The slowdown in US growth is set to continue before the fiscal package can contribute to improving economic activity in the second half. The 1% growth which we expect in 2008 is far from incompatible with a technical recession: two consecutive quarters of contracting GDP. In fact, the carry-over from 2007 (end 2007 activity compared with the average for the year) is already close to this figure. US growth came in at only 0.6% at an annual rate in the final quarter of 2007. GDP growth slowed down from 2.9% in 2006 to 2.2% last year. The decline in housing investment that started in spring 2006 has since cut about one point per year from growth, and even accelerated at the end of the year (-4.6% in 2006, -17% in 2007 and -25.2% annualised in Q4 2007). Investment in non-residential construction has been very strong, but is now showing some signs of moderating (12.4% in Q4 after 16.4% in Q3 and 26.2% in Q2). Over the last few months, it has also lost its ability to make up for employment losses in the residential sector. Investment in equipment only increased 3.1% in the final quarter (6.2% in Q3). The pace of consumption growth has slowed (2.3% in Q4 after 2.8%  in Q3). The contribution to GDP growth from final domestic demand slowed from 2.9% in 2006 to 1.9% last year (1.3% in Q4). A recovery in foreign trade helped generate a positive contribution to economic activity in Q4 2007 (1.0 point), with a decline in imports (-1.4%) due to weak domestic demand more than making up for a slowing of export growth (6.5% after 19.1% in Q3). Economic indicators are very weak. After a quite surprising recovery in January, the ISM manufacturing index fell back to 48.3 in February, below the 50 level that separates economic expansion from contraction. The orders index was at 49.1, below the 50 level for the third month in a row, while the employment component came in at 46.1. The ISM non-manufacturing index recovered to 49.3 after a dizzying fall in January (to 44.6 from 53 in December), indicating stagnation at best (Chart 1). The Fed’s Beige Book, published on 5 March and covering the period from 7 January to 25 February, reveals weak demand in most districts.

Household consumption

Consumer spending has been affected by strong headwinds: erosion of purchasing power due to accelerating inflation, particularly as a result of rising energy and food prices, deteriorating labour market conditions, tightening credit conditions, downturn in wealth effect, fall in confidence. The onset of consumer spending weakness seems set to continue. Retail sales fell by 0.6% in February, and over the last three months have contracted by 0.2% at an annualised rate (+3.6% in the fourth quarter of 2007). Demand for durable goods seems to have been badly affected (-1.4% in February, -11.7% over three months at an annualised rate). Since these figures are expressed in nominal terms, adjusting for inflation leads to an even more negative real trend (Chart 2). In fact, the rise in energy prices has caused real income growth to turn negative since fuel prices have risen by 50.1% over 12 months (38.1 in December, 27.2 in November), while food prices are up 7.4% (6.4% in December, 5.7% in November). In year-on-year terms, nominal wages are up 3.7% compared with an inflation rate of 4.0%. Conditions in the labour market are also deteriorating rapidly. Employment contracted by 63,000 in February after a drop of 23,000 in January. This deterioration is affecting the whole of the private sector, with 39,000 jobs being lost in construction, 52,000 in manufacturing industry and 12,000 in services. It is hard to expect an improvement when the employment components of both the ISM surveys, manufacturing and non-manufacturing, are in contraction territory (below 50). The unemployment rate has fallen from 4.9% to 4.8%, but only because of a decline in the participation rate (ratio of the active population to the working age population). As a result, it is not surprising that household confidence deteriotates. Consumer confidence, as reflected by the Conference Board index, fell from 76.4 in February to 64.5 in March (108.2 in March 2007). With the exception of March 2003, when the Iraq war started, the index is at its lowest since 1994.

The wealth effect is no longer supporting demand

Household debt has continued to grow in recent times. The debt ratio (ratio of debt to gross disposable income) hit 143% at the end of last year, according to the Flow of Funds Accounts. At the same time, the rise in property wealth has unsurprisingly stopped (+6.4% in 2006, +1.3% in 2007, but -0.8% in Q4). The potential for using real estate collateral to withdraw cash has been blunted. As a result, the gap between new mortgage lending and housing investment, which had reached $348bn in 2006, fell to $135bn in 2007, and to $24.8bn annualised in the fourth quarter of 2007. The growth of financial wealth has moderated (+9.3% in 2006 and 4.9% in 2007, but flat in the fourth quarter). The equities component shrank by 11.8% year on year in 2007 (+5.2% in 2006), with the impact of net sales by households on stock market wealth ($761bn in 2006, $988.5bn in 2007 and $1,315bn annualised in Q4) no longer offset by the valuation of those shares. Given the trends in wealth, the ratio of net wealth to income fell from 5.6 times at the end of 2006 to 5.58 times at the end of 2007. Given recent trends in real estate and share prices, it is hard to believe that there will be a positive wealth effect to support consumption. Remember that the Fed has calculated that, other things being equal, a $1 decline in real estate wealth leads to a $0.06-$0.07 fall in consumption. The impact of movements in financial wealth, which is more concentrated in the population, is about half as much(1).

Housebuilding

The wrenching adjustment being experienced by the housebuilding sector is set to continue for several more quarters. Despite a recovery in the affordability index due to the combination of trends in income, real estate prices and interest rates, which has taken the index back to its average level for the period 1997 to 2003, sales continue to decline (new home sales were down 1.8% in February and are now 55% below their peak in the third quarter of 2005). High inventories are hurting prices: the Case Shiller index shows a 10.7% year on year fall in January and a 19.8% fall at an annualised rate over the last three reported months. The trend is clearly accelerating downwards. An increase in defaults will certainly not lead to any relaxation of lending conditions, which have tightened considerably (see below). Default rates (60 days or more in arrears) have hit 23.8% (5.8% two years ago and 9.1% in the aftermath of the 2001 recession). This surge, which is particularly pronounced among adjustable rate mortgages, is certainly not set to moderate despite a fall in 6-month LIBOR, which serves as the reference point for rate adjustments (155 basis points below the average level of the fourth quarter of 2007; the Mortgage Bankers Association has announced a 61% increase in refinancings in the first quarter). Since many loans were made on high loan to value ratios, the fall in real estate values is causing the number of owners with negative equity to increase, which is an incentive to default. A rising foreclosure rate (3.44% compared with 1.28% in the fourth quarter for conventional subprime loans, and 5.29% compared with 1.25% for adjustable rate subprime loans) is causing inventories of houses for sale to grow. As a result, the gloom is set to continue. New housing starts, which have contracted at an average monthly rate of 6% since the middle of last year, fell again in January by 5.2%.

Companies

Increasing investment gave way last year to virtual flatness ($1,036.3bn according to the Flows of Funds, compared with $1,302.9bn in 2006). The outlook has been affected by uncertainty about economic activity (the capacity utilisation rate in manufacturing industry is 79.5, below the long-term average), tightening financing conditions (see below) and a downturn in profits. Underlying orders for capital goods (excluding planes and defence equipment) fell by 1.6% in the final quarter of 2007 and contracted again in January (-1.8%) and February (-2.6%). The 11.2% increase in gross profits in 2006 gave way to stabilisation in 2007 (-0.4%). Tax receipts, whose strength is delayed relative to the economic cycle, increased by 8.3% and dividends distributed increased by 10.2% after growing by 126.7% in 2006. Companies made large share buybacks amounting to $836bn in 2007 and $1,157bn annualised in the final quarter ($614.1bn in 2006). As a result, despite the slowdown in investment, the funding requirement increased to $253.9bn in 2007 ($303.5bn in the fourth quarter) compared with $186.6bn in 2006 and a surplus of $110.1bn in 2005.

Foreign trade

In the last few years, exports in volume have grown at a vigorous pace in excess of 8% per year. Growth has been driven by the dynamism of the word economy and by the dollar’s depreciation. As a result, the US has recently stopped losing market share. Exports are likely to resist the slowdown in the word economy. The dollar’s depreciation since the beginning of 2002 (the effective exchange rate has fallen by 24.5% since then) has only become more intense recently, stimulating the competitiveness of American products. This is true against both the currencies of industrialised countries (-35.2% in six years), where growth is set to slow significantly in the wake of the United States, and against the currencies of emerging markets (-14.4%), which are likely to hold up better. From this point of view, there is a positive aspect in the growing share of US exports accounted for by emerging markets, where growth is stronger. Such countries are currently the destination for 50% of the goods exported by the US, up from only 38% twenty years ago. Finally, the deceleration in US exports is unlikely to be very pronounced in 2008 (6.5% growth is expected). Import growth in volume fell from 6% in 2005 and 2006 to 1.9% last year and 1.0% in the fourth quarter, mainly due to the slowdown in domestic demand. Growth forecasts for 2008 are likely to confirm the downturn in import volumes. Since 2006, the US has managed to return to a situation where net exports make a positive contribution to growth. This contribution amounted to 1.0 point of GDP in the fourth quarter of 2007. Such support for growth is set to last this year, although it is of course far from sufficient to offset the downturn in domestic demand.

Inflation

The inflation rate (CPI) was 4.0% in February (4.3% in January). As elsewhere, rising energy and food prices have pushed the index up. Underlying inflation is also accelerating, reaching 2.3% year on year, but 2.7% at an annualised rate over the last three months. Some components, such as clothing, have stopped benefiting from downward pressure due to falling import prices, but others are set to moderate. The same is true for owner equivalent rent (imputed cost of owned housing, 30% of the core CPI), whose 2.6% year on year growth is set to slow down as a result of the real estate cycle. The same is true for the rent component, which is up 4.9% year on year. Finally, the decline in consumption, which is particularly noticeable in the discretionary component (cars and other consumer durables) is also likely to favour moderation.

Monetary policy

In such a context, the Federal Reserve continued to ease monetary policy rapidly in March, notably by lowering the Fed funds target by 75bp, from 3% to 2.25% (see chart 3). The discount rate was also lowered, by 100bp overall in March, to 2.5%. In addition, in days preceding the scheduled meeting, the Federal Reserve took several important measures in order to bolster market liquidity and prevent the systemic risk from rising. These strong policy decisions have been justified by the fact that the main downward risks identified by the Committee have all increased in recent weeks: stress in financial markets has intensified, labour market conditions have deteriorated further, and housing data have remained in the doldrums. The context is all the more tricky that inflation has increased significantly in recent months. However, the Fed’s priority will not change in the short term. The key final paragraph concludes that “downside risks remain”, a clear indication that monetary easing has not come to an end. Consequently, the Fed funds target may be soon lowered below 2%. Rate cuts look unavoidable in the current crisis phase. They support the banking sector’s funding activities (as did Fed policy after the Savings and Loans crisis broke) and reduce interest costs for debtors with short-term or variable rate debt. However, they have limited effects on long-term interest rates and on credit, where conditions have tightened considerably. This is demonstrated by the rise in yields on corporate bonds, the widening of spreads on credit derivatives (CDS) to 192 on the main CDX (investment grade) index and to 408 on the CDX crossover index (high-yield bonds), compared with scarcely more than 100 a year ago. Bank lending conditions have also tightened. The last Fed survey (the Senior Loan Officer Opinion Survey) showed a rise in the balance of opinions between banks reporting that they were tightening conditions and those that were easing them. In three months, the balance has risen from 55.5 to 71.5 for subprime mortgages, from 60 to 84.6 for Alt A loans (intermediate category between prime and subprime), and from 40 to 52.9 for traditional loans (prime). Above all, the tightening lending conditions are not restricted to mortgages, in fact far from it. The trend in balance of opinions is clear in all lending categories: credit cards (from 3.9 to 9.7); other consumer loans (from 26 to 32.1, compared with zero at the beginning of 2007); non-residential property loans (from 19.2 at mid-2007 to 80.3 at the beginning of 2008); and industrial and commercial loans (from 19.4 at the end of 2007 to 32.3 at the beginning of 2008).

Fiscal policy

The budget deficit shrank last year to 1.3 points of GDP (1.9 in 2006), below the long-term average (2.4%). The draft budget for 2009 calls for a deficit of $400bn ($163bn in 2007). This surge is due to the impact of the automatic stabilisers, that is the effect of the economic cycle on revenue, an increase in the cost of military operations, and tax reductions in the fiscal package adopted at the beginning of the year (1.1 points of GDP). There is a strong chance that the projected deficit will be exceeded. First, it is based on economic assumptions which look excessively optimistic (growth of 2.7% in 2008 and 3% in 2009); second, the future of the cost-saving measures announced, both discretionary spending and social programmes (Medicaid, Medicare and pensions) totalling $205bn over five years is far from clear. Finally, should the economic weakness last after the direct effect of the recently-adopted fiscal measures has worn off, everything suggests that a new package is likely to be implemented. The deficit could then reach, if not exceed, $500bn next year.

(1) See P. d’Arvisenet, The bubble, growth and banking (“La bulle, la croissance, la banque”) in Societal, Q1 2004.

Graphics

Sources: ISM, BEA

Sources: Federal Reserve, BLS

D'Arvisenet editorial reflects the view of the Economic Research Department of BNP Paribas. It is published for information purposes only. Neither the information nor the opinion expressed constitutes an offer or solicitation to buy or sell any investments. Information contained herein has been obtained from sources believed to be reliable but BNP Paribas does not guarantee its accuracy or completeness. All opinions and forecasts are subject to change. Discretion with respect to suitability should be prudently exercised.