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U.S. Economy - Another Boom?

By Scott B. MacDonald

NEW YORK (KWR) -- Anyone looking for evidence that the U.S. economy is recovering did not have to look too far beyond the recent flow of data. The third quarter real GDP number was 7.2% -- the fastest pace of growth since Q1 1984. It clearly had the flavor of an economic boom number. Full year real GDP expansion is likely to be over 3%. The consumer, of course, played a major role in pumping up the economy, partially due to the impact of the federal government tax rebates. The excitement about the strength of the Q3 real GDP number, which easily surpassed the consensus estimate of 6%, is understandable. Adding to the excitement, unemployment for the month of October fell from 6.1% in September to 6.0%, largely driven by greater employment in the services area.

Most people (except those heavily invested in gold) want to believe the worst is behind them – the recession is becoming a distant memory and the good times are about to roll again. Are we on the edge of a new economic boom? Although we see a pick up in growth in 2004 (in the 3.3%-3.6% range), there are a number of nagging issues that could function as a brake to another boom.

First the good news. What was the most encouraging about the Q3 GDP figure was that it included corporate equipment purchases. Business investment in equipment and software rose at a 15.4% annual pace, the fastest since Q1 2000. Indeed, total corporate spending rose at 11.1%. Equally important, inventories in many sectors were depleted and now need to be replenished – something that will continue to fuel growth. Other news on the U.S. economy was generally upbeat. This included durable goods orders, construction, consumer confidence and manufacturing. Adding to positive sentiment is that corporate earnings are doing well. There have been fewer major disappointments and most companies appear to be on track for a better year compared to 2002.

Where do we go from here? We expect the economic data will continue to be generally positive, with 4th quarter real GDP around 4%. More importantly, we expect there will be a slow improvement of the unemployment numbers, which will become more pronounced in 2004. We do not see much of an improvement in U.S. unemployment below 6% in 2003. What will make the difference will be the shift in the driver of the economy from consumer spending to corporate spending. Q3 2003 corporate spending numbers were encouraging and we expect Q4 numbers will reflect the continuation of this trend, reinforcing recovery.

Although there is concern about the growing nature of the U.S. fiscal deficit, we see this more as an issue for 2005. While the build-up of red ink is potentially problematic, the deficit must be put in historical perspective. In the past two recessions, the fiscal deficit as a percent of GDP was much larger. In 1983, the deficit was 6% of GDP; in 1992, it was 4.7%. As of September 30, 2003, the federal deficit was 3.5% of GDP (it will probably be over 4% by year-end). The point here is that the federal deficit is manageable – thus far. If the U.S. economy has hit a period of sustainable growth (which is likely) the revenue base should improve. Consequently, the deficit is not a concern for 2004. However, if revenues do not recover and costs are not brought under control in 2004, the deficit could become a more pronounced negative factor in 2005. Indeed, a voracious federal borrower could crowd out private sector companies in credit markets, undermining the sustainable nature of the recovery.

What makes us somewhat cautious about jumping on the robust growth bandwagon is that we see consumer spending and housing demand tapering in Q1 2004 as the federal economic stimulus fades. This is not to argue that we see a collapse in either consumer spending or housing, but a marked slowdown as American household do a little consolidating of their own high debt numbers. If corporate spending does not pick up the slack, then the economic activity could slow. Instead of looking at 4% growth, the number could be closer to 3%, which would still be relatively strong, but a disappointment to the stock market.

There are two other potential spoilers sitting out in the reeds like alligators in 2004 – the potential for a faster than expected rise in interest rates (if economic growth continues at a fast pace) and a geopolitical tremor (another major al-Qaeda attack on the United States or North Korea).

Although the most recent Federal Reserve meeting left rates at 1% and the language was neutral on inflation, that dynamic could change if the pace of U.S. growth stays at a higher level. Consequently, the Q4 real GDP number will be closely watched. Only a few months ago many analysts expected that the Fed would maintain no change in rates through most of 2004. That consensus is changing. In November 2003, both the Reserve Bank of Australia and the Bank of England, two countries that often run on the same business cycle as the United States, raised rates for the first time in a long while. A shift in interest rate policy – especially one that comes quickly – could have a negative impact on the stock market and would certainly ripple through the financial sectors – banking, brokerages, insurance companies and credit card companies. It could also put many individual buyers under pressure – something that could trickle into the general economy and make the tapering of the consumer into a crumbling of the consumer. We do not see this as likely – at this point, but it is a possibility that should be carefully watched.

The other issue is that of a major geopolitical incident. This could come in the form of terrorist attack on the United States by al-Qaeda, which is constantly threatening, or from a potential outbreak of war in Korea. North Korea clearly remains a wild card in the geopolitical game, a situation made that much more dangerous considering the high probability that the Kim Jung-il regime possesses nuclear weapons. Even if war does not occur, North Korea could provoke an Asian financial crisis if it collapses and forces the South to pick up the costs of reunification. An implosion of the Kim regime could be bloody, economically costly (estimates for rebuilding the North range from $500 billion to $1.75 billion), and highly dangerous in terms of international relations, drawing in not just South Korea, but the United States, Japan, China and Russia. It would also make a bet on Asian equities a bad decision.

Consequently, we see the U.S. economy on a roll – good economic data is likely to continue, interest rates are under control and corporate earnings have generally been good. The Dow should end 2003 a little over 10,000. That takes us through the end of the year and into 2004. Once into 2004 a new set of variables, as outlined above, takes on greater significance. A new game will be afoot – there is an economic turnaround and faster growth, but how fast and how does it measure with expectations is the unanswered riddle.