Amidst the Noise, US Economy Has Slowed

cougar

Published: Fri 27 May 2011


    * Another week, another run of disappointing data. Over the last month, our US-MAP scoring system has indicated a major downshift in incoming data. Our Current Activity Indicator (CAI) has fallen from 4.3% for March to just 1.5% for April, and there are few signs of a significant acceleration in May so far. On Tuesday we cut our Q2 GDP forecast to 3.0% (qoq annualized) from 3.5%, but we already see downside risk to that estimate.
    * What explains the recent weakness in the data, and how long is it likely to continue? Some of it is clearly due to temporary shocks that should abate in coming months, including higher oil prices, the natural disasters in Japan, seasonal adjustment problems, and flooding in the South.
    * However, the special factors cannot explain all the recent weakness in the data. We are somewhat puzzled by this because many of the trends that made us more optimistic around yearend 2010—progress in private sector deleveraging, easier credit and financial conditions, and an improving labor market—are still in place.
    * A more upbeat picture may start to emerge in late June as the Japanese automakers begin to ramp up production. But if the data flow fails to improve in coming months, we may need to consider a further downgrade to our US growth forecasts.
    * In any case, whether the slowdown is temporary or persistent, next week’s first-tier releases will refer to the same period in which many indicators downshifted significantly and are therefore likely to look soft. We forecast below-consensus payroll growth of 150,000, and a below-consensus factory ISM of 56.5.

Another week, another run of disappointing data. Over the last month, our US MAP score has averaged -2.8, indicating a major downshift in incoming data (Exhibit 1). Our Current Activity Indicator (CAI) has fallen from 4.3% for March to just 1.5% for April, and there are few signs of a significant acceleration in May so far. On Tuesday we cut our Q2 GDP forecast to 3.0% (qoq annualized) from 3.5%, but we already see downside risk to that estimate (Exhibit 2; more detailed table available upon request).

What explains the recent weakness in the data, and how long is it likely to continue? It is a deceptively simple question, as there have been an unusual number of new shocks and temporary distortions. Most importantly, oil prices unexpectedly increased at the start of the year, and are now about 25% above our original assumptions. Simulations suggest the increase should cut into consumption first and cumulate to a drag on GDP growth of about 0.75 percentage points by Q4. We cut our GDP growth forecasts on May 6 to account for this shock.

The events in Japan have also disrupted the supply chains for the Japanese-brand automakers based in the US. We estimate that this shock will cut about ½ percentage point from GDP growth in Q2 (see Andrew Tilton, “Additional US Ramifications of the Japanese Supply Chain Disruptions.” US Daily, May 24, 2011). The auto supply chain shock has also subtracted from industrial production, added to jobless claims, and may have weakened several of the monthly business surveys. Supply chain disruptions could have affected businesses in sectors like electronics as well, although we believe the impact there has been somewhat smaller.

On top of these, a laundry list of one-time factors and/or technical distortions has affected recent data, including: seasonal adjustment bias; flooding and tornados in the South; a sudden drop in defense spending; an administrative error in the calculation of personal income; and severe winter weather.

Quantifying the Effect of Temporary Factors

The clearest example of the impact of temporary factors is the recent volatility in jobless claims. Relative to their average in February and March, initial jobless claims rose by about 85,000 by the end of May. Using detailed claims figures for individual states, we divided the increase in to the portions which we thought could be explained by seasonal adjustment problems, auto production cuts, and poor weather in the South (Exhibit 3; see Zach Pandl, “Rise in Jobless Claims Mostly Temporary,” US Daily, May 16, 2011).

Consistent with the idea that these temporary factors would fade over time, jobless claims have fallen by about 55,000 since their late-April peak. However, the remaining difference suggests that only about two-thirds of the increase was due to special factors. Last week claims actually increased, and the pickup looks too large to be explained entirely by Southern storms (e.g. the area of Louisiana intentionally flooded by the Army Corps of Engineers contains only 2,500 residents, according to press reports). Moreover, the Department of Labor has cited layoffs in the construction sector as one factor behind the rise in claims since March, and these are likely unrelated to oil prices or supply chain problems.

A similar story holds for the various business surveys. Our research suggests that oil price shocks typically do not have a major effect on these measures. For example, we estimate that a 20% oil price shock lowers the Philly Fed index by about 2 points after one quarter and 5 points after four quarters (Exhibit 4; see Sven Jari Stehn, “Will Rising Oil Prices Weigh on Manufacturing Surveys?” US Daily, March 14, 2011). Given the share of motor vehicle-related production in total manufacturing output, we also guesstimate that supply chain problems in the auto sector might have subtracted about 7 points from the Philly Fed index. Taken together, these figures imply that the identifiable shocks can account for only 9-12 points of the 40-point decline in the Philly Fed since March.

The breadth of recent weakness is also concerning. The Empire State, Kansas City Fed, and Richmond Fed manufacturing surveys all also declined this month, as did the Richmond Fed’s services survey and several foreign PMIs. Our GS Analyst Index fell by 10 points to 57.7, and is now at a level similar to the soft patch in growth last year. In a special question, roughly half of our equity research colleagues said that special factors were not the major source of weakness. Instead, they believed it resulted from generally slower growth in the US economy.

Finally, some of the one-off distortions are too small or too isolated to explain broader weakness. Flooding in the South has affected only a small portion of the nation’s cropland, and does not seem to have seriously impaired activity in the energy sector. We are convinced that seasonal adjustment bias distorted the non-manufacturing ISM for April, but do not find evidence of this problem in other indicators. Although durable goods orders often weaken in the first month of each quarter, this effect has historically been quite small—and statistically insignificant—in April (see Zach Pandl, “How to Read the Durable Goods Report.” US Daily, May 25, 2011).

In summary, special factors do seem important, but they cannot explain all the recent weakness in the data, and the economy does seem to have slowed. We are somewhat puzzled by this because many of the trends that made us more optimistic around yearend 2010—progress in private sector deleveraging, easier credit and financial conditions, and an improving labor market—are still in place.

Soft Patch Should Persist for a While

A major improvement in the data appears unlikely in the near term. For one, May auto sales should be quite poor due to supply chain problems and higher gas prices. We are forecasting an annualized rate of 12.3 million units, down from 13.1 million in April. Weak auto sales should also turn up in the April retail sales report on May 14.

We also expect a sizable step down in nonfarm payroll growth. Specifically, we forecast that employment growth cooled to 150,000 in May from 244,000 in April. The consensus forecast appears too high given the sharp increase in initial jobless claims in late April. Although these fell before the payroll survey week, many of the filers are likely still out of work and therefore will subtract from payrolls. We also think payroll growth in April overstated the underlying trend and so may naturally decelerate a bit.

A more upbeat picture may start to emerge in late June as the Japanese automakers begin to ramp up production. But if the data flow fails to improve in coming months, we may need to consider a further downgrade to our US growth forecasts.