Research US: Nothing to fear, but fear itself

• The recovery is looking increasingly robust as the labour market is turning and underlying domestic demand has improved faster than expected. Downside risks from a jobless recovery are now limited.

• The debt crisis in Europe is the main risk. It is already taking a toll on growth via deteriorating financial conditions. If market conditions do not improve a more pronounced slowdown is in the offing for H2.

• In any case the manufacturing cycle is set for a slowdown in H2 as inventory dynamics turn less favourable. Leading indicators, including the ISM, will start moving lower very soon.

• The longer-term outlook is for moderate growth with tough fiscal consolidation and financial regulation ahead. Easy monetary conditions and pent-up demand are expected to support above trend growth.

• Inflation pressure is expected to remain moderate. Core inflation will bottom around 0.5% late this year and move only gradually higher. Headline inflation is expected to remain below 2% throughout the forecast period.

• Financial turmoil will delay the initial Fed rate hike to March 2011. This will be preceded by verbal preparation of markets and liquidity draining. An escalation in market stress could reverse this process and force the Fed to reintroduce credit and liquidity programmes.

A more robust recovery

Following a solid Q4 with 5.6% q/q AR growth, the economy performed close to our expectations printing 3.0% q/q AR growth in Q1. The recovery is now looking increasingly robust as job growth has returned and consumers are ramping up spending. While there are still pockets of weakness in housing and commercial construction, the recovery has broadened with all other sectors showing progress.

Over the past few months data has been picking up further, suggesting a reacceleration in growth. Consequently, we have revised Q2-Q4 GDP growth up to 3- 3.5% from 2.5-3% q/q AR previously – a revision that would have been even bigger if it was not for the recent financial turmoil. The forecasts for annual growth in 2010 and 2011 have been upped to 3.3% and 3.2% vs 3.2% and 3.0% in Global Scenarios March 2010.

Generally, we continue to expect a moderate recovery compared with historical standards and relative to the depth of the recession, as fiscal contraction and financial regulation is set to cap growth in the medium term.

Inventory dynamics feeds into spending

In the previous version of Global Scenarios (March 2010) we argued, that the positive dynamics from the inventory cycle would boost the labour market sufficiently to put the economy back on a sustained recovery path. This is indeed what has been happening over the past few months and the risk of a jobless recovery now appears very limited. Since December 2009 monthly gains in private non-farm payrolls have improved from minus 64,000 (preliminary release) to 231,000 in April. The outlook is now for monthly gains in non-farm payrolls (excluding census) in the range of 200,000-250,000 throughout the year and for a decline in unemployment to about 9% by year-end.

A return to relatively robust job growth has for some time been the cornerstone in our view of a sustained US recovery, as it is a premise for a sustained upturn in personal spending. On top of this the headwinds from huge net wealth destruction are easing and consumer credit is loosening up. Along with the declining unemployment rate, this implies that the upward pressure on the savings rate has eased considerably.

With low core inflation and oil prices only marginally higher on the year this provides room for a moderate recovery in consumption. We look for quarterly consumption growth to average 3.2% q/q AR this year, but expect it to lose some steam in 2011 when fiscal support is removed.

However, this is not the only implication of the turn in the labour market. When hiring returns businesses usually ramp up investment spending and begin restocking, as spending on labour and capital goes hand in hand. Indeed this is now acting to support the positive recovery dynamics.

Finally, as we emphasised in Global Scenarios in March continued solid exports demand and pent-up demand on cars, housing and capex will be making up for some of the missing strength in personal consumption and facilitate above trend growth through the forecast horizon.

Hence, despite pockets of weakness in residential construction and structures the stage should now be set for a self-propelling recovery. The only real threat to this scenario is the appearance of any new shock.

Will the US catch a cold from Greece?

This is where the Greek debt crisis becomes relevant. First, it has battered the outlook for the eurozone and second it has led to a significant deterioration in financial market conditions over the past couple of months.

However, the impact from the debt crisis in Europe is expected to be limited. First, the eurozone makes up only 10% of US exports. Second, the contribution to export growth has not been of any significance during this recovery. Third, even though the EUR/USD has moved lower the real effective exchange rate remains not far from its 12-month average.

Much more of a concern is the general deterioration in financial conditions. The equity market has corrected some 10% from its cyclical peak, credit spreads are widening and money markets have become distressed.

This is already taking its toll on growth in the near term even with the cushion from declining commodity prices.

To assess the impact we have simulated two scenarios; one with no shock (i.e. financial variables fixed at the end-April levels) and one with the current shock (i.e. financial variable fixed at the current level).

The scenarios indicate that if the market conditions do not improve GDP growth is likely to take a hit of 1-1½pp in H2 10 and ¾pp through 2011. The simulations also demonstrate that the growth rate would probably have approached 4% in H2 if it has not been for the contagion on global financial markets.

The assumption behind our forecast is that the intervention from fiscal and monetary authorities will finally succeed in calming down the markets. In this scenario the recovery will remain intact. There will be a cost from the turmoil in the short run, but it will to some extent be paid back later on.

Contagion could speed up manufacturing slowdown

Over the past three quarters the US manufacturing sector has experienced a classical V-shaped recovery. The manufacturing ISM index reached a cyclical high of 60.4 in April, but fundamentals now suggest that leading manufacturing indicators are very close to a peak and that the pace of manufacturing growth is bound to slow in H2.

This should in fact be of little surprise. Production has been expanding faster than demand over past quarters and the gap between the two has narrowed. As output catches up with demand, production growth will eventually settle down to more average levels. We are now close to this point in the cycle and the ISM is set to move lower in H2.

While fundamentals are suggesting that the descent in the ISM will be relatively moderate, the recent deterioration in financial market conditions could speed up the slowdown in the manufacturing sector. Discounting the recent turmoil ISM should be heading for 54-55 by year-end. However, in the event that conditions do not improve these levels could be reached as early as November and the ISM would reach 50 in Q1 (see Euro crisis could speed up manufacturing slowdown).

Inflation to stay low but deflationary trap unlikely

Core inflation dropped to 0.9% y/y in April, its lowest level since 1963. A major disinflationary impulse from the housing component is currently dragging core service price inflation lower and there are no signs of a turnaround in housing inflation any time soon. Service prices outside housing are usually very stable, but with a major slackening in the labour market, we believe that this inflation component will move lower as well.

Outside services, there is evidence of upward pressure on core goods prices. Core crude and intermediate PPI has surged over the past year, but a sharp decline in unit labour cost growth has offset the upward price pressure and finished goods PPI has kept relatively stable. We expect the downward trend in unit labour cost growth to continue keeping a lid on core goods inflation.

In summary, we expect annual core inflation to trough at 0.5% in Q4 and trend only gradually upward to 1.2% by end-2011. Given our outlook for a moderate increase in oil prices, we expect headline inflation to bottom at just above 1% and increase to 1.7% by end-2011.

Fed exit delayed by financial turmoil

Even though growth indicators have been stronger than expected over the past few months and the outlook for H2 remains above trend GDP growth, the recent turmoil in financial markets is likely to delay policy normalisation. Low and declining inflation pressures and a continued large output gap affords the Fed time to wait and see how the current crisis develops. The latest FOMC minutes showed that most members expect inflation to fall below target in the medium term at the same time as the European debt crisis is seen as a risk to both growth and US financial markets.

Financial contagion and de-risking has only accelerated since then. We have therefore postponed the initial Fed hike from November 2010 in the latest Global Scenarios to March 2011. This is likely to be preceded by discount rate normalisation and liquidity draining together with a moderation of the ‘extended period’ language. We expect the Fed to deliver a 25bp hike at each of the following meetings until the fed funds rate has reached a neutral level.
If the financial market turmoil develops further we would not rule out a reintroduction of other liquidity and credit facilities on top of the recent reopening of FX swap lines (see: Thoughts on the Fed and the money markets). In that event the normalisation process would be dragged out, delaying the initial Fed funds rate hike beyond March 2011.