Monday, July 20, 2009

Q3 growth likely to surprise positively but not final sales

The near-term outlook for growth is clearly improving and positive growth rates for Q3 and into Q4 can be expected. The key drivers of a return to positive growth rates should be the abating of the inventory correction, the reduction in negative growth contributions especially from residential construction as well as from auto manufacturing and increasing effects from the enacted fiscal stimulus. As Janet Yellen, president of the San Francisco Federal Reserve, stated earlier this year: "It takes less than many people think for real GDP growth rates to turn positive. Just the elimination of drags on growth can do it. For example, residential construction has been declining for several years, subtracting about 1 percentage point from real GDP growth. Even if this spending were only to stabilize at today’s very low levels—not a robust performance at all—a 1 percentage point subtraction from growth would convert into a zero, boosting overall growth by 1 percentage point. A decline in the pace of inventory liquidation is another factor that could contribute to a pickup in growth. Inventory liquidation over the last few months has been unusually severe, especially in motor vehicles—a typical recession pattern. All it would take is a reduction in the pace of liquidation—not outright inventory building—to raise the GDP growth rate." For example, investment in single family structures (the most important component of residential investment) has fallen from roughly 3.5% of GDP in 2006 to 0.8% of GDP in Q109, substracting approx. 1% of GDP per year (see chart). This is significantly below the average level of the past decades and clearly it can not substract much more from GDP growth.

So, purely due to technical reasons, growth is likely to rebound. This already gets mirrored in the situation in the job market. The chart below shows the jobs lost and gained during the recession (i.e. in between Dec 2007 and June 2009) in %-terms. Motor vehicles and parts (i.e. the auto industry) lost one third of its jobs. Furthermore, as a lot of auto workers have been sent home, the usual seasonal drop in auto employment during the summer months is a lot less pronounced. As the Atlanta Fed puts it: "On an unadjusted basis, the initial claims data showed a fairly large increase last week—up 86,000 workers. But claims for unemployment compensation typically rise in early July as auto plants shut down to retool for the new model year. The jump in claims this July hasn't been as large as in years past since many of the auto plants were waylaid earlier in the year. So on a 'seasonally adjusted' basis, the data showed a drop in claims of 47,000 workers."

Now, we know that GDP data is also seasonally adjusted. Therefore, if the auto firms let go less people than usual for the summer (as they fired them earlier), then they will not cut production as much as usual (because they cut production earlier). In turn, it is very likely that seasonaly adjusted GDP will be showing a positive growth contribution from the auto sector this quarter.
But be warned: the real picture about the underlying strength of the auto industry will only emerge towards autumn. At that time the seasonal adjustments assume that the layed-off workers for the summer break are being re-hired again. While this may also be true this year, I do not expect this seasonal pattern to be as pronounced as is usually the case.
Overall, Q3 GDP growth in the US (and likely else
where as there are the same phenomenons at work) promises to be positive and likely even significantly so due to the less pronounced seasonal drop in production during the summer months. This should underpin risky assets in the short term.

I have to admit that while I expect the current upward movement across risky assets to be a 1-2 weeks phenomenon with the potential for new highs in equity markets (see here), the risk has grown somehwat that this move will be more pronounced and last a little longer.

However, despite this short-term risk, the medium term outlook remains very subdued. Given the ongoing deleveraging by private households (i.e. rising savings ratio) as well as rising unemployment coupled with limited wage growth, end-user demand does not promise to stage a significant and sustained comeback. Therefore, growth in final sales should do significantly worse than GDP growth during H209. In turn, the recovery in risky assets remains a temporary one whereas the sell-off in government bonds as well will prove to be another opportunity to buy into.

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