U.S.: A Strong Third Quarter--but at the Expense of the Fourth

Consumers did it again, partly because of summer auto incentives

Surprise! Third-quarter economic growth is turning out to be a lot stronger than most economists had expected in the wake of the summer stock market plunge. Thanks again to the resilience of consumers, fears that the second quarter's paltry 1.1% growth rate was a precursor to a new round of economic stagnation are turning out to be wasted worry.

But don't get too excited just yet. The pattern of this moderate economic recovery remains uneven. Third-quarter growth may well best the 3% average of the past three quarters. But some of this quarter's gains may have been "borrowed" from the fourth quarter, because they were fueled partly by car buyers' positive reaction to 0% financing. So fourth-quarter real gross domestic product growth could dip back below 3%. But growth will remain positive, and fears of a double-dip recession should become passé.

Certainly, the latest data are encouraging for the outlook. August retail sales were unexpectedly good, suggesting that households aren't as gun-shy as the recent dip in confidence might suggest (chart). With consumer prices remaining tame, households are able to stretch the buying power of their earnings. And amid record refinancing activity, many consumers are taking cash out of their homes, giving spending a further boost.

Elsewhere though, businesses remain hesitant to commit funds to new capital projects. That, plus the long-run influx of imports, is weighing on U.S. manufacturing. Although retailers and wholesalers are cautiously lifting their inventories, factories are still cutting stockpiles, and August manufacturing output fell for the first time this year. This dichotomy between healthy demand and soft production is why the recovery, though moving forward, is doing so in fits and starts.

IT'S ALSO WHY CONSUMERS remain the crucial sector in the outlook for demand. Retail sales increased 0.8% in August, on the heels of July's 1.1% jump. Rising car sales accounted for the lion's share of the two increases, but spending on other items rose as well. The Commerce Dept.'s data generally had a much firmer tone than the August results on same-store sales recently reported. Plus, weekly reports suggest that September buying is stronger than the August showing.

Yet even if September car sales fall back, and other sales are flat, real consumer spending on goods and services is on track to increase in the third quarter at an annual rate of 4% to 4.5%. That would be enough, by itself, to add up to three percentage points to growth in real GDP. But since the cheap financing lured buyers to act now rather than later, weaker car sales in the fourth quarter will probably subtract from fourth-quarter consumer spending.

Consumers, however, still have plenty of spending power. In the three months through July, their real aftertax income was up 5%. Consumer prices rose 0.3% in August, but they are up only 1.8% from a year ago. Also, refinancing activity hit a record in the third quarter. Economists are estimating that households will extract some $100 billion in cash from the increased equity in their homes in the second half.

History shows that consumers tend to spend about half of this cash immediately. In addition, home equity loans have surged. So despite ongoing job worries, households may still be able to bring some holiday cheer to retailers in the fourth quarter.

ANOTHER UNEXPECTED BOOST to third-quarter growth could come from net exports. Real GDP growth could even hit 4% if the July improvement in the trade deficit continues into the fall. The trade gap widened in the second quarter in part because U.S. companies ordered imports in anticipation of a longshoremen strike. Now that a strike has been averted, import growth should ease back to its long-term trend. Indeed, a 1% drop in imports contributed to the fall in July's trade gap, to $34.6 billion from $36.8 billion in June.

Some of that import buildup went into inventories, especially at retailers and wholesalers (chart). After declining steadily since early 2001, total business inventories have increased for three months in a row, including July's 0.4% gain. Business sales jumped 1.2% in July, so the ratio of stockpiles to sales continued to fall to a point below its long-term trend. That suggests, even with the extra import stocking, inventories are generally at or perhaps below their desired levels. If so, U.S. manufacturing could benefit from a pickup in orders next quarter.

Right now, though, the factory sector has hit a dry patch. Industrial production fell 0.3% in August. Factory output alone slipped 0.1%. Although real GDP could be growing three times as fast as it did in the second quarter, factory output probably isn't rising any better than its 3.6% rate of the spring quarter.

WHAT'S HOLDING BACK MANUFACTURING? Three factors are coming into play now, and unfortunately, they may stick around for a while. First, manufacturers are grappling with uncertainty, not just from scandals and war tensions but also over the strength in demand. As a result, factories are still filling orders from inventories rather than ramping up production or hiring new workers. Even as retailers and wholesale distributors built up inventories, factory stockpiles so far this year are down at a 4.4% annual rate.

Second, most capital-spending projects remain on hold, another offshoot of the uncertainty hanging over the uneven recovery. Capital-goods output accounts for about 13% of industrial production, less than half of the share for consumer products, but it is far more volatile. A boom in capital spending adds greatly to total output.

That's not happening now. Output of business equipment fell 0.3% in July and 0.4% in August. Demand has been hurt by the problems at the airlines, the telecom bust, and overcapacity in many industries. Factories themselves are using only 74.4% of their facilities. But until business investment turns the corner, factory output won't show any signs of acceleration.

The third drag on manufacturing is the influx of imports (chart). Although the dollar has declined this year, it's still strong enough that most U.S. goods are competing against cheaper foreign-made goods. So imports are growing at a faster pace than U.S. exports and U.S. production of similar goods. In the year ended in the second quarter, U.S. output of consumer goods edged up 0.3%, but similar imports jumped 8.2%. Output of business equipment fell 9.4%, but capital-goods imports were off only 0.9%.

Foreign trade's drag on manufacturing will not go away soon. And the factory sector's weakness is a key reason this recovery remains patchy. The third quarter is shaping up to be a pleasant surprise. But with war still not out of the picture and the stock market wobbly, the fourth quarter could bring another disappointment.

By James C. Cooper & Kathleen Madigan

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