Weak Retail Sales Could Dampen Q3

Action Economics has lowered its third-quarter GDP estimate to a 2.8% rate in response to a surprising drop in June sales data

Friday the 13th wasn't unlucky for U.S. data watchers, but it did provide a few reminders of potential trouble spots for the economy. A weak report on U.S. retail sales for June, released on July 13, took the luster off the big sales gains of May and March and looked more like the weak initial reports for February and April.

Meanwhile, another report released on July 13 showed firm gains in export and import prices that could prove troublesome for the Federal Reserve as it endeavors to keep a lid on inflation.

But there was good news as well. A surge in a widely followed consumer sentiment index for July suggests only limited downside risk to consumer spending in the current quarter. And a big rise in business inventories in May boosted prospects for second-quarter growth as well.

On the whole, the reports signal that risks to the second-quarter gross domestic product outlook probably shifted more to the upside than the downside, despite the weak retail figures. Action Economics' second-quarter GDP annual-rate estimate remains at 3.4%. However, we have lowered our third-quarter GDP estimate to 2.8%, in response to the weak June sales data, leaving an oscillating pattern in GDP growth rates since the second quarter of last year around an underlying trend that we would currently peg at just below 3%.

Here is our rundown of the July 13 releases:

Retail sales: They fell 0.9% in June, while sales excluding autos were down 0.4%, both weaker than expected. This followed an upwardly revised headline gain of 1.5% in May (1.4% previously), though April was bumped lower to -0.3% (from -0.1%). The ex-auto figure for May was revised up to 1.6% (from 1.3%), but April was knocked down to -0.1% (was +0.1%).

June's declines were broad-based. Motor vehicles and parts sales declined 2.9% after a 1.1% surge in May. Gas station sales were down 1.1%, while clothing sales were off 1.4%. Furniture and building material sales declined 3.0% and 2.3%, respectively.

The report revealed widespread June weakness that reversed part of the outsize strength in May. Yet the revisions to past months were minor, so the impact for the quarterly forecasts is greater for the third quarter than the second. The data are consistent with a slowing in real consumption growth to 1.3% in second quarter, vs. our prior 1.4% estimate, following the outsize 4.2% gains in each of the prior two quarters. We have lowered our third-quarter consumption forecast to 2%, from 2.5%, though the outlook will depend on whether the big swings in the monthly sales figures extend into July. The strong July Michigan confidence reading (see below) raises prospects for a July-August bounce.

Trade prices: Import prices increased 1.0% in June, and export prices rose 0.3%. May's 0.9% surge in import prices was revised up to 1.1%. May export prices were also revised a bit higher, to 0.2%, from 0.1%. On a year-over-year basis, import prices are up 2.3% (vs. 1.1% in May). Export prices are up 4.1% year over year (from 4.3% in May).

Among June imports, petroleum prices were up 4.7% on top of hefty gains since February. Excluding petroleum, import prices edged up 0.2%. Agricultural export prices surged 2.9% in June, while the up trend in core export prices moderated in the month to a 0.1% gain, following increases of 0.3% to 0.5% in each of the prior six months.

The U.S. trade price indexes for June revealed the strength that had been expected, given price pressures related to global strength in food and energy prices, a strong global economy, and a falling dollar.

The core figures took a breather this month relative to the powerful run thus far in 2007, but this should prove temporary. For imports, prices rose 0.2%, below the 0.3% to 0.5% gains of the past three months, while core export prices rose 0.1%, following six straight months of gains in the 0.3% to 0.5% range. Even these moderate gains are problematic for the Fed, however, as foreign trade generally restrains U.S. prices via weaker gains for the core figures from this sector than from the broader economy. In this case, the lull in the figures still left gains that roughly matched the trend in the domestic inflation measures.

We will continue to assume 0.2% headline gains for the producer price index, consumer price index, and personal consumption expenditure chain price reports for June, with 0.2% core price gains for all but PPI, where we assume a 0.1% core gain. The firm June trade price data, and overshoots in other core and headline measures from desired rates, will remain a thorn in the side of the Fed, as it continues to focus disproportionately on inflation risks.

Business inventories: Inventories rose 0.5% in May, while sales surged 1.3%, following April's 0.4% inventory gain and the 0.7% increase in April sales. The inventory-sales ratio continued to shrink, falling to 1.26, from 1.27, in April and 1.30 as recently as February.

The U.S. business inventory report revealed a big headline inventory gain in May that was driven by a much-bigger-than-expected 0.6% retail inventory gain. That's important for the second-quarter GDP outlook, given that the surge was only partly auto-related. The ex-auto retail inventory figure enters the GDP calculation, and this rose 0.7%. This gain occurred alongside the already released inventory gains of 0.3% for the factory sector and 0.5% for the wholesale sector.

The mix, which left a 0.5% overall inventory gain that followed a 0.4% April increase, leaves a big April-May inventory reversal in place from the sizable inventory correction through the fourth quarter 2006-first quarter 2007 period.

University of Michigan consumer sentiment: The Michigan sentiment index jumped to 92.4 in the preliminary print, vs. 85.3 in June, which was much better than expected. Strength was paced by the future economic outlook, where the index rose to 83.9 from 74.7. The current conditions index climbed to 105.7 from 101.9. The one-year-ahead inflation expectations median slipped to 3.3% from 3.4%.

Renewed stock price strength and a modest gasoline price correction may have helped these readings. We will boost our forecast for the Conference Board's consumer confidence index for July to 106, following the 103.9 reading in June.

Overall, though the various confidence measures have moderated in recent months from the heights reached at the start of the year, they remain solid on an historic basis and are consistent with third-quarter strength in retail sales, despite the downswing just noted in the June sales data.

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