The Second Quarter Wasn't So Bad, And The Second Half May Be Better

You know the drill: To handle any project successfully, you have to dot the i's and cross the t's. In analyzing the second-quarter economy, the "i" is inventories and the "t" is trade. Usually overlooked, these two sectors had big roles in determining growth last quarter, and they say a lot about the outlook in the second half.

Real gross domestic product grew at an annual rate of just 0.5% last quarter, down sharply from 2.7% in the first. The GDP fixed-weight price index showed that inflation also slowed, with prices throughout the economy rising at a mild 2.8% rate, from 3.1%.

The severe slowdown in inventory accumulation accounted for almost all of the GDP weakness. Inventories shot up by $51.1 billion in the first quarter, and then by only $30.4 billion in the second. That shift subtracted more than 1 1/2 percentage points from growth last quarter. Auto inventories swung from a small accumulation in the first quarter to a drop in the second. That alone cut one point from GDP growth.

In addition, a $6.5 billion widening in net exports last quarter trimmed another half-point. The quarterly trade deficit is the biggest in 7 1/2 years. Exports grew at a respectable 7.2% pace, but imports soared 9.4%, on top of a 10.1% surge in the first quarter.

Even though GDP growth was the weakest in 3 1/2 years, demand by consumers, businesses, and governments actually held up quite well last quarter. Final sales--GDP less inventories--grew by 2.1%, only down a bit from the 2.6% advance in the first quarter (chart).

Looking ahead, the latest reports on consumers, industry, and construction show that the economy has more strength now than earlier in 1995. One promising sign: Purchasing managers suggest that the inventory correction is largely played out, laying the foundation for higher production, payrolls, and consumer incomes.

OF COURSE, the second quarter could look even worse as time passes. Because not all of the June data are available, the Commerce Dept. made what seem to be generous assumptions for June inventories and foreign trade. A shortfall in either sector could put GDP growth at zero when the data are revised Aug. 30.

Moreover, Commerce said on Aug. 2 that under its chain-weighted GDP index, the economy contracted at a 0.2% annual rate last quarter. This new index will replace the fixed-weight measure in December.

But the second quarter is history. More important to the outlook is what the latest data are saying about the second half. Here, the inklings about the future are good. The government's index of leading indicators, for instance, rose 0.2% in June, stopping a three-month string of declines. And personal income and spending were healthy in June.

INCREASING INCOMES are especially important because what's in the wallet will determine the course of consumer spending. In June, personal income rose a sturdy 0.4%. After adjusting for taxes and prices, real disposable income was up 0.3%. Incomes would have increased more except for a fall in farm subsidies.

Real consumer spending advanced 0.2% in June. Demand for goods increased 0.4%, but outlays for services were flat, down sharply from the average 0.4% gain of each of the four previous months. A drop in household operations, including utility demand, offset gains elsewhere. July's heat wave, however, virtually guarantees that consumers pumped up electricity use to run everything from pool filters to air conditioners.

Although consumer purchases grew at a solid 3.1% in the year ending with the second quarter, outlays have not risen as quickly as aftertax income, up 3.3% (chart). One reason: The fastest income growth has come in investment-related earnings, such as interest and dividends, that are less likely to be spent. But they add to a feeling of wealth, which may be why consumers in 1995 are more willing to use credit. So as long as paychecks grow modestly, shoppers will stay in a spending mood in the second half.

A consumer-related sector that still looks flat is housing. Residential construction fell at a 14.2% annual rate in the second quarter, the third drop in the past four quarters. And the monthly data suggest that little headway will be made in the second half.

New single-family home sales rose 6.1% in June, to an annual rate of 728,000, the highest in 1 1/2 years. Buyers were attracted to the low mortgage rates in June. But because rates have risen again, mortgage applications to buy homes peaked in early June and then trended lower. That means homebuilding will offer little, if any, help to GDP growth in this half.

Industrial construction is where builders are busiest. Construction spending jumped an unexpected 0.9% in June, while commercial projects alone surged 3.5%.

According to the F.W. Dodge Div. of The McGraw-Hill Companies, rising building contracts suggest that commercial real estate will remain on the rebound. Total contracts rose 3.6% in June, and nonresidential construction gained 3.8%. For the first half of 1995, nonresidential contracts are running 9% above last year's first half. Housing contracts are down 10%.

FOR MANUFACTURERS, the revival in commercial real estate, after the recession years of the early 1990s, is very good news. Not only does the comeback mean greater demand for concrete, gypsum, and steel, but companies will need computers, machinery, and file cabinets when the buildings are done.

The capital-spending boom has kept the industrial sector going even as consumer spending slows. Investment in producers' durable equipment rose 12.7% in the second quarter, on top of a 24.5% leap in the first.

Demand for capital goods continues to rise. New orders for all durable goods were basically flat in June, after rising 2.6% in May. But bookings for capital goods outside of the volatile aircraft industry jumped 2.5% on top of a 5% surge in May. Businesses are splurging on machinery because they have the cash. According to the Corporate Scoreboard, profits continued to soar in the second quarter.

Partly thanks to increased orders, the industrial sector rebounded in July (chart). The National Association of Purchasing Management's index rose in July, to 50.5%, after falling in May and June. A reading over 50% indicates that the industrial sector is expanding. The NAPM reported that orders, production, employment, and inventories bounced back in July.

The NAPM inserted a special question on inventories into its survey. It reported that the majority of responding purchasers "feel both their organizations' and their customers' inventories are now at about the right level for the expected amounts of sales." If so, that means that factory output and jobs could pick up steam in coming months.

To be sure, the top-line GDP number looked awful last quarter. But growth--like God--is in the details. Yes, foreign trade and inventory accumulation do matter, but the larger demand sectors, such as consumers and construction, present a truer--and healthier--view of the economy's future performance.

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