The Economy's Gloomy December Start

Thanks to the contracting manufacturing sector and a drop in construction spending, expectations for fourth-quarter GDP growth have been lowered

November ended with a volley of unfriendly data for the U.S. economy, and it looks as if December is starting out the same way. Weakness in U.S. economic reports released on Dec. 1 concerning the Institute for Supply Management's factory sentiment index, and construction spending—following the weak releases on durable goods orders, the Chicago purchasing managers' sentiment index, and initial jobless claims earlier in the week—have taken a big chunk out of the near-term U.S. GDP outlook. But the reports probably won't move the Federal Reserve from its current policy path.

The culprit in all this seems to be the housing sector. The reports suggest that we are finally seeing some "pass through" of housing weakness to other sectors of the economy, and the factory sector in particular. This partly reverses what has been, up until now, a surprising containment of weakness in the single-family segment of the residential construction market.

Here is Action Economics' rundown on the Dec. 1 reports:

ISM Manufacturing Index: The ISM fell to 49.5 in November from 51.2 in October, and the sub-50 reading reflects a contracting manufacturing sector. The employment index edged down to 49.2 versus 50.8. Prices paid rose to 53.5 from 47.0. New orders declined to 48.7 from 52.1.

The report revealed even greater weakness than the lean November Chicago PMI figure of 49.9. We will now assume a 55 level for the Dec. 5 release of the November ISM Non-Manufacturing index.

The combination will leave a 53 average for the major ISM-adjusted sentiment readings for the month, versus an average within one point of 55 in each of the prior five months. We have been looking for a drop to the 53 area for these readings, on average, for some time, but the sudden adjustment this month may have ripple-through effects on other November reports. We now expect the November employment report to show a 100,000 payroll gain, down from our previous forecast of 120,000, and November industrial production to post only a 0.3% gain.

Construction Spending Construction spending tumbled 1.0% in October following a revised 0.8% decline in September (-0.3% previously). The residential sector remained weak, falling 1.9% after better than 1% declines the past five months. This sector is down 9.4% year-over-year.

Meanwhile, nonresidential spending was flat and is up 13.6% year-over-year. Private construction spending was down 1.5% after a revised 1.1% decline in September (-0.7% previously). Public construction spending was up 0.8%.

The report for October was weaker than expected, and has taken a chunk out of our business investment and gross domestic product forecasts for the fourth quarter and 2007 first quarter. We now expect the residential construction component of GDP to roughly subtract the same in the fourth quarter as in the third quarter, and the third quarter decline should be revised $3 billion lower to leave nearly a 20% rate of decline. For nonresidential construction, we now expect only a 6% rate of real growth in the fourth quarter, following the 16.7% third quarter growth clip, which could be nudged down.

We now peg fourth quarter GDP growth at 2.0% and 2007 first quarter growth at 2.6%. We still expect a 2.2% third quarter GDP gain, as the downward construction revisions offset the upward consumption revisions signaled in yesterday's retail sales revisions.

What does this weakness mean for the outlook on Federal Reserve policy? Implied rates on Fed funds futures now show a nearly 80% chance for a 25 basis point easing to 5% by the end of the March Federal Open Market Committee meeting. A cut to 5% is fully priced in for the end of the second quarter, with the July contract reflecting small risk of another cut back to 4.75%.

We still believe a steady Fed stance for an extended period is the better bet. The FOMC maintains a bias toward tightening amid an elevated core inflation rate and a tight labor market, and we suspect it will take several more months of weak data (which we don't anticipate) to get the FOMC to start to think of easing rates.

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