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U.S.: Don't Let the Second Quarter Get You Down


Four percent is very good economic growth. Keep that idea in mind--and repeat it often--when news about the second quarter's dismal performance rises to a fever pitch. The latest data suggest that real gross domestic product grew at an annual rate of 2% or less during the spring. But since that followed a 6.1% jump in the first quarter, the U.S. economy grew at an impressive pace of about 4% for the first half. More important, nothing in the latest trends suggests the economy can't grow at least 3% in the second half.

The Commerce Dept. will report the second-quarter gross domestic product numbers on July 31, and economists are already trimming their expectations, with some forecasting a gain of less than 2%. The main triggers for the markdowns are a shopping respite by consumers and a much wider trade deficit than previously expected.

Neither development, however, signals real trouble in the U.S. economy. Other, newer trends will allow momentum to build in the second half. Consumers, for instance, will benefit from cheaper fuel and low mortgage rates. Capital spending is showing signs of life after a long slump, while some pricing power may be in the pipeline (chart), which will improve the profits outlook. Inventories are set to grow, and a weaker dollar may boost exports. Add it all up, and the U.S. economy seems ready to wake up from its spring nap. If there's a big risk to the outlook, it's how investors will handle the news about this bump in the road.

THE MAIN SOURCE of last quarter's weakness was a slowdown in household spending. Real consumer purchases edged up just 0.1% in April and were flat in May. Retailers blamed poor weather for keeping shoppers out of stores in May, and weekly retail surveys show that sales bounced back in June. Plus, the reintroduction of zero-percent financing suggests vehicle sales will increase in coming months.

Even so, real consumer spending probably rose at less than 2% last quarter. Excluding the weakness related to September 11, that pace would be the smallest quarterly gain in five years. Ever since the tax rebate program began last summer, consumers have been curbing their spending in favor of savings. The extra cash was a cushion against possible job loss and an offset to stock portfolio declines. In May, the savings rate was 3.1%, up from 1.1% in May, 2001 (chart).

Will consumers keep holding back? Probably not. Jobless claims stayed under 400,000 in each week of June, indicating that companies are ending their huge waves of layoffs. And real aftertax income is up 4.5% from a year ago. So even if consumers want to sock away some cash, they still have money to spend in the second half.

Households will also get a budget boost from falling fuel prices and continued low interest rates. Gasoline prices are down from their recent peak in early April. And 30-year fixed mortgage rates were near 6.5% in late June. Bargain borrowing costs will keep housing healthy and enable those homeowners who missed last year's mortgage refinancing boom to cash in now.

BETTER YET, CONSUMERS may not have to carry the recovery on their own since the latest data suggest that Corporate America is starting to join the rebound. The Purchasing Managers' Index from the Institute for Supply Management rose to 56.2% in June, from 55.7% in May. The indexes for production, export orders, and employment advanced, while delivery times lengthened--a sign that increased demand is prolonging the time from order to shipment.

One critical trend in the PMI data is the emergence of pricing power among suppliers. The four-month rise in the prices-paid index means some companies are regaining the ability to raise prices. Given that productivity-driven companies are reducing their costs, especially for labor, any increase in unit prices goes right to the bottom line.

Another plus for the outlook: Inventories have fallen so much, said the ISM, that their members' "customers do not have sufficient inventories on hand at this time." Rebuilding stockpiles will lift industrial production in coming months and add to real GDP growth.

The brighter prospects for pricing power and an industrial rebound may be reasons behind the nascent turnaround in capital spending as shown by the government's April and May data on shipments and orders. Capital-goods shipments have edged up so far in the second quarter, suggesting business investment on new equipment eked out a small gain last quarter. That would contrast with no growth over the winter and drops in the previous five quarters.

Equally important, new orders for nondefense capital goods excluding aircraft have also increased for two quarters in a row, meaning that demand is growing--although at a modest pace (chart). The recovery in business investment and a rebuilding of inventories will ensure a more balanced U.S. recovery, benefiting more sectors of the economy and more workers.

Some of the increased domestic demand last quarter was satisfied by foreign-made goods, and that's unlikely to change in the second half. Because of a jump in imports, foreign trade may have subtracted one percentage point or more from real GDP growth. But trade won't take as big a bite out of growth in this half. Although imports will continue to gain, export growth should pick up slowly, thanks to the recent weakening in the dollar and other upturns around the globe.

OF COURSE, risks remain in the forecast. Terrorism and geopolitical uncertainties are dangers. A spike in oil prices or an unruly drop in the dollar could cause inflation jitters. The return of federal deficits could roil the bond market and push long-term rates higher.

But the major risk to a second-half bounceback is Wall Street's reaction to the news of a second-quarter bust. When investors finally put their horror over corporate scandals behind them, they will shift their focus back to the economy. But that could happen just as the data seem to show a flagging economy.

Investor disappointment would be a mistake. After all, the second quarter is history. Stock prices should be set by the earnings outlook, not last quarter's economic performance. And with pricing power returning, productivity still on a strong uptrend, and demand growing, profit reports may offer more positive surprises than negative news.

Bear in mind that the economy never runs in a straight line. A burst of growth is often followed by a catching-up period. That was what happened over the course of the first half of 2002. But on average, the economy started this recovery at a good pace. Which goes back to the coming weeks' mantra: Four percent is very good growth. And better still for job seekers, investors, and executives, the growth should be followed by solid gains in the second half. By James C. Cooper & Kathleen Madigan


Steve Ballmer, Power Forward
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