US Perspectives: Some Problems Won't Go Away

Global debt and policy issues are distractions from positive GDP indicators, says Morningstar's Bob Johnson.

Robert Johnson, CFA 12.09.2011
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Though the two key data points of last week (the services PMI and the balance of trade) were highly positive, the market continued to focus on European debt issues. The lack of a direct policy response from the Federal Reserve and a jobs program announcement from President Obama that didn't contain any new or radical solutions were no help to investor confidence either. Topping off the week, Texas Instruments reduced its revenue and earnings estimate citing broad- based weakness. This already comes on the heels of bad news from tech sector compatriots Hewlett-Packard and Dell.


Third-Quarter Real GDP Growth Could Easily Exceed 2.5%

Despite all the bad news, a sharp shrinkage in the trade balance, continued consumer spending, and decent capital goods shipments all point to third-quarter GDP growth in the range of 2.5%-3.0%, up "remarkably" from the second quarter's dismal 0.9% growth. This isn't based on a leap of faith that things will get better in September, but from data already available from July and August and assumes no further improvement in September. An improving services sector, as embodied in last week's ISM Non-Manufacturing Report, might help too. Rebounding auto production (from the Japanese transplants) will be a key component of the positive GDP report. Unfortunately, a lot of the positive news from the auto sector will be over by October--unless consumers meaningfully step up their auto purchases in the months ahead.


European Sovereign Debt: The Problem That Won't Go Away

As has been typical of the last two months, the market is deeply worried about the European situation, and rightly so. Greek debt is priced as if default is all but inevitable. Greek economic performance eroded further according to the latest data, endangering recently negotiated debt and budget targets. Given that European banks don't have the capital to support multiple country defaults and that governments are too indebted to bail out all of the potentially afflicted banks, the European outlook continues to darken. Without some type of debt restructuring and potential debt guarantees from the EU's stronger members, the situation will continue to deepen and spread. Whether the European difficulties get bad enough to sink the U.S economy remains an open question. Direct U.S. bank loans and U.S exports to the most difficult economies remain negligible. However, indirect exposure and contagion issues could still cause significant problems here in the U.S. that are difficult to identify in advance.


Few U.S. Policy Options Remain Open

News on the U.S. policy issues revealed how few options are open to the government to make the economy better. For now, Ben Bernanke and the Federal Reserve are keeping their options open and not providing any specifics as to what they might do next. That's not making the markets happy. President Obama's remarks and proposals didn't do any better at assuaging market fears. The president's bill contained some interesting twists, including payroll tax relief for employers, unemployment benefit extensions, and infrastructure projects. I think the proposals struck the market as being too small and too similar to the previous stimulus package to help the economy by much. Of course, the bill still has to make it through Congress, which is not a given.


Services Take the Lead, Finally

Last week's ISM Purchasing Managers' Report for Non-Manufacturers (i.e., the service sector) showed a surprise jump, from 52.7 in July to 53.6 for August, whereas expectations were for a decrease to 51.0. More importantly, the new orders component, the most forward-looking component of the index, increased to 53.8 from 52.7. The service sector is just under twice the size of the goods-producing sector of the economy. For most of this recovery, the services sector badly lagged manufacturing. Now, however, the August PMI for services at 53.6 exceeds the PMI for the manufacturing sector, whose current reading is a lower 50.6. Since May, the services index has outperformed the manufacturing sector in three of the last four months.


Purchasing Managers Data


PMI Manufacturing

PMI Services

























Source: ISM


In fact, quarterly data show that the services part of the economy is already making a bigger contribution to GDP than the manufacturing sector (though the effects of the Japanese supply chain issue, especially for autos, are responsible for the horrid goods number for the second quarter of 2011). Admittedly the Japanese situation is unusual, but a slowing of manufacturing sector and an acceleration of the services sector is a relatively typical pattern in an economic recovery. Larger recessionary declines and massive inventory rebuilding generally lead to large early gains for manufacturers that are not sustainable over the long term. Services have less ground to recover and are generally less volatile.


Percent Contributions to GDP




Q1 2010



Q2 2010



Q3 2010



Q4 2010



Q1 2011



Q2 2011



Source: Bureau of Economic Analysis


Balance of Trade Improves Sharply Despite Japanese Auto Rebound

As I surmised the week before last week, the balance of trade report was far better than most forecasters predicted, with the deficit falling from a downwardly revised $51 billion in June to $44 billion in July, a 13% improvement. The decline came the right way, too, with a nice increase in exports and a small decline in imports (less positive would have been no growth in exports with all of the improvement coming from a decline in imports). By the numbers, exports jumped 3.6%, while imports declined 0.2%. Declining oil imports accounted for about 40% of the decline in the deficit overall. A big jump in fuel oil exports (yes, we refine it in the U.S., but we can't use it all, so much of it is exported to Asia from the West Coast), chemicals and plastics (this industry has gotten a big boost from a ready supply of cheap natural gas), and increased shipments of some metals and coal drove exports upward during the month. Auto and capital goods also helped the export picture. On the import side the equation, a big jump in auto imports (primarily Japan) was roughly offset by a large decrease in petroleum imports.


Exports Remain a More Important Part of the U.S. Economy

Exports have certainly helped the U.S. recovery and now account for almost 14% of GDP, up from the 8%-10% range of the 1980s and even comfortably above the previous cyclical high of 13.4% reached in 2008. That partly explains why U.S. markets are so concerned about diverse international issues ranging from the Greek debt situation to the Chinese PMI. However, the data show that U.S. exports are more dependent on our next-door neighbors Canada and Mexico (32% of exports) than China (7%). The troubled countries of Portugal, Ireland, Greece, and Spain combined account for less than 2% of U.S exports and a couple tenths of U.S. GDP.


Export to US Neighbors (through July 2011)

Export Destination

$ in Billions

% of US Exports

% of US GDP

North America








Pacific Rim




South America












Source: Morningstar Calculations, Bureau of Economic Analysis, Census Department


Government Retail Sales Should Be Good but Not as Good as The Week before Last Week's Shopping Center Report

The International Council of Shopping Centers report showed August year-over-year growth of 4.6%, exactly the same level of growth as in July. With all the debt ceiling worries and the European sovereign debt crisis in August, there were fears that retail sales might collapse. This week brings a more comprehensive retail sales report that includes, autos, gas stations, and restaurants that are not included in the shopping center report. The consensus forecast is for retail sails to show 0.3% growth in August (3.6% annualized) down from July's more robust 0.5% growth. Most of the fall-off will be a result of lower gasoline prices. The last-minute effects of Hurricane Irene on East Coast shoppers and relatively stagnant auto sales will also keep a lid on this month's report.


Meaningful Progress Expected on the Inflation Front

In July, inflation went through the roof, increasing at a 0.5% rate (6% annualized) according to the consumer price index. Even on a more conservative year-over-year basis, prices were up 3.6% compared to the same month a year ago. Expectations are for a much tamer August with the consensus forecast estimating a more mellow 0.2% increase. I think the results might even be lower than that based on falling gasoline prices and attractive back-to-school promotions.


Seasonal Factors Swamped July CPI, Better News on Tap for August

Interestingly, a lot of seasonal adjustment factors for the transportation sector were responsible for the huge month-to-month jump in July. Car prices usually fall in July as dealers close out the model year, but this is built into the seasonal adjustment factor. However, this July prices rose instead because of a shortage of Japanese cars. In addition, gasoline prices usually go down in July as all the refineries have been cut over to summer production and the Fourth of July Holiday driving push is over before the month-end survey. I suspect the gasoline component will reverse itself in August based on prices I've seen at the pump. The new car sector will not fully reverse itself in August but should still have a less negative effect than it did in July. Looking ahead to September and October, when auto prices typically go up, prices may actually come down as the Japan auto dealers finally have an adequate supply. This could serve to keep a lid on the CPI for most of the remainder of the year.


Manufacturing News Will Continue to Be Weak

The consensus suspects that industrial production will fall back from a robust 0.9% month-to-month growth rate for July to a less substantial 0.2% rate for August. A big rebound in auto production in July isn't likely to be repeated in August, and the utility sector may not be as robust as in previous months as temperatures begin to cool. The auto industry is now pretty much back to where it was in March in terms of production, and any additional improvement in auto production will be dependent on increases in actual auto sales. Ford has indicated its intent to step up production in the fourth quarter, but probably not enough to have a significant increase in industrial production. With last week's warning from Texas Instruments and last month's negative announcements from Hewlett-Packard and Dell, we certainly can't count on much from the tech sector either in terms of production. Though they have their weaknesses, the various purchasing managers' reports indicate that the manufacturing sector is no longer booming but instead just creeping ahead after a strong rebound early in the recovery.


The Philly Fed and the Empire State manufacturing reports are due this week. Both reports are expected to remain in negative territory, but less negative than in August. These reports have been quite negative and very volatile over the past several months. However, they both collapsed in July, while the more important national survey barely budged and industrial production was strong. Therefore, I wouldn't get too excited about either report.



This is an edited version. The article originated from Robert Johnson’s column at

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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