US Economy Slumps – Is A Recession Next?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
June 12, 2007

IN THIS ISSUE:

1. The Economy Weakened More Than Expected

2. More Positives Than Negatives In The 2Q

3. Where The US Economy Goes From Here

4. The Fed & Inflation – The Dilemma

5. Equities – The Bull Market Continues, But…

6. Higher Prices Mean More Volatility & More Risk

The Economy Weakened More Than Expected

On May 31, the Commerce Department revised its estimate of 1Q Gross Domestic Product from +1.3% (annual rate) in its initial report to only +0.6%. This was below pre-report estimates. The weaker than expected GDP report, according to the government, was primarily due to sagging business investment in inventories, the continued slump in the housing market, a decrease in federal spending and weaker exports (larger trade deficit) in the 1Q.

GDP Growth Q1 2007

The weaker than expected 1Q GDP number surprised many analysts. It was the weakest quarterly growth rate in more than four years, and significantly below the 2.5% pace in the 4Q of last year. Many mainstream analysts are now legitimately pondering whether or not the latest surprising GDP report means we are headed for a mild recession later this year. The gloom-and-doom crowd, of course, is euphoric and would have us now believe that we’re not only headed for a recession but a depression. What else is new?

Digging into the Commerce Department’s latest GDP report, we find that the much larger than expected trade deficit in the 1Q shaved a full 1% off of the final GDP number. The higher than expected drop in inventories cut another full 1% off of the number. The continued housing slump reduced the GDP number even more.

The question now is, will there be more negative surprises in the 2Q? Could we in fact be headed into at least a mild recession in the second half of this year? To answer that (or at least attempt to), let’s quickly run through the latest economic data.

More Positives Than Negatives In The 2Q

First, let me state the obvious: the 1Q is now over two months in the past. We need to focus on more recent economic data that has been released in the last few weeks. Those data suggest that the economy is rebounding in some key areas in this 2Q. Let’s start with those numbers.

Manufacturing is definitely picking up as businesses are finally beginning to rebuild inventories. The ISM manufacturing index improved for the third consecutive month to 55 in May from 54.7 in April. The closely watched Chicago Purchasing Managers Index jumped to 61.7 in May from 52.9 in April. Factory orders rose 0.3% in April (latest data available) following a revised 4.1% jump in March. Durable goods orders climbed 0.6% in April following a 5.0% jump in March. Industrial production rose a healthy 0.7% in April. So, the manufacturing sector is getting in high gear to rebuild inventories.

What about on the consumer side that accounts for apprx. 70% of GDP? A good indicator is the ISM Non-manufacturing Index, which is commonly referred to as the “Services Index.” This index hit 59.7 in May, up from 56 in April and the best since April 2006. The Consumer Confidence Index surprised again in May, hitting 108.0, up from 106.3 in April. Personal spending increased 0.5% in April according to the Commerce Department, following a rise of 0.4% in March.

The US unemployment rate remained at 4.5% again in May. A whopping 157,000+ new jobs were created in May, well above expectations. As I will discuss below, the labor market remains very tight, and wages are on the rise – not only in the US but also around the world. This is a good thing and not indicative of an economy that is headed for a recession, provided inflation doesn’t heat up.

While the reports above are very encouraging, I would be remiss not to include the latest reports on the housing market. The latest data available are those for April, which show a mixed picture. New home sales in April increased briskly, while sales of existing homes fell modestly. Housing starts actually rose modestly in April over March levels, but building permits fell slightly in April. The median sales price for existing homes fell 1.8% in the 1Q to $212,300.

While the latest housing numbers are slightly negative, and there remains a sizable glut of unsold homes on the market, the latest data are a far cry from the horror stories we were hearing late last year. Yes, home prices are down somewhat in most parts of the country, but there has been no collapse in home prices as many predicted. And may I remind you that the “sub-prime” mortgage dilemma has not resulted in a major financial crisis as so many predicted just a few months ago. We rarely hear about this supposed crisis any more, as I have predicted over the last couple of months.

Where The US Economy Goes From Here

While most of the above economic reports are encouraging, let me emphasize that the US economy is still not out of the woods. The Index of Leading Economic Indicators (LEI), which I follow very closely, was down 0.5% in April. For the year, the LEI was +0.1% in January, -0.5% in February, +0.1% in March and –0.5% in April. Overall, this is a negative reading and is indicative of an economy that is still in a slowdown.

While the US economy is starting to mount a comeback, the most likely scenario is that we will see another couple of quarters of slow growth, especially in light of the weaker than expected 1Q GDP report and the latest LEI report. But barring any significant negative surprises, we should not fall into a recession this year or next year.

Rather, we should start to see more encouraging signs on the economy over the summer and heading into the fall. I suspect that the disappointing 1Q GDP number will have been the low point. That does not mean there won’t be the occasional negative report as we move forward – certainly there will be. But with manufacturing already on the clear upswing, with consumer spending remaining strong, and with the housing slump not becoming a disaster, I continue to believe that the US not only avoids a recession, but sees a modest economic rebound next year.

The Bank Credit Analyst agrees. Here are excerpts from BCA’s latest June issue:

“The trend in the labor market remains the key issue for consumer spending – far more important than what happens with gas prices, housing or the stock market. As long as people have jobs, their incomes will rise and spending will be supported [meaning the economy will continue to grow]…

While U.S. growth seems likely to be stuck at a below-trend pace for another couple of quarters, most other regions are barely pausing for breath [ie – booming]… Strong global growth will provide a boost to U.S. exports, providing some offset to weak domestic demand.

How long can this perfect environment of sustained growth and low inflation go on? The forces keeping inflation down are structural, and we do not anticipate a change anytime soon… In sum, we expect that the favorable investment climate will persist at least until the end of this year. The environment clearly favors stocks over bonds.”

Clearly, BCA does not believe the US economy is headed for a recession. While the US is likely to remain in a “soft-spot” economically for another couple of quarters, there is no reason to believe we are headed into a recession later this year, barring some major unexpected negative surprises.

BCA continues to believe that the US equity markets are in a bull market that has further to run. That should sound very familiar to regular readers with my own advice over the past several years. But I should caution readers that BCA also believes that the US equity markets have become overheated on the upside this year, and that a downward correction is overdue. We may be seeing that downward correction unfold as this is written. More on that below.

The Fed & Inflation – The Dilemma

As we all know, the Fed has felt comfortable leaving short-term interest rates unchanged for almost a year now. The debate over the last few months has been whether the Fed will lower rates this year now that the economy is clearly slowing down. While the economy has been slowing down, even more than expected, the inflation rate has not been exactly cooperating with the Fed’s wishes.

It is widely believed that the Fed focuses on the “core” inflation numbers – core being all inflation less food and energy. While many believe the Fed should include food and energy in their analysis, the core rate is what the Fed supposedly focuses on. If we are to believe what the Fed says, they want to see a core inflation rate of 2% or less. Let’s look at the latest inflation numbers.

The Consumer Price Index has risen 2.6% over the last 12 months, while the ‘core’ CPI, less food and energy, has risen 2.3% over the same period, according to the official Labor Department statistics. This is slightly above the Fed’s supposed target of 2% or less. But we are told that the Fed also pays particular attention to the inflation component of the GDP report, which is called the “GDP Price Index,” formerly the GDP Price Deflator.

In the latest GDP report for the 1Q, the overall Price Index rose 3.6% for the 12 months ended April. The ‘core’ rate (minus food and energy) was 2.8%. A core rate of 2.8% is clearly above the Fed’s target for inflation, and might imply some rate increases later this year.

But herein lies the dilemma. While the GDP Price Index for the 1Q might argue for rate increases, the economic numbers suggest the opposite [ie- the flagging 1Q GDP number of 0.6%]. The Fed does not want to impose higher rates on a clearly sluggish economy.

At the latest FOMC meeting on May 9, the Fed once again elected to leave the Fed Funds rate at 5.25%. In the statement released after the May 9 meeting, the Fed indicated once again that its “predominant policy concern remains the risk that inflation will not moderate.” But for the second time in a row, the FOMC elected to omit language suggesting that the Fed might raise rates in the near future.

As I have suggested previously, I think the Fed is quite content to leave short-term rates where they are and wait to see the economic data for the 2Q, which as I have suggested above should be better than the 0.6% GDP number for the 1Q. The first estimate of 2Q GDP will come in late July. The next FOMC meeting is on June 27/28, with another to follow on August 7. I would not expect the Fed to make any changes until the August meeting when they will have the advance estimate of 2Q GDP.

Global Growth Sparks Inflation Concerns

While the Fed is counting on inflation moderating in the US later this year, as a result of the slower economy, most of the rest of the world continues to enjoy very strong economic growth, as I discussed in my April 24 E-Letter. As a result, concerns about inflation are rising in many developed countries.

For over a decade, the world has enjoyed low-cost labor from China, India and Eastern Europe, which has fueled an era of very strong economic growth with falling inflation. However, many overseas companies are now operating at or near full capacity, while at the same time are facing shortages of raw materials and higher costs.

Central bankers fear that the combination of production capacity constraints and rising raw materials costs will lead to rising inflation. Add to that the fact that workers in low-cost countries are demanding higher wages. All of these factors have central bankers in many countries raising interest rates, even as the Fed has held steady. The European Central Bank raised its euro-zone rate to 4% last week, and the Bank of England is expected to raise its short-term rate above 5.5% next month. Canada and Japan are also expected to boost their short-term rates soon.

These growing global concerns about inflation have also affected the bond markets. US Treasury bond yields have risen significantly in recent months, from below 4.5% to above 5.25% as this is written. T-bond futures are now forecasting a rise to 5.5% in the long bond. A similar rise has been seen in Germany’s 10-year bond, which is Europe’s benchmark long rate.

It remains to be seen if central bankers around the world will go too far in raising rates, and if US bonds will become oversold and provide another buying opportunity at some point. Whatever happens, rising US and global bond yields are not positive for the equity markets in general.

Equities – The Bull Market Continues, But…

The US stock markets have been on fire since the brief correction in late February/early March. The Dow Jones surged to a new record high of 13,676 on June 4, and the broader S&P 500 flirted with its previous all-time high as well. Last week, however, the major indexes turned lower, and we may be seeing the next significant correction occur. Traders cited concerns about rising interest rates and inflation abroad, as discussed above.

Also troubling, the Labor Department reported last Wednesday that non-farm business labor costs rose an unexpected 1.8% in the 1Q, well above its previous estimate of 0.6%. This report raised concerns about inflation in the US as well. When you have equity markets that have risen vertically for this long, it does not take much bad news to spark a wave of profit taking.

From a technical perspective, last week’s highs were a bad place for the broad markets to turn lower. Notice in the chart below that the S&P 500 failed to close decisively above its all-time highs just over 1500 reached back in late 1999 and early 2000 – and then turned lower. This will be viewed as a sign of weakness by the chartists, and could well contribute to a meaningful correction.

S&P 500 Index

If in fact we get a meaningful downward correction in the US equity markets just ahead, we could see another buying opportunity. The last time we had a correction in the broad equity markets was in late February/early March. In my March 6 E-Letter earlier this year, I recommended adding to positions, and that advice was right on the money. This time, however, with the Dow Jones and S&P 500 so much higher than in early March, I don’t know that I would recommend buying this dip, especially for those investors who are completely out of the equity markets.

On the other hand, for those of you who are in the market, presumably from much lower levels, and would like to add to your positions, there may be a good opportunity just ahead. Obviously, no one knows if we get a further correction or how far it might carry, but I would expect the S&P 500 to find good support in the 1450-1400 area, if not above that level. As noted above, BCA does not believe the bull market is over.

By the way, there are a LOT of investors who are on the sidelines. The latest poll by the American Association of Individual Investors found that only 33% were bullish while 45% were bearish. How can you be bearish when the Dow Jones has set new record after new record? Answer: when you’re on the sidelines and hoping the market comes down!

Here’s another interesting fact. Even though many stocks reached new all-time highs this year, US households don’t hold as much stock as they did at the end of 1999. According to Federal Reserve data, household ownership of equities totaled $5.5 trillion at the end of 2006, as compared with $9.7 trillion at the end of 1999.

Such data continue to confirm what I have said for years. Many investors came late to the party when stocks were last booming in the last half of the 1990s. Many people didn’t jump onboard until very late in that cycle at prices near the highs. And we know all too well what happened after that - the S&P 500 plunged 44% in the bear market of 2000-2002. Millions of investors bailed out during that gut-wrenching decline, and many have not come back into the markets since.

Higher Prices Mean More Volatility & More Risk

As equity prices rise to higher and higher levels, the degree of volatility in the markets is likely to increase in proportion. Let us not forget that the Dow Jones plunged 540 points lower at one point in a single day back on February 27, and the market is much higher today. The point is, there will likely be more days like February 27, or even a string of sharply lower days in a row.

Likewise, the risks grow proportionately as prices continue to rise – some argue more than proportionately – and I would agree. With many equity prices at unprecedented levels, it doesn’t take much in the way of negative news or reports to send the markets into a tailspin.

These are just a few of the reasons why I have most (90+%) of my equity portfolio directed by successful professional money managers that use “active management” strategies that can move to cash or “hedge” long positions in the event of a significant market downdraft.

I also have some of my equity portfolio with managers that have the ability to “short” the market should we get into a prolonged downward correction, or if a new bear market develops. (I should note that shorting the market is an aggressive strategy that is not suitable for many investors, and past results are not necessarily indicative of future results.)

To check out the professional money managers I use and recommend to my many clients around the country, you can visit our website at www.halbertwealth.com or you can call us at 800-348-3601. I would be happy to speak to you personally, as my schedule permits.

Wishing you profits in a dicey market,

Gary D. Halbert

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