This Expansion Has Slowed To A Summer Stroll

The inflation-mongers had to give it a rest after the Commerce Dept.'s decidedly temperate estimate of the economy's growth rate last quarter. Even the bond market, ever vigilant against the slightest hint of price pressures, backed off. After the news broke on July 29, bonds staged their biggest one-day rally since mid-May, pushing the yield on the benchmark 30-year Treasury bond to 7.39%, from 7.55% the day before.

More important, much of the latest data are forcing the markets to rethink the economy's strength. Not only was growth in the first half more moderate than many had feared, but signs of an even slower second half, ranging from shaky consumer spending to weakening construction activity to stagnant leading indicators, continue to crop up.

Such a reevaluation could have a further positive impact on long-term interest rates. And while it's not likely to prevent another widely expected hike in short rates by the Federal Reserve in mid-August, a cooler economy could put further tightening on hold into 1995.

Even the Fed acknowledged some slowing in its Aug. 3 survey of regional economies that was prepared for its Aug. 16 policy meeting. The report noted that business activity remained generally solid but also pointed to "scattered indications of some slowing or slight declines" in some regions.

The economy's real gross domestic product grew at an annual rate of 3.7% in the second quarter, following a 3.3% pace in the first quarter, revised down from 3.4%. The government's revisions, which went back to 1991, were generally downward, but they were unusually small. Last quarter's growth was a bit less than the general expectation and well below the 41/2%-to-5% reading that some big securities firms had their trading desks braced for.

However, second-quarter growth was more important for its mix than its magnitude. Final sales of all goods and services rose a scant 1.5%, while inventories bulged (chart). Stock levels swelled by $54 billion, the largest quarterly increase in seven years. In the past, the combination of demand that weak and inventory gains that large has almost always led to a slowdown in GDP in the subsequent quarter, as businesses cut back on ordering while they work down their stockpiles.

The numbers strongly argue that some of the inventory increase was unintended and not the product of business optimism about future sales. In fact, for two consecutive quarters now, final sales have slowed, while inventories have accumulated faster.

Moreover, the bulk of the pileup occurred at wholesalers and retailers, right where you would expect it, given the quarter's weak 1.2% advance in consumer spending. Because of the sturdy pace of job growth through June, consumers are capable of spending at a faster clip than that, but for the second half, their top speed is probably about 21/2% to 3%. The savings rate is historically low, and higher interest rates are taking a toll on home buying and consumer durables.

Heading into the third quarter, retailers report only slim sales increases through the first four weeks of July compared with June, according to Johnson Redbook Report. That means efforts to reduce stock levels could be a plus for inflation, as stores and distributors are forced to reduce prices to move out unsold goods.

Imports, however, soared by 15.1% last quarter and must have accounted for some of the inventory bulge. To the extent that's true, the inventory adjustment will not be felt by U.S. manufacturers alone. Instead, less ordering from abroad will slow imports, a plus for GDP that will offset some of the expected slowdown in inventory growth.

So far, U.S. manufacturers seem unaffected by the jump in wholesale and retail inventories, mainly because their own stockpiles are in excellent shape. Inventories at factories rose only 0.1% in June, while shipments increased by 0.9%, pushing the ratio of stocks to sales to a record low 1.37. However, that reading chiefly reflects manufacturers' new skill in managing their stock levels.

Factory activity in July held at its healthy, if unspectacular, level of recent months, says the National Association of Purchasing Management (chart). Its composite index of orders, output, employment, delivery times, and inventories edged up, to 57.8%, from 57.5% in June. Although the July index was the highest in seven years, it remains well below the average peak of 67.9% reached in each of the eight previous expansions since World War II.

The purchasers continued to report increased price pressures, though these costs remain a long way from being passed on to final consumer products. NAPM's price index edged lower in July, but the breadth of increases widened, as 50% of the 300 companies surveyed reported paying higher prices for materials.

Such price hikes were primarily responsible for the 0.2% rise in the index of 11 leading indicators in June. However, that was a slim gain, and the index has made little headway in the past three months--another signal of slower growth in coming months.

One significant area that will provide little, if any, help for the economy in the second half is the construction industry. The building sector has directly contributed 14% of the growth in GDP over the past year, even though it is only 7% of the economy. But the steady rise in mortgage rates, as well as an overhang of already-built homes, will slow construction down.

Home sales were stunningly weak in June. Demand for existing homes fell 3.6%, to an annual rate of 3.96 million, while sales of new single-family homes plunged 14.1% in the month, to a two-year low of just 591,000 (chart). All regions shared in the decline in new-home sales.

As a result, just like retailers and wholesalers, homebuilders ended last quarter carrying more inventory than they probably wanted. The supply of unsold homes jumped to 6.1 months from 4.7 months in May.

Demand is caving in to higher interest rates. Mortgage applications to buy a home popped up in the week ended July 22, but for the first four weeks of the month, the pace of applications was way below the average of June, which was down from May.

The drag from housing is showing up in the other construction data as well. Total construction spending in June edged up just 0.2%, much lower than expectations. All of the increase was in nonstructures, such as utility and telecommunications lines, in addition to government projects. Both nonresidential buildings and housing fell in June. Housing outlays fell for the first time in more than a year.

For this quarter, the extremely rainy weather in the South and East suggests that construction outlays may have fallen in July. And the latest news on contracts indicates that an outright downtrend may be starting (chart). New agreements for building projects fell 1.7% in June, according to the F.W. Dodge Div. of McGraw-Hill Inc. Residential contracts dropped a steep 10%.

For the second quarter, total contracts were 14.3% below the first quarter, at an annual rate. And since contracts typically give a forward look at activity, the decline suggests a rapid slowdown in construction outlays, especially housing.

A dropoff in building will be a blow for an expansion that has increasingly counted on housing to lift growth. Indeed, residential investment has slipped in only one quarter during the three-plus years of this upturn. Housing's glory days may well be over, however. And that--along with an inventory correction and more moderate consumer spending--completes the laundry list of reasons why the economy will grow even more slowly in the second half than it did in the first.

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