Strong GDP number shows underlying weakness

U.S 2Q07 GDP rose at a 3.4% annual rate - the fastest since 1Q06. Having a closer look at the detail:

• consumer spending increased 1.3% in the second quarter after a 3.7% gain in the first. The increase in consumer spending included a 2.2% gain in spending on services, a 1.6% rise in spending on durable goods and a 0.8% decline in spending on nondurable goods, the weakest in 16 years.

• Real disposable income fell 0.8% annualized in the second quarter, after rising 5.9% in the first quarter. The savings rate was 0.6% in the second quarter, down from 1.1% in the first.

This is the biggest concern - an ailing consumer. As stated previously the consumer drives 2/3 of US economic activity and is clearly now feeling some pressure from higher food and energy prices.

Remarkably the University of Michigan said consumer sentiment improved in July over June, although it fell somewhat over the past two weeks. On the inflation front:

• Core inflation (excluding food and energy) slowed to a 1.4% annual rate in 2Q07 from 2.4% in the first, pushing the on-year gain down to 2.0% - the top of the Fed's "comfort zone" for inflation.

• However headline consumer inflation accelerated to a 4.3% annual rate, the fastest pace since 4Q90. That's not a misprint, 1990.

Granted that excluding food and energy prices from inflation numbers historically is a better guide for picking the underlying trend in inflation. What it doesn't do however is capture what the consumer is experiencing as they go about the mundane tasks of eating food and driving cars which funnily enough a lot of people do in the US.

Where did the growth come from?

• Business investment increased 8.1% in the second quarter, contributing 0.83 percentage points to growth. Investments in structures jumped 22.1%, the fastest pace since 2Q94.

• Imports fell 2.6% in 2Q07, while exports rose 6.4%. The better terms of trade adding 1.2 percentage points to growth.

• Government spending increased 4.2% after falling 0.5% in the first quarter. Defense spending rose 9.5% in 2Q07, and non-defense spending rose 1.3%. Government spending contributed 0.8 percentage points to growth.

• Businesses added $3.6 billion to their inventories after adding only $100 million in the first quarter. The change in inventories added 0.15 percentage points to growth.

• Residential investment fell 9.3% in 2Q07, the smallest decline since 1Q06. Investment in residences subtracted 0.49 percentage points from second quarter growth, compared with 0.93 percentage points from first quarter growth.

Obviously some positives here especially strong business investment in commercial property and the lowest hit from the downturn in residential construction for more than a year. Given the current state of housing residential investment will continue to be a drag, will the strong performance in commercial construction continue? That's a wait and see.

Heavy spending on defense drove the government spending number - not encouraging. Of course if the semi-literate chimp that occupies the White House decides to invade Iran then government spending could well continue to contribute strongly to growth.

Businesses replenished their inventories in 2Q07 after the draw-down in 1Q07. There won't be the need to re-stock to such levels in 3Q07.

Longer term, the latest durable goods orders do not bode well for capital spending. Goods orders were down 2.3% in May and up 1.4% in June. After stripping out transportation goods, orders fell 0.5% in June.

Not all doom and gloom but the latest GDP numbers don't instill a lot of confidence. 3Q07 will definitely be weaker but just how weak will it get next quarter and into 2008? Personally I'm leaning towards a recession in the second half of 2008.