Second-Quarter Weakness, Second-Half Comeback?


By Margaret Popper If you're wondering whether the April rise in unemployment to 4.5% has ruined the chances for a recovery this year, take your cue from the stock market's May 4 reaction to the labor report. The Standard & Poor's 500, the Dow Jones industrial average, and the Nasdaq dipped on the news first thing in the morning, but by noon, all were back in positive territory. They ended the day sharply higher.

Why? The market had factored in an unemployment jump back in February and March, when companies were announcing layoffs in droves. The latest number just shows that Corporate America is doing what it said it would do.

Far more shocking in some respects than the last three months' rise in the jobless rate was the gross domestic product's 2% real growth in the first quarter. That's double what most economists were predicting. The stock market rallied in celebration when the Bureau of Economic Analysis released that number on Apr. 27. No doubt the figure will be edged down when the BEA releases a revision based on more data on May 25. But GDP is still likely to show far more strength than most economists were anticipating.

BOTTOM IN SIGHT. The real question is whether that unexpected economic resilience could be repeated in the second quarter. The answer is not likely. But the good news is that second-quarter GDP growth will probably be only slightly lower than the first quarter because of slower business and consumer spending.

That's a heck of a lot better than the negative growth estimates from the alarmists' corner. And even though unemployment will probably creep up further, the economy should manage signs of recovery in the third quarter -- the fourth at the very latest.

That's not to say the road ahead doesn't have its share of potholes. But as long as the jobless rate doesn't break much above 5%, or energy prices don't spin wildly out of control, with either phenomenon sending consumers into hibernation, the economy will likely bottom out this quarter, many analysts say.

The best thing about the first-quarter GDP number that bodes well for a third-quarter recovery was the amount of inventory correction that has already taken place -- $7.1 billion worth. When companies burn off inventory rather than producing more, it lowers GDP.

FEWER IMPORTS. But it also sets the stage for future growth. "The sharpness of the inventory correction in the first quarter looked very much like it would yield a V-shaped recovery," says Wrightson Associates economist Lou Crandall. "With inventory having shrunk more than expected in the first quarter, it won't drag down GDP as much as expected in the second quarter."

Of course, the inventory correction contributed in no small way to a slimmer-than-expected trade deficit, which improved significantly when imports dropped 10% in February. "Because companies were burning up inventory, they weren't importing," says Milton Ezrati, senior economist and strategist at fund manager Lord, Abbett & Co. in Jersey City, N.J. "The decline in imports probably added a point and a half to GDP in the first quarter," says Ezrati. "[The imports will] pop up next quarter when most of the inventory buildup is gone." That will put downward pressure on GDP.

But even if low inventory levels spur companies to start shelling out on new production, it's unlikely that the strength of capital spending that surprised economists in the first quarter will be repeated in the second quarter. "It appears that even though businesses spent less on technology in the first quarter, they increased their spending on bricks-and-mortar facilities," says Ezrati.

FINISHED FIXING. The result was that capital spending, which declined about 11%, didn't drop off as much as the 16% or more that everyone expected. However, now that companies have refurbished their plants, that bricks-and-mortar spending boost will evaporate in the second quarter, another reason to expect slower GDP growth.

At the same time, consumer spending is likely to slow down as the reality of layoffs sinks in. "We're expecting 1.5 percentage points less consumer spending in the second quarter," says Goldman Sachs economist William Dudley. That still would result in a 1.6% gain in consumer spending -- not great but probably enough to squeak by without setting off a recession.

Could rising unemployment frighten consumers into not spending at all? Not likely at these levels. With the economy in a ticklish state, people have a tendency to hyperventilate with each new economic statistic, but we've not yet taken our seats in the recession ballpark.

The most recent monthly labor statistics set off a flurry of scary-sounding headlines that focused on how April's 4.5% unemployment rate represented a percentage jump in the level of jobless claims not seen since 1992. But let's not forget that 4.5% is still near post-war historical lows. "In 1991, which was a mild recession, [unemployment] peaked at 8%," says Joseph Abate, economist at Lehman Brothers.

DELAYED BOOST. One wild card that could shock consumers into savings mode is the cost of energy. Right now, gas prices at the pump are climbing due to a refining capacity shortage. As warmer summer weather and the crucial vacation driving season arrive, demand for natural gas to fuel air conditioning could increase price pressure. The price of crude oil recently inched about a $1 a barrel higher, to a little over $28 a barrel. However, most economists expect crude to retreat from this level.

Ironically, the worldwide economic slowdown could be helpful in keeping energy prices in check because the downturn will lower oil demand. If that happens, consumers will get some breathing room in their budgets by the third quarter.

And don't forget: The Federal Reserve's aggressive easing will be felt more strongly later this year, not to mention the federal income tax cut that could put $100 billion in consumers' pockets in the third quarter. All of a sudden, you've got the makings of a recovery. "You'll see the lagged effects of the current [Fed-engineered] interest-rate cuts further stimulate the housing market and investment," says Lehman's Abate, who predicts 3% GDP growth in the third quarter, ticking up to 4% in the fourth. "You'll probably have some form of tax relief, and even if consumers only spend a third of it, that's enough to add one percentage point onto third-quarter growth."

Despite the alarm created by the latest employment numbers, many investors believe, correctly it seems, that the odds still favor the economy escaping a recession this year. Popper covers the markets for BW Online in our daily Street Wise column


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