U.S. economy slowed, but growth is anticipated in '07

While the U.S. economy is rolling through a soft patch – mainly because of a market correction in housing, weaker than expected consumer spending and a long-overdue slowdown in manufacturing activity – stronger growth is ahead in 2007, according to an analysis released January 12 by The Conference Board, the global research and business membership organization.

“The U.S. dollar has been hard hit because markets anticipate that short-term interest rates will decline, an expectation that is reflected in both the forward rates and the sharp decline in 10-year Treasury yields,” says Gail D. Fosler, executive vice president and chief economist of The Conference Board. Her analysis appears in StraightTalk, a newsletter designed exclusively for members of The Conference Board’s global business network. “But these observations are backward looking and do not reflect how changed dynamics have set the stage for a shift toward somewhat better growth in 2007.”

New growth forces include a decline in gasoline prices that should add at least a percentage point to consumer spending growth over the next several months, a drop in energy prices from their peaks, and low long-term interest rates that are stimulating another round of consumer refinancing.

U.S. manufacturing is stabilizing
Although the Institute for Supply Management (ISM) Purchasing Managers’ Index dipped below 50 for the first time in more than three years, the December report shows the manufacturing sector is gaining strength. Gains in new export orders, rapid inventory cuts, and new product introductions in the auto sector will help stabilize manufacturing. Moreover, the recent ISM survey also showed price increases picking up. Manufacturing still enjoys a broad base of demand, both domestically and internationally, suggesting the current adjustment will be brief.

Broad-based global growth continues
Despite weaker U.S. economic performance, moderate to rapid growth is under way in almost every other part of the world.

“For the first time in many decades, the global economy enjoys multiple sources of economic growth, of which the U.S. is not the most important,” says Fosler. “From the ongoing restructuring in Europe, to rapid growth across most sectors in China and India, to the related benefits of strong agricultural and raw materials demand elsewhere in the emerging world, the current global expansion is one of the broadest since the 1970s.”

The acceleration of growth in other parts of the world breaks a well-established tendency in recent years for the U.S. economy to lead economic trends globally. Fosler says that while it is much too early to “declare victory,” the expansion of economic opportunity outside of the U.S. could open the door to redressing the huge global imbalances in consumer spending and trade.

The Conference Board forecast for Europe expects growth to approach 3 percent this year and continue at around a 2.5 percent rate next year. These rates are the highest since 2000, but they are far less robust than the growth under way in other parts of the world. A better job picture has helped propel European consumer confidence to its highest levels since 2001, although still far below the highs reached in the late 1990s.

Against a backdrop of decent but relatively bland growth in the advanced economies (including Japan), China, India, and much of the emerging world continue to boom.

Although interest rates are edging up, Indian growth has accelerated from almost 8 to over 9 percent in the past year. But the sustainability of such growth is a major issue in both India and China. Still, both countries are awash in liquidity, making the prospect of a slowdown resulting from central government actions remote.

Can China and India keep booming?
Rapid growth in China and India is helping sustain the commodities boom that, along with high agricultural prices, is driving growth in Latin America, Africa, Russia, the Middle East, and elsewhere. There are few emerging markets today that have growth rates under 4 percent, and many are enjoying 6 percent to 7 percent growth marked by burgeoning consumer markets.

“The global economy is fast approaching the point where emerging markets will represent half of global gross domestic product and three-quarters of global growth,” says Fosler. “In other words, for the first time in modern industrial history, what goes on in emerging markets is more important to the direction of global growth than events in the industrial world.”

China and India, themselves emerging markets, are fulfilling the role of growth engine for much of the emerging world. The enormous growth in these countries, their much-anticipated impact on global production capacity for all sorts of goods and services, and the investment that is flowing into and out of them serve as a global stimulus of enormous proportions. The whole demographic profile of economic activity and wealth is changing globally.

Chinese imports, especially in the low-end manufactured goods sector, have slowed down in the past two years, and this deceleration has started to hurt the rest of Asia. The bilateral trade balance between many ASEAN countries and China is moving into negative territory. Korea is one of the few countries with a high bilateral surplus with China.

The shifting sands of the Asian trade environment are more worrying because the key currencies are moving in opposite directions. Since January 2005, the Japanese yen has declined 13 percent versus the U.S. dollar and 15 percent versus the Chinese yuan. The ASEAN currencies, by contrast, are up 5 percent against the U.S. dollar and the Korean won is up 10 percent. It is unlikely that Korea and the ASEAN countries can continue their superior trade performance relative to Japan if their currencies continue to appreciate relative to Japan.

How sustainable is global growth?
Today’s rapid global growth rates are driven by very high rates of investment, especially in emerging market countries. Correspondingly, consumer spending growth lags are creating huge gaps in consumer share of GDP that are large, structural, and persistent. If the U.S. were to reduce its consumer share to the 56 percent level of middle-income countries in one breathtaking step, it would have to reduce consumer spending by $1.7 trillion. One way to assess what would be required to make these structural adjustments to better the economic balance of all countries is to examine what it would take for the consumer shares of the U.S. and middle-income countries to meet at 62 percent, which is where the U.S. was in the mid-1960s.

First and foremost, this hypothetical case demonstrates that this adjustment would have to be made over many years. There are simply no reasonable assumptions for growth in the rest of the economy to offset the impact of a consumer spending shortfall. Even assuming a 10-year time frame, the changes are significant and would not be easily achieved. If consumer spending were to hold at about a 3 percent growth rate for 10 years (about one percentage point below its long-term average), the rest of the economy would have to grow at about 7 percent in order to keep overall real U.S. growth close to 4 percent. If the consumer share were to decline linearly and the rest of the economy were to grow at only 4 percent, which is closer to its historical average, real growth in the U.S. would average only about 1 percent to 1.5 percent a year for the next 10 years.

The adjustments on the middle-income emerging market side of the equation are equally sizeable. If the non-consumer-related portion of the economy were to grow at 4 percent, consumer spending would have to grow, on average, at 7 percent a year during the 10 years for the consumer share of GDP to go up to 62 percent. If the non-consumer related portion of the economy were to continue at recent historical rates of close to 7 percent and consumer spending were simply to rise linearly, these economies would grow at annual rates of 8 percent to 10 percent. This scenario is not unlike what is happening in China today.

“The rebalancing of the global economy will likely take a generation, not a few years,” says Fosler. “The differences are too large and too fundamental for exchange rates to have much impact.”