2007 US Economic Outlook: A Long Slowdown?

The US economy is ending the year with less momentum than it had at the start. We see second-half real GDP growth averaging no more than 1%, well below the 4% growth rate in the first half of 2006. The way we see it, the economy is in the early stages of a mid-cycle slowdown. But we see no fundamental evidence to suggest that the relatively weak growth will end soon. As such, we are expecting a long slowdown in 2007, driven by softness in big-ticket consumer spending and residential investment. We also expect to see moderating core inflation and a modest reduction in official and market interest rates.

Anchoring our growth forecast is the underlying trend in our liquidity indicator. As a demand-driven indicator for money and credit, AllianceBernstein’s Liquidity Index provides guidance on the direction, speed and duration of the economy’s growth cycle. The good news is that it has stopped decelerating; the bad news is that the year-end 2006 growth rate of roughly 1.5% suggests economic softness extending well into 2007.

The economic script for 2007 could change, but much depends on Federal Reserve policy. Typically, when liquidity is growing 1.5% (or less) at the end of the year, official interest rates are usually cut early in the following year—resulting in some improvement six to 12 months later. Conversely, in those few instances when policymakers raised the fed funds rate, the economy slowed even further, often leading to a hard landing.

Despite evidence of a broadening economic slowdown and reduced wage and price pressures, Federal Reserve policy is still not settled. Several policymakers continue to argue that core inflation remains too high and, as a result, official rates might have to be raised to avert higher inflation in 2007. Also, policymakers view financial conditions—as seen in equity prices, nominal yield levels and credit spreads—as being accommodative and therefore do not consider an easier policy warranted at this time.

We don’t share these views. Inflation pressures seem to be fading and a consumer with a buy-in-advance of higher prices psychology was never present in our minds. In fact, a more credible case could be made that consumers have adopted a skeptical view on prices, as they seem to be waiting for discounts before purchasing. Financial conditions, as measured by equity prices and nominal yield levels, on the margin appear to be somewhat accommodative, but sluggish growth in our proprietary liquidity index indicates that consumers and businesses are not responding favorably to the terms and conditions of the financial markets. Moreover, projected nominal GDP growth of 4% in 2007 would be far below that of the current 5.25% target on the fed funds rate. That tells us that monetary policy will have to become more relaxed to support the economy in 2007.

Slower Consumer Spending

Real consumer spending is estimated to rise 2.1% in 2007, the weakest increase of the current cycle and the lowest annual gain since 1991. Durable-goods spending is seen climbing a mere 0.7%, reflecting the weakness in motor-vehicle sales and some pullback in house-related expenditures. Motor-vehicle unit sales are estimated at 16.2 million units for 2007, down from an estimated 16.5 million units in 2006.

Nondurable-goods spending is expected to rise 2.1%, as we expect spending on nondiscretionary items (food and apparel) to slow but remain positive. Spending on consumer services is estimated at 2.4%—the first time spending on services would exceed spending on goods since 1991. Real spending on medical care accounts for most of that projected growth.

The downside risks to the consumer are centered in employment and housing. Historically, housing corrections that prove to be large and long tend to result in a significant loss of jobs, directly in housing-related construction, and indirectly in manufacturing and services heavily exposed to residential real estate. These job losses have so far been small, but should increase substantially in 2007. Indeed, we see the jobless rate rising to 5.1% by year-end 2007.

Weakness in house prices is another downside risk to the consumer. In recent years, the quick acceleration in house prices has allowed consumers to extract cash or liquidity from their homes. This trend contrasts with more typical periods, when housing is instead a net absorber of liquidity—reflecting higher principal and interest payments, property taxes and general maintenance expenses.

The Federal Reserve’s household-mortgage financial-obligation ratio provides a good illustration of how rising homeownership absorbs liquidity. (This series, which is related to growth in disposable income, includes the cost of servicing mortgage debt, both principal and interest payments, along with the added expenses of insurance and property taxes.)

Not surprising, as the housing market boomed and homeowners took on more debt (and sometimes more houses as well), this ratio increased, rising from 9.1% in 2000 to 11.6% in mid-2006. Yet, their actual net housing costs actually fell because they extracted equity from their home. But with house prices declining in many markets and the prospect of a recovery dim, mortgage-equity withdrawal has come to an abrupt halt. Consequently, net housing costs are moving back in line with outstanding debt levels. This spells trouble for big-ticket durable-goods spending in 2007.

Accommodative financial markets are an upside risk, as rising equity markets provide a nice boost to household net worth. However, equity ownership is heavily skewed to the upper-income groups, so while it is a plus factor, we don’t think it will offset the loss of liquidity from the housing market.

House Sales to Weaken Further

Housing starts are estimated at 1.43 million units in 2007, down 21% from this year’s estimated 1.82 million units. Clearly, the housing industry enters the new year with relatively poor fundamentals. Housing turnover (sales divided by the number of households) has been running well above trend for years and is poised to decline sharply in the next year or two. This comes at a critical time as the industry faces record numbers of unsold new and existing homes.

Admittedly, recent price declines have helped to stabilize demand in some markets. But price weakness is no panacea because the vast majority of households that buy a house already own one. Lower prices therefore don’t boost long-term demand, as they generate neither the incremental spending power nor the optimism that accompanies rising prices.

To reduce the huge inventory, builders will instead have to limit the number of homes under construction and hold the level of new construction at a level well below demand for several months. Thus, even though we see starts of 1.43 million in 2007, only 3.4% below October’s level of 1.48 million, the risks are clearly skewed to the downside. That’s especially clear in light of our expectation that job growth—a key driver of housing demand—will slow in 2007.

We also believe that comparisons being made between the US and UK housing cycles are not relevant. The UK market never developed an inventory overhang and it also faces tight limits on the number of available building lots. Both factors tend to shorten the correction in terms of depth and duration.

Investment Is Positive but Not Robust

Continued growth in business investment is a bright spot for 2007. Construction of nonresidential structures should increase 8.2% and business spending on equipment and software should climb 5.8%. The F.W. Dodge Construction survey, which tracks new building contracts, suggests increased spending on hotels, schools and industrial, commercial and institutional buildings next year. The rise in equipment spending should be broad based. There are, however, questions as to how much of a lift the launch of Microsoft’s new Vista platform in January will provide to business demand for laptop and desktop computers. Industry contacts suggest that current orders are below expectations, so there could be a slow start for the tech sector in early 2007.

A big plus factor for capital spending is record corporate profitability. US company profits as a percent of nominal GDP stand at its highest level in 50 years. The modest rebound in wages, low financing costs and ongoing gains in productivity have all contributed. In fact, given the strength of profits, we wonder why capital spending has not been even greater.

Apparently, the top-line growth attraction of emerging economies and the low operating costs of emerging markets have shifted the investment in physical capital expenditures by US firms to their affiliate operations overseas. This off-shoring of investment is another factor that could weigh on growth in 2007 and it could also make the eventual rebound from the mid-cycle slowdown less robust.

One potential downside risk for 2007 is that with profit growth bound to slow (3% to 5% in 2007 versus an estimated 27% gain in 2006), US firms might be even more reluctant to invest at home—especially when their all-important end customer markets are weakening.

Record Backlog May Signal Strong Exports

Real exports should increase 5.8% in 2007, and with record order backlogs for leading US exports like commercial aircraft and machinery equipment, they could rise even more. The incremental growth in new orders in 2006 has largely been tied to overseas demand, so a larger share of US industrial output should be shipped overseas next year.

This trend shift is readily apparent in the order patterns of many US multinationals. For example, through the end of November, Boeing has booked orders for 855 new commercial planes, and roughly 85% represent orders from foreign carriers. In addition, Parker Hannifin, a large diversified US machinery firm, has posted 5% to 6% year-on-year order gains in the past two months and most of that has come from its international segment, while its domestic industrial orders have stopped growing, reflecting the weakness in the automotive and housing markets.

Importantly, the recent weakening in the dollar and the good growth in overseas markets, makes the export outlook even brighter, although it will take time to influence contract prices and even more time to affect orders and shipments.

Real imports, meanwhile, are expected to grow only 4.5%, reflecting sluggish consumer demand for durable and nondurable goods. Importantly, the dip in import growth, combined with the rise in export growth, will not be enough to add to overall real GDP growth.

Less Inventory Investment

Inventory investment is expected to slow to an annual build of $17 billion, far below this year’s estimated $42 billion. There appears to be too much inventory in the wholesale channel, especially technology equipment, and an overhang of motor vehicles. Indeed, third-quarter real inventory at the wholesale level posted its largest increase on record and roughly half of that was concentrated in technology equipment. Information from purchasing agents also suggests there is too much inventory in the channel. Each month, purchasing agents are asked about the level of inventory at their key customers. From this information the Institute of Supply Management constructs a diffusion index—and both the change and the level of the index are important. In October and November, the Customers’ Inventory Diffusion Index stood above 50%, well above the levels posted earlier in the year, indicating that purchasing agents believe that many of their key clients have too much inventory on hand.

Not surprising, the Purchasing Managers’ New-Orders Diffusion Index fell below 50% in November for the first time since early 2003. This probably reflects the inventory overhang. Additional weakness in the New-Orders Index is likely to extend into early 2007 as firms attempt to reduce high inventory levels in the face of slower domestic demand.

Moderating Inflation

Headline consumer price inflation is expected to slow in 2007 to just 1.6%. With consumer prices lower this quarter as a result of a marked decline in energy prices, the take-off point for 2007 is relatively low, biasing the 2007 calendar year number downward. (Headline inflation should rise about 2.3% from the fourth quarter of 2006 through the fourth quarter of 2007.) This assumes crude-oil prices stay in the $55-to-$60 range, so actual inflation could easily swing a half point in either direction if oil prices lie far outside that range.

Core consumer price inflation, excluding rents, stabilized in 2006 and stood at 1.9% in November. Core consumer price inflation is expected to moderate to approximately 2% to 2.25% in 2007, as gains in owners’ equivalent rent (the CPI measure of housing costs) slow. In addition, weak consumer demand should also keep a lid on other prices such as housing-related equipment and autos. The weaker dollar is unlikely to add much to inflation because the decline against the currencies of Asia—the source of many consumer products—has been very small.

Monetary Policy, Interest Rates and the Dollar

A very weak end to 2006 and sluggish growth in early 2007 lead to our expectation that the Fed will lower interest rates at the end of the first quarter. For the full year, we expect the Fed to lower official rates by 75 basis points, bringing the fed funds target to 4.5% from today’s 5.25%. The interest-rates futures market has already priced this in (and then some), so the effect on market rates will be very small. But we do see the potential for the yield on 10-year US Treasuries to drop another 25 basis points to 4.25%. Our view is that the trade-weighted average of the dollar should fall about 5% in 2007, with most of the adjustment coming against Asian currencies and the Euro. A bigger decline might limit the flexibility of the Fed and lessen the odds that they will reduce official rates as much as we expect.

Summary

• Official Rates: Bothered by core inflation, policy-makers may decide to raise rates.
• Consumer Spending: Unemployment could be exacerbated by the continuing housing slowdown. If home prices continue to fall, even modestly, housing may revert to it traditional role as an illiquid asset.
• Business Spending: US firms may remain hesitant to spend, especially if they continue to see their all-important US customers pulling back.
• Inflation: Headline inflation could easily swing a half point in either direction if crude-oil prices vary from the $55-to-$60 range. Supply disruption is a serious concern, given the tensions in many oil-producing regions.

• Business Spending: Continued growth in business investment is a bright spot. There is a potential that our estimates could be low given the strength in profits. We see nonresidential structures increasing 8.2% in 2007, while business spending on equipment and software should climb 5.8%.
• Consumer Spending: Low nominal rates typically enable homeowners to refinance. Gains in equity markets should boost household net worth, albeit modestly. Both plus factors could lift consumer spending more than we expect.

Net Exports: US exports are mainly capital goods (especially commercial aircraft and machinery equipment). Foreign order backlogs for both industries are at record levels and that may result in even greater export growth in 2007.

For an illustrated discussion with charts and graphs, please download the pdf at the top of the page.

There is no guarantee that any forecasts or opinions in this material will be realized.