Research & Commentary

Cloudy Forecast for the Second Half of 2007

July 9, 2007 David Rosenberg, Merrill Lynch North American Economist, said three key developments recently occurred that have clouded the outlook for the second half of the year: 1. The capital expenditures outlook is being trimmed Durable goods orders slid 2.8% month-to-month in May. The declines were fairly broad-based across the "old economy" industrial areas. The overall data were weak enough to prompt us to shift our second-quarter CAPEX forecast to about 5.5% sequential annualized growth, from 6%. We also lowered our third-quarter forecast to 4%, from 5.5%. It's worth noting that technology is the new bright spot in the economy (and the markets), with two months in a row of impressive gains of nearly 2% in new orders. 2. The housing situation is going from bad to worse As we see, it, market participants can forget about a recovery in the housing sector until next year. The starkest piece of recent information was the news that the national inventory of unsold single-family homes and condos surged at an astounding 82% annual rate so far this year. The overhang is now up to an 8.9 months' supply, the highest inventory-to-sales ratio in 15 years. By way of comparison, the months' supply of inventory was 6.4 a year ago and 4.3 two years ago. The current massive excess supply is going to reinforce the deflationary state in the housing market at a time when home prices, on average, have declined at an annual rate of 5% in the past six months (which is the biggest price drop since the summer of 1991). Moreover, fully three-quarters of the country is now deflating. Clearing out the excess inventory points to at least another 10% downside in average home prices, in our view, which will extend the weak performance of the homebuilders, the financials, and the consumer discretionary space. 3. The housing correction is spilling over to consumers There is unmistakable evidence that the downturn in housing is spilling over into the consumer space. Consumer spending in real terms rose by less than 0.1% month-to-month in May. That took the three-month trend in real consumer spending growth down to an annual rate of less than 1%, from 5% at the start of the year. What's ahead? We already know anecdotally that June auto sales fell by 3.4% month-to-month and chain-store sales are running half-a-percentage point below plan. All told, we have shaved our forecast for second-quarter consumer spending growth to 1.9% at an annual rate, from 2.5%; that would be the weakest pace since the fourth quarter of 2002 (excluding the Hurricane Katrina period). Consumer confidence fell to a 10-month low in June, and the level is lower now than it was at the onset of the past two recessions. Second-half outlook What does all this means for the second half of the year? The consensus is at 2.8% for real GDP at an average annual rate; we are barely at 2%. That 80-basis-point difference is going to make or break whether investors want to have a cyclical or defensive orientation in the second half of the year. With the books closed on first-quarter GDP (growth came in at a 0.7% annual rate), the big drag was the fact that an inventory liquidation occurred (a rare event). That means that inventories were replenished in the second quarter, which is why the manufacturing diffusion indicators (the ISM, for example) have looked bullish. But here's the concern. The guts of private sector demand — consumer spending, CAPEX, nonresidential construction and housing — collectively slowed to a 1.7% annual rate in the second quarter from a 2.2% pace in the first quarter. The history of the U.S. business cycle shows that when an inventory rebuild is not accompanied by a pickup in final sales, the rebound in GDP growth ends up getting snuffed out.