Economic growth during the first half of 2008 was somewhat better than anticipated at the
beginning of the year. The better-than-expected performance was the result of continued
strength in economic activity abroad and tax rebates, which provided a substantial boost to
real disposable income during the second quarter. With the rebate distribution now behind us,
the household sector will likely show renewed weakness as labor markets continue to
deteriorate and home prices continue to fall. Real consumer spending in June was below the
level of the second-quarter average, setting the stage for third-quarter weakening. In addition,
economic growth abroad is now showing signs of substantial weakening. This weakening
will likely erode the very substantial support that strong export growth and the narrowing
trade gap have provided to the U.S. economy and domestic corporate earnings growth.
To highlight the contribution that foreign strength has made to the domestic economy:
if it were not for the contribution from strong export growth and a narrowing trade deficit,
gross domestic product (GDP) would have contracted by an average of 0.5% during the
past three quarters. Manufacturing sector indicators have displayed disproportionate strength
relative to other indicators during this period, but we are likely to see this source of support
for domestic economic activity fade in the coming months. Purchasing manager indices for
both the manufacturing and nonmanufacturing sectors showed a sharp decline in new export
orders in July in addition to the key indicators for major foreign economies that point to
upcoming weakness. With the housing contraction ongoing, we will likely see the broader
economy weaken during the second half of this year and likely into early 2009.
The 2009 economic forecast has been reduced to expect growth of just under 1% for the
full year, and we will likely see the unemployment rise to 6.8% by late next year.
Inflation pressures are likely to moderate as economic slack continues to build domestically,
and additional Fed easing is likely at some point as the unemployment rate continues to
climb. Lower inflation and interest rates are supportive of equity valuations, but earnings are
likely to be weaker than anticipated in this environment.
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