to be an unequivocal yes, it is. In support of this view he fields a fairly impressive collection of data, ranging from last week's significantly better-than-expected international trade and retail sales reports, to a possible bottoming-out in the inventory cycle, a greatly reduced level of energy prices, and even a comparatively mild winter.

In fact the US trade balance narrowed in November from US$58.8 billion in October to US$58.2 billion, a figure which was a 16-month low, and tucked away in the data is the rather interesting detail that exports (+0.9%) increased significantly faster than imports (+0.3%). This improvement in the trade balance will, of course, impact positively on 4th quarter 2006 GDP.

At the same time retail sales have been improving, gaining 0.9% in December (with auto sales rising 0.3% and ex-auto sales rising 1.0%). Part of the picture here was a 3.8% increase in spending at petrol stations, but the general picture was also positive with sales at electronics stores rising 3.0%, general merchandise 0.9%, restaurants 2.3%, drug stores 1.2%, and furniture stores 0.7%. So there is clearly life left in the US consumer yet awhile.

The important question of course is the sustainability of this trend into the future,and here two issues loom large: housing and energy costs. On the housing front a considerable debate continues to rage. The pessimists take the view that the problem is just beginning, whilst the optimists would like to have us believe that the worst is nearly over (Dave Altig reproduces the data from the Case-Schiller Home Price Index which, as he says, does seem to offer some confirmation for the more optimistic view). Most commentators, however, do continue to point to the high level of uncertainty in this area, and I tend to concur. The incoming data are mixed, and some measures certainly suggest that the housing market is bottoming out, while others do nothing to ease the concern that another downward leg may be yet to come.

We do know that in the final months of 2006 demand for housing started to level out. Mortgage applications - for example - as measured by the Mortgage Bankers Association index, picked up both for purchases and refinancing. New-home sales, on the other hand simply stabilized, inching up from an annualized rate of 979,000 in July to 1,047,000 in November. Even if demand does remain stable at current levels, both construction and house prices could face continued weakness because of the large overhang of unsold homes - which were at a level of 6.3 months of sales for new homes in November (and this figure could yet rise if their are subsequent cancellations).

The November data indicated an uptick in home starts, but new permits continued to decline. This suggests home starts may well weaken once more after the effects of unseasonably good weather disappear. House prices may well stabilize nationwide in 2007, but the aggregate figure may mask substantial variance in local markets and in the sub-prime market, which caters to marginal buyers. Nouriel Roubini has been consistently flagging the subprime end of the picture, and the problems that this may pose should not be underestimated. Delinquency rates on subprime mortgages have already shot up, and credit spreads on sub-prime mortgage pools have widened considerably.

At the end of the day two factors seem to be important here, the inbuilt upcoming demand, and the future path of interest rates. I will comment on the former in my next post, but as regards the latter there does not seem to be any strong reason to expect any sudden and dramatic change in interest rates. Most observers seem to feel that the Fed will now be on hold for the foreseeable future, with the balance of probabilities leaning in favour of an eventual reduction rather than an increase, and of course should the housing market reveal an increased weakness in the coming quarter, the Fed does have considerable room to maneuver if it needs to try and put a floor under the market. Obviously the inflation picture is the one obvious obstacle to freedom of action on this front, but I am not especially pessimistic in this regard. Clearly global conditions will play a part in this regard, but todays decision from the bank of Japan to keep rates on hold gives us one indication of the way the wind is blowing, and as Claus and I will be arguing, there are strong reasons to think that the ECB may be nowhere near as aggressive in raising as some comentators have been imagining.

Clearly another key factor in the situation is the future path of oil prices. Today we learn that the rate of consumer inflation in the US increased for the first time since the summer (also see here) as the consumer price index rose 0.5%, driven, significantly enough, by a rise of 4.6% in energy prices. Oil futures have been falling systematically throughout the second half of 2006 driven by the expectation for rather weaker global growth in 2007, but the most recent estimates (see the IMF view here) suggest that things may not be as weak as had originally been thought (although downside surprises in both Japan and some parts of Europe may be in store, even if China and India and other emerging markets may surprise on the upside) and were this impression to be confirmed then there would obviously be a further upward pressure on oil prices which would have implications for both the US trade balance and for the US CPI.

As to the future course of oil prices things again are far from clear. Richard Berner takes (as is his normal want) the rather optimistic view that prices will be rather more resilient to upswings this time round due to the relative increase in supply capacity, but how robust this will prove to be should global economic growth remain strong throught the year really remains to be seen. And of course, we are still very vulnerable to supply shocks with geopolitical risk being as much in the forefront as ever. Serhan Cevik had a timely piece on the GEF yesterday on the risk of instability which centres on things in Iraq (and in particular, though he doesn't mention this explicitly even if it can't be far from his mind, in Turkey and Kurdistan). At the same time Nigeria is a problem which may well just be waiting to draw itself to everyone's attention).

So all in all a complex picture moving forward with lots of room for uncertainty. At this stage, barring the observation that it seems rather unlikely that the US economy is recession bound in the short term I will refrain from any explicit 2007 growth forecast, there is just too much noise in the data to be comfortable with doing this, and there are plenty of reasons for imagining that we may well have a year in front of us which is well and truly stacked full of surprises.