Macroeconomic Assessment: First Quarter 2007

Here is a May 1st, 2007 throwback submission for a macroeconomics graduate class taught by a great professor, Dr. Matthew J. Higgins. The assignment was to assess the current macroeconomic environment and compare the current environment with the previous year. Per the syllabus, one of the aims of the assignment was to teach students how to “cultivate the ability to process the vast amount of macroeconomic data that is put out and shape it into an assessment.”

Looking back on the assignment, I highlighted some ominous trends in housing that obviously affected the course of the economy quite negatively (to use an understatement). I wish I had the foresight of the guys in “The Big Short“. As an aside, Merry Christmas.


Overview

Gross Domestic Product for the first quarter of 2007 increased from the fourth quarter of 2006. In billions, gross domestic product rose from 13458.2 to 13632.6 [5]. In nominal terms, the economy expanded 5.3% but 4% inflation sapped most of that growth [1]. In real terms the increase was more modest at about 1.3% well below an already low projection of 1.8% [4]. Considering previous growth percentages of 5.6%, 2.6%, 2% and 2.5% for the four quarters of 2006, 1st quarter growth was lackluster. In fact, first quarter 2007 results were the weakest growth numbers since before the 2003 tax cuts [3] and well below many economists’ expectations [2]. However, some economists believe that the economy has hit its low point and is ready to rebound.

“The first-quarter GDP report was “probably the low point in the cycle,” said Nariman Behravesh, chief economist at consulting firm Global Insight. “It suggests that in fact we may be setting the stage for a very slight rebound this quarter.” Mr. Behravesh believes the economy will be growing at a rate of close to 3% by the end of the year” [2].

 Housing

Residential Investment, which is a proxy for the housing market, was the biggest drag on 1st Quarter results. Residential Investment decreased from about 717 billion in the 4th quarter of 2006 to 687 billion, a slide of about 4.2% [5]. This aforementioned decrease shaved about one percentage point off of overall GDP.

In the 4th Quarter of 2006 residential investment lowered overall GDP by 1.21%. This slide in investment has been ongoing and falling for six consecutive quarters. The downside to the destabilization of the housing sector is that it could force consumers and businesses to cut back sharply in spending. Former Federal Reserve Chairman Alan Greenspan estimated that the cash homeowners extract from their homes accounted for almost 3% of all consumer spending as of the third quarter of 2006 [2]. Similarly, studies have shown that a 1$ increase in housing wealth increases consumption by seven cents [6]. The main driver of the U.S. economy is personal consumption. A significant drop in consumption most likely would have an adverse effect on GDP. Falling home prices and fewer home equity extractions could potentially curb personal consumption as well.

Interestingly, the slowing U.S. housing market is also having an effect on Latin American countries. Home construction is the main gateway industry for immigrants entering the United States [7]. These immigrants contribute a significant portion of the estimated 50 billion in cash sent from the U.S. to family members in their home countries [7]. “In a recent study of 15 Latin American economies tracked by BCP Securities of Greenwich, Conn., all but three showed better than a 90% correlation between the ebb and flow of U.S. housing starts and the swelling and shrinkage of remittances as recorded by the nations’ central banks” [7].

Trade and the Dollar

For the first quarter of 2007 exports fell 1.2%, the biggest decline in nearly four years. Imports on the other hand increased 2.3%. Net exports subtracted 0.5 of a percentage point from growth. The decline in exports was puzzling considering a rise of 10.6% in the fourth quarter of 2006.

A weakened dollar and European and Asian growth have allowed exports to be a driver of the U.S. economy in recent years. “The Federal Reserve’s Trade-Weighted Dollar Index, which measures the dollar’s performance against seven currencies, fell to its lowest level this past week since the index’s inception in 1973.” [8]. The dollar recently traded at $1.3647 per euro after touching $1.3679 April 29th, near the record low of $1.3681 set April 27 [7]. The dollar dropped 2.22 percent to $1.3651 in April for its biggest monthly drop since November [7]. The weakening dollar will begin to alter the flow of trade by making domestic products cheaper in foreign markets and imported products more expensive. As consumers begin to buy less imported products the economy will be positioned to experience more gains from consumer spending as more money will stay with domestic business.

Another benefit of the weakening dollar is the strong boost it provides domestic companies that do significant business in foreign markets. Companies such as Caterpillar, McDonalds and General Electric reported first quarter 2007 earnings that surprised Wall Street Analysts [9]. PepsiCo Inc. for example reported a 16% increase in first-quarter profit, more than half of which it attributed to sales outside North America. U.S. based businesses with foreign operations will be able to increase their profits when those profits are converted back to dollars. Companies in the S&P 500 derive about 30% of their revenue from abroad, up from 22% five years ago [2]. The current weak dollar will allow companies to gain market share simply by holding their prices steady in dollar terms.

Personal Consumption and CPI

Personal consumption expenditures increased by an annualized 3.8% in the first quarter of 2007. While this was better than the overall 2006 number of 3.2% growth, it lagged behind the fourth quarter 2006 4.2% growth. The Reuters/ University of Michigan Consumer Sentiment index was down from 88.4 in March of 2007 to 87.1 in late April [10]. The drop in consumption was attributed to an increase in certain areas. Medical-care services are up at a 5.9% annual rate over the past six months [11]. Fuels and utilities increased at 1.2% and household energy increased 1.4% as well [11].

Interestingly the CPI exhibited a major price increase in fruits and vegetables. For February of 2007 fruits and vegetables increased 4.7% as a result of the government’s efforts to develop a market for ethanol fuel. An increase in the price of corn has ramifications for the prices of many products.

A major freeze in California in winter 2006 had an impact on the price of fruit and led to drastically lower crop yields. All California crops sustained about 1.3 billion dollars in damage and losses for citrus crops were estimated at 800 million [12].

Rising gasoline prices have also contributed to a decrease in consumer confidence. Gasoline prices as of April 30, 2007 were at $3.02 a gallon and up 80 cents, or 36% since bottoming out in late January at $2.21 a gallon [13].

All of the aforementioned price increases have had an adverse effect on consumer confidence and have been a drag on personal consumption.

Government Consumption Expenditures and Gross Investment

Government consumption expenditures and gross investment lagged in the first quarter of 2007. Overall this area grew at about 1% in annualized terms as compared with a 3.4% increase in the fourth quarter of 2006. National defense was down 6.6% as opposed to a 12.3% increase in the fourth quarter [5]. In a role reversal, Nondefense spending increased as opposed to a decrease in the previous quarter. State and local government expenditures were at 1.672 trillion dollars and grew at a 3.3% annualized rate from the previous quarter [5].

Conclusion

Overall GDP growth was disappointing with respect to the previous quarter and year. Exports which had been a strong component of GDP in the previous year due to the weakening dollar, fell drastically. The weak dollar and a strong global economy have provided a boon to U.S. companies with foreign operations. This situation has been conducive towards the Dow Jones Industrial Index reaching record levels. Although personal consumption is still the engine that powers the U.S. economy, it has weakened somewhat with respect to 4th quarter 2006 levels. The Reuters/ University of Michigan Consumer Sentiment index has experienced a third-consecutive monthly decline and reached its lowest level in seven months [2]. An increase in food, utilities, medical-care services and gasoline have caused consumer sentiment to wane recently. Residential Investment has continued to be a drag on the economy and hobble expansion. This housing downturn has the potential to affect consumer purchases as homeowners experience a drop in home prices. Federal government expenditures were below 2006 levels although buoyed by strong state and local expenditures. This continued weakness in the economy combined with rising prices could be the recipe for stagflation in the near future.

References:

[1] Nutting, Rex “ECONOMIC REPORT: U.S. Economic Growth Slows To 1.3% Pace In First Quarter” Dow Jones Business News (7 April 2007): Factiva

[2] Dougherty, Conor and Whitehouse “Mark Economy Slows But May Hold Seeds of Growth — Weak First Quarter May Signal a Bottom; Consumers Keep Buying” The Wall Street Journal (28 April 2007): Factiva

[3] “Hot Topic: Economic Ups and Downs “ The Wall Street Journal (28 April 2007): Factiva

[4] “ECONOMIC REPORT: Capital Spending Bounces Back In March” Dow Jones Business News (25 April 2007) : Factiva

[5] http://www.bea.gov/national/pdf/dpga.pdf

[6] “Hot Topic: Finding Meaning in Dow 13000” The Wall Street Journal (28 April 2007): Factiva

[7] http://www.bloomberg.com/apps/news?pid=20601085&sid=akQspI2qj7dM&refer=europe

[8] Karmin, Craig “Dollar Touches a New Low Against Euro — U.S. Currency’s Slump Is Likely to Aid Profits, But Add Inflation Risk” The Wall Street Journal (28 April 2007)

[9] Bruno, Joe “U.S. firms benefiting in sales from weak dollar” Associated Press (29 April 2007)

[10] “US: Roundup of Economic Indicators through April 30” Market News International (30 April 2007) :Factiva

[11] Dougherty, Conor “Inflation jumps in U.S. as manufacturing gains” The Wall Street Journal Asia (19 March 2007): Factiva

[12] Raine, George “ECONOMIC DEEP FREEZE / January cold spell inflicts hardship on the state’s citrus workers “ The San Francisco Chronicle (7 March 2007): Factiva

[13] “ECONOMIC REPORT: Gas Prices Jump 10 Cents To $3.02 “ Dow Jones Business News (30 April 2007): Factiva

 

 

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