The economy lost momentum during the first half of 2019, and recent data have been uninspiring. Our revised forecast is that growth will stabilize and we will continue to muddle through. However, there is an elevated level of uncertainty in the current situation, and that uncertainty has been increasing during the first month of Q3. Caution is warranted.
NIPA Data
The release of advance data on economic activity during the second quarter also included revisions to previous data back through 2014. For the entire revision period output growth was lowered to 2.4% from 2.5%. For the most recent quarter (2019Q1) growth was unchanged at 3.1%. However, growth was revised lower for the last three quarters of 2018, putting growth for the year (4th-quarter to 4th-quarter) at 2.5% down from the previous 3.0% estimate. The revisions were quite significant on the income side of the accounts, where personal income was increased and corporate profits lowered.
Compared to our recent forecasts the new data for the second quarter are generally discouraging. Our May estimate for real GDP growth was 2.7% while the actual number was 2.1%. However for final sales (leaving out change in inventories) the difference was just 0.1% (3.0% actual versus 3.1% forecast).
At a disaggregate level the second quarter was a mixture of strengths and weaknesses. On the strength side were consumption (up 4.3%) and government purchases (up 5.0%). Both categories may have included some residual bounce-back from the government shutdown.
Investment and trade, on the other hand, were notably weak. Business investment actually declined slightly with equipment purchases barely positive (+0.6%) and a huge decrease in structures (down at a 10.6% annual rate). Residential investment was again weak (down 1.5%). Housing has declined in each of the past six quarters.
On the international front the impact of the China trade war and general foreign economic weakness were fully in evidence. Exports declined by 5.2%, while imports were basically flat. The net result was that the real trade deficit worsened by $35 billion. This amounts to nearly three-quarters of a point off GDP growth.
Overall, the NIPA data suggest caution as the economy enters the second half of the year. Growth in the 2nd quarter was adequate, but not broadly based. The two pillars of second quarter growth – consumption and government purchases – were both substantially above trend. If (when) they revert to more sustainable growth rates, it will cut output growth by about one and a half points – that is, a reduction in final sales growth of 50%. The question for the near-term future is whether investment and trade will cover some of this shortfall .
Recent Events
Recent monthly data have not been bad, but are not a source of optimism either.
Especially on the business side where industrial production, ISM indexes, and housing starts have all been lackluster. Total IP was flat in June and is up only1.3% over the past year. The manufacturing component rose in May and June, but was down in each of the first four months of the year. It has barely risen over the past year (+0.4%).
Both ISM indexes decreased in July. This marked the fourth straight decline for manufacturing putting that index at just 51.2, barely above the 50 breakeven level.
Monthly housing data continues to be weak. Starts for both May and June showed no growth and were at a relatively weak level. Permits have slowly fallen so far this year.
Data relevant to the household sector are somewhat more encouraging. Monthly data on income and consumption have remained solid. Over the past 12 months consumption has grown by 2.5%, but this is below income growth meaning that personal saving has been strong. Consumer sentiment, which dipped in June, bounced back strongly in July.
The labor market report for July, while not a blockbuster, was reasonably good. Payroll employment increased 164 thousand. The unemployment rate held steady at 3.7%, even though the labor force increased by 370 thousand. This is more than double the long-run trend for the labor force, and it pushed the participation rate up a tick to 63.0%.
Finally, events in financial markets have been troubling to say the least. Markets across the board and the globe are reacting – mostly with distress – to every turn in the U.S. - China trade war. The stock market is well off recent highs, and interest rates have dropped significantly. The 10-year Treasury rate is now at its lowest level in nearly three years. Relative to the 3-month rate, the yield curve is inverted out to the 20-year maturity.
Overall the new data do little to engender optimism about the trajectory of the economy .
Baseline Forecast
But our model remains relatively sanguine. As can be seen in the chart, our new forecast for real GDP growth is only a little weaker than three months ago. [Deviations through 2019Q1 are due to data revisions. The deviation for 2019Q2 is our forecast error.] Over the next six quarters our model now shows average output growth at 2.3%, down from 2.5% in our May outlook.
On a sectoral basis, this outcome represents a scenario in which consumption and government spending moderate to sustainable growth. At the same time, investment (both business and housing) and exports rebound significantly from their dismal Q2 performances.
In the labor market we expect that employment growth will continue to decelerate through 2020 as the drag of demographics exerts its downward pull. This is a more pessimistic outlook than in our May forecast, which had stronger labor force growth than we now anticipate. Over the same time period the unemployment rate remains close to its current 3.7%, which is our model setting for "full employment."
Summary
A high level of uncertainty characterizes the current economic situation. We think our current forecast is cautious in some regards, but possibly optimistic in others.
The main area of caution is our expectation that consumption will follow a near-term path that is just consistent with long-run sustainability. But the household sector is in a good place right now. The labor market is strong – arguably the best in a half century. Income is growing for workers at all levels. Household saving is healthy, and consumer confidence is high. All this could support spending levels above those in our forecast.
On the production side of the ledger the situation is not so healthy. The trade war, slowing growth abroad and financial market instability have each had negative impact on business sentiment. Capital goods orders and production have been disappointing. Consumer demand in important areas (e.g. autos) seems to have plateaued. Construction has been contracting. This certainly raises questions about our forecast levels for business and residential investment.
The international sector is even more fraught. And – at least for us – totally unpredictable. In our forecast we assume a steady and relatively modest growth for U.S. exports. The actual path will certainly not be even close to steady. Whether it averages to modest growth or something worse is guesswork.
If some of the current uncertainties resolve themselves, there may be a little upside from our forecast for the next year. If they remain unresolved or worsen there could be a significant downside .