CONTOS AMERICANOS - 2007, 2º. Semestre

The U.S. Growth Weakness Will Persist in the Second Half of 2007...And Financial Markets Are Signaling a Credit Crunch Ahead Nouriel Roubini Jul 26, 2007 http://www.rgemonitor.com/blog/roubini

The first estimate of US Q2 GDP growth will be out tomorrow Friday. After a dismal "growth recession" in Q1 (0.7%) Q2 growth is expected by the consensus to recover towards 3% (plus or minus a 0.3%) as net exports, inventories and capex spending may have partially recovered in Q2 in spite of a sharp slowdown of private consumption and a continued severe housing recession. Even if Q2 growth were to turn out to be around 3% the average for Q1 and Q2 would be a mediocre and weak 1.8%, well below potential growth.

But since we are already in Q3 the main issue is now what will growth be in the second half of 2007. I see many elements of economic weakness ahead.

First, the housing recession is getting worse, rather than better. Thus, housing will continue to be a significantly negative contributor to growth. I predicted a year ago this will be the worst US housing recession in the last five decades and that real home prices will sharply fall for three years: all indicators on housing - including the latest new and exisiting home sales - suggest that the housing recession is extremely severe as sharply worsening. Also, home prices are falling and expected to fall throughout 2008. For the first time since the Great Depression of the 1930s home prices will fall this year at the national level on a year over year basis. And the glut of unsold new and existing homes will worsen well into 2008 as: demand from potential subprime borrowers sharply falls given the credit crunch in mortgages; rising foreclosures will increase the excess supply of homes in the market; $1.5 trillion of resetting ARMs will lead many homeowners under stress to sell their homes; condo-flippers and others who bought homes for speculative reasons will dump them in a falling market to minimize their capital losses.

Second, as discussed in much more detail in a previous blog of mine, private consumption (representing 70% of GDP) is likely to grow very slowly in H2 continuing its Q2 slowdown. Weakness in private consumption will be driven by a consumer that is saving-less and debt burdened and who is experiencing rising oil and gasoline prices, falling home values (as home prices are falling), falling home equity withdrawal, a credit crunch in the mortgage market, rising consumer interest rates, falling consumer confidence and a weaker labor market than what the official numbers suggest. Indeed, recent data on weekly chain store retail sales in July suggest that the softness of retail sales in June is persisting in July with sales falling in the latest reporting week. Thus, I expect that real private consumption will grow less than 2% in H2.

Third, real investment (in software and equipment) by the private sector will remain weak. The alleged recovery of capex spending in Q2 - after a dismal Q4 2006 and Q1 2007 - is fizzling out: today's figure on capital goods order - falling in June for a second month in a row - suggest that even in Q2 the alleged recovery in corporate capital investment was more modest than the consensus expected. And with housing, the auto sector and several other housing-related sectors already in a recession, it is highly unlikely that capex spending will be strong in H2. Why should firm invest a lot if final consumption demand is slowing down?

Fourth, accumulation of inventories will provide a boost to growth in Q2 but they are likely to be a drag on growth in H2. Inventories can go up for two reasons, one positive and one negative. On the positive side, if firms are optimistic about future sales/demand they may accelerate output/production above demand to build inventories for future sales. But if demand is unexpectedly slowing below production, the built up of unsold inventories is bad news as it signals lower demand ahead and the need to cut production ahead. Thus, if I am correct that private consumption, housing and capex spending will be weak in H2, the current accumulation of inventories signals a build up of unsold goods that will trigger output adjustment and a reduction of inventories in H2.

Fifth, net exports are not likely to be - unlike Q2 - a positive contributor to growth in H2. With oil prices rising and expected to remain high for the rest of 2007, the improvement in the real trabe balance due to a weaker dollar may be swamped by high oil and other commodity prices increasing the import bill.

Sixth, government consumption of goods and services is rising only modestly; thus its positive contribution to growth will be modest in H2.

Add to these weaknesses in aggregate demand the significant worsening in US financial conditions: a credit crunch in subprime that is now spreading to near prime and prime mortgages; massive losses - at least $100b in subprime alone - in mortgage markets; a significant recent increase in corporate yield spreads; the beginning of a liquidity crunch in capital markets that starts to look like the one experienced during the LTCM crisis (swap spreads are at 70bps, at their highest levels since 2002 and close to the levels that triggered the 1998 LTCM crisis); the shut down of the CDO market as investors risk aversion towards complex derivative instruments - whose official ratings are clearly bogus given the subprime ratings debacle - is sharply up; dozens of LBO deals now in serious trouble as the credit crunch is spreading to the leveraged loans and LBO market; and the overall increasing stresses in a variety of credit markets ("a constipated owl" where "absolutely nothing is moving" is how Bill Gross of Pimco described the effective recent shutdown of the CDO market); credit default swap spreads are sharply up; the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all show rising risk aversion of investors, sharply rising credit default spreads and significant concerns about credit risk in a variety of credit markets (US and Europe corporate, high yield corporate, commercial real estate, leveraged loans), not just in subprime or in mortgage markets. Thus, the real economy and the main components of aggregate demand are likely to slow down or fall in H2. And the financial conditions are suggesting - even given unchanged Fed policy - a significant tightening in financial conditions as we are starting to see the beginning of a generalized credit crunch in a variety of financial markets, not just in subprime mortgages. Thus, the weak average economic growth of the first half of 2007 is likely to persist - or more likely weaken further - in the second half of the year. The most likely scenario is one of a "growth recession" for the rest of 2007.

Friday Morning Update: The first estimate of Q2 GDP growth - at 3.4% - confirmed what I said yesterday. Private consumption growth actually slowed down even more than any analyst and myself expected: at 1.3% growth the US consumer is at a tipping point bombarded by high oil prices, falling housing values, sharply lower mortgage equity withdrawal, and the beginning of a credit crunch. Consumption is entering H2 with even stronger headwinds than in Q2; thus consumption growth in H2 could weaken further. In Q2 capex investment in software and equipment was mediocre and anemic (2.3%) and it will get worse in H2 given the tightening in financial conditions. And in Q2 inventory accumulation was even lower than expected.

What saved Q2 growth was government spending (up a whopping 4.2% SAAR), a sharply improved trade balance (that boosted Q2 growth by a sharp 1.2%) and non-residential construction (up 22% SAAR). Those factors that boosted growth in Q2 are not sustainable ahead: with high oil prices the real trade deficit will not improve much more in H2; non-residential construction will have a slowdown following the residential bust as demand for shopping centers and offices follows with lags falling housing demand; and government spending usually grows less than real GDP on a trend basis. So factors that supported Q2 growth may prove temporary.

Conversely, the factors that were weak in Q2 (private consumption, capex investment and residential investment that represent about 85% of aggregate demand) entered H2 with an even weaker momentum than in Q2 at the time when financial conditions are seriously tightening in credit markets with the beginning of a credit crunch. In particular, the slowdown of private consumption to 1.3% in Q2 is a very ominous sign for the economy ahead as preliminary July data suggest further weakness in retail sales. No wonder that Fed futures are now starting to price a Fed Funds cut some time in the fall. So I expect growth in H2 to be worse than the already weak average of 2.0% in H1; we are facing a "growth recession" ahead, if not worse.