Pre-GDP news

As we wait for the GDP release later this week we are still getting insight into the state of the economy courtesy of the normal flow of lesser data points.

For instance today we learned that home prices edged up 1.2% in August – that came from the Case Schiller index; and that consumer confidence fell for the second straight month – that came from the Conference Board.

“The odds are unlikely the economy will shrink again next year, but the expansion could well be very small.”

What do we make of these two snippets of information?

First, that slight uptick in home prices has to be treated with a little reserve. Yes, it seems to indicate that the endless plunge in home prices has reached a bottom. We have talked about that here before. All the evidence is now accumulating in favor of the notion that the national collapse in home prices has ended. that doesn’t mean, of course, that local problems won’t persist for many months to come. In fact I think we can expect places like Nevada and Florida to experience ongoing weakness for a long time – perhaps even years. This was a doozy of a bubble, so the aftermath will be equally prolonged. There is reason to be a little cautious however. This is because we really have no idea what the effect of the expired tax credit for first time buyers has been on prices. We do know that the volume of home sales picked up as a result of the credit. It seems reasonable to assume that prices firmed a little also – remember those infamous supply and demand curves from your school days. The effect of the credit was to induce higher demand. Given relatively static supply – as we have seen recently – that surely had to drive up the equilibrium price for houses, by about the value of the tax credit, or $8,000. The question then arises: is this shift upwards only temporary? Or is there sufficient organic demand to maintain the new price level?

For that we have no immediate answer. But we must bear the question in mind. That home prices have bottomed seems fairly clear from the aggregate data we have been seeing for the last three months. Whether the uptick in prices shown in the Case Schiller index the past two months portends a generalized strengthening in the immediate future is a whole different question.

I remian somewhat doubtful it does.

Why?

For the same reason I get a little squeamish reading the Conference Board’s report on consumer confidence.

It seems that consumers are retreating from their early summer views. The index fell to a very weak 47.7 in October from September’s 53.4. This is the lowest level of confidence registered on this index for 26 years. Clearly there are very grey clouds hanging over the average consumer. This cannot be good news for the economy, and in particular calls into question the sustainability of the current recovery.

Not to beat a dead horse, but without a steady return to spending by consumers the outlook for the next few quarters gets much bleaker. The current consensus forecast for GDP in the third quarter – that’s the number we will get our first look at later this week – is for growth at annual rates of around 3.7%. Given that this includes an inevitable element of ‘bounce’ from the recession most analysts think GDP will settle in at around 2.5% to 3.0% next year. As you know I don’t agree – I expect something quite a bit less, more in the range of 1.5%. My relative pessimism is anchored on my view of consumer attitudes. Today’s report of a second straight drop in confidence simply reinforces my notion that next year is a lot more dicey than most other people expect. The job market remains grim by any decent standard. Companies are doing their best to keep costs low – that means they will be very hesitant to re-hire workers, and they may well wait to get a better handle on 2010 sales before they ramp up production.

But it goes deeper than this.

A very large number of the jobs shed during this down cycle are not governed by a production cycle, they were in services. All the evidence suggests that service jobs have a much longer and more shallow cycle. Some sectors like health care are still doing well, but others such as the financial and retail sectors are not. Those will remain soft spots throughout next year, and will dampen the employment picture for a long time.

Given the hammering household wealth has taken – the combination of home equity and stock market loss has depleted most middle class household’s asset base enormously – the poor job outlook simply is compounding the difficulty we face.

Think of it this way: working class folks depend upon job availability and wage increases for cash for spending. The middle class consumer relies on those two, plus an ability to dip into wealth, for its spending power. Both groups have a limit to their discretionary spending – there is plenty of stuff they have to buy to survive, which squeezes the amount of cash left for discretionary stuff. So the shape of the outlook for the next few months is heavily dependent upon the way in which these consumers feel they can edge up to the limits of their cash flow. Obviously when they feel unsure they save rather than spend. This is the essence of that Keynesian ‘propensity to consume’ variable used in his economic theory.

Economics then becomes heavily based upon attitudes. And the trade-off between saving and spending dominates the medium term outlook.

That’s why data about consumer confidence is so important. It does not have a direct relationship with ‘hard’ data like retail sales, but it is highly correlated with the longer term and gives us insight into the likely trajectory of consumption. It is what I call ‘thematic’ data: it helps us develop the likely themes we will be dealing with.

Indeed we already see the theme reflected in the ‘hard’ data: savings have risen sharply since the recession started and there is yet little evidence of those savings being drawn down. That implies a lower propensity to consume. If this settles in as a more permanent theme, our potential GDP growth rate will shrink from its recent ‘norma’ of about 3.5% to something a lot less.

It is this developing theme that conditions my view about the economy’s growth next year.

In the absence of anything arising to offset it – an export boom; a sudden recovery in real estate construction; or a boom in business investment – this depressed level of spending resulting from consumers saving more of their incomes, will diminish growth more than most analysts are expecting.

Furthermore: take away the government stimulus as it wears off next summer, and we may see a second recession. The odds are unlikely the economy will shrink again next year, but the expansion could well be very small.

So I am sticking to my 2010 GDP growth target of 1.5% for the moment.