Subject: David Hale: Can the US Economy Regain Momentum?
From: "David Hale" <[email-masked]>
To: "R. Hunter Biden" <[email-masked]>
Date: Fri, 10 Aug 2012 15:40:23 -0700 (PDT)

To download [August Monthly Report-Can the US Economy Regain Momentum.pdf], click on the following link:
http://ci26.actonsoftware.com/acton/ct/3037/s-000d-1208/Bct/l-sf-cl-701C0000000UEmJIAW-0024/l-sf-cl-701C0000000UEmJIAW-0024:15c/ct0_2/1

Dear Clients, 

While the pace of economic activity across the world has been 
disappointing in recent months, I remain optimistic that policymakers 
will rise to the challenges facing their economies. Despite a clear 
recession in Europe, and uncertainty regarding whether the German 
constitutional court will decide that it is legal for the ESM to 
directly recapitalize banks, recent comments by Mario Draghi and actions 
by government leaders give me hope that the eurozone crisis remains 
solvable. Uncertainty stemming from the looming fiscal cliff and 
eurozone overhang may be limiting US growth, but a reemergent housing 
market should be a growth driver for the US economy going forward. In 
China, a real estate recovery and a government willing to pursue 
stimulative measures should help to counteract slowing growth across 
other sectors of the economy. 

Attached you will find our latest monthly report, "Can the US Economy 
Regain Momentum?" Key conclusions include: 

Recent data predict that housing will be a significant source of growth 
in the US economy going forward 

The euro area recession will soon include Germany and France, where 
signs of contraction are already evident 

Higher wages and eco-subsidies for cars have boosted Japanese consumer 
spending 

The Chinese housing market is showing signs of recovery after a long 
period of decline 

High levels of exposure to China and Europe are causing the 
disappointing East Asian export growth figures 

As always, we welcome any questions or comments. 

Best regards, 

David Hale 

Chairman 

David Hale Global Economics, Inc. 

847-386-6009 (tel) 

847-386-6011 (fax) 

[email-masked] 

http://davidhaleweb.com 

http://davidhaleweb.com 

http://whatsnextbook.com 

http://whatsnextbook.com 

Copyright 2012, David Hale Global Economics Inc. All rights reserved. 
This document is not for attribution in any publication, and you should 
not disseminate, distribute or copy this e-mail without the explicit 
written consent of David Hale Global Economics, Inc. 

Can the US Economy Regain Momentum? 

  

KEY CONCLUSIONS 

US growth slowed in the second quarter as a result of weaker consumer 
spending and structures investment as well as a downturn in government 
spending 

Recent data have indicated that housing should be a significant source 
of growth in the US economy going forward 

The Federal Reserve may keep its powder dry until the fiscal cliff 
situation is resolved 

The euro area recession will soon include Germany and France, where 
signs of contraction are already evident 

The German constitutional court's ruling on the legality of the ESM 
directly recapitalizing banks could be a flashpoint for the eurozone 

Higher wages and eco-subsidies for cars have boosted Japanese consumer 
spending 

The Chinese housing market is showing signs of recovery after a long 
period of decline 

High levels of exposure to China and Europe are causing the 
disappointing East Asian export growth figures 

Australia has the ability to cut interest rates further should the 
recession in Europe and slowdown in China start to crimp growth 

Brazilian growth continues to disappoint while Mexico has seen no 
negative repercussions from the markets following Enrique Pena Nieto's 
presidential victory 

Emerging market central banks continue to show interest in increasing 
their gold reserves 

  

UNCERTAINTY IS DEPRESSING GLOBAL GROWTH 

The Federal Reserve Beige Book in July made thirty references to the 
term "uncertainty" compared to thirteen in January, nine in February, 
ten in April, and fifteen in June. The last time the Beige Book had more 
references to uncertainty was in September 2011 when thirty-eight 
references were made. The September 2011 Beige Book was compiled during 
the height of the debt ceiling negotiations between Congress and the 
White House in July and August of last year. The current uncertainties 
again center on federal fiscal policy, especially the fate of tax cuts 
scheduled to expire at year end, as well as international issues such as 
the European debt crisis and evidence of slowdown in many hitherto 
robust emerging market economies. There is a risk that uncertainty could 
dampen business confidence and prevent a rebound in hiring and 
investment during the second half of 2012. 

CONSUMERS ARE HOLDING BACK US GROWTH, BUT REAL ESTATE COULD BE NEW 
DRIVER 

The Commerce Department has published its first estimates of second 
quarter GDP growth as well as revisions in the data extending back three 
years. The department now estimates that real GDP growth contracted 4.7% 
during the recession compared to 5.1% previously. It also reports that 
the initial recovery was more subdued than originally reported. Real GDP 
increased 2.4% during 2010 compared to 3.0% in the earlier estimates. 
The growth rate for the fourth quarter of 2011 was revised upward, 
however, to 4.1% from 3.0% previously. The economy slowed to a growth 
rate of only 2.0% during the first quarter of 2012 and eased again to 
1.5% during the second quarter. The revisions indicate there has been a 
clear seasonal pattern to output growth in which the economy slows 
sharply around mid-year and then rebounds to an average growth rate of 
3.5% during the fourth quarter—one percentage point above the economy's 
post-2009 trend. Private sector growth during the fourth quarter was an 
even more stunning 4.8%. The GDP revisions indicate that private sector 
growth during the past two years has been 3.2% compared to 2.8% in the 
previous data. The government sector, by contrast, has been a drag on 
growth since the second quarter of 2010, and has declined by 5.5%, which 
is the largest drop since the early 1970s. 

There were three factors which dampened the economy's growth rate during 
the second quarter. First, the growth rate of consumer spending declined 
to 1.5% from 2.4%. Auto sales declined while spending on other goods 
dropped to 2.2% from 3.6%. Secondly, there were once again declines in 
government spending. State and local government spending declined at a 
2.1% annual rate while federal spending fell at a 0.4% rate. Thirdly, 
business spending on structures increased at only a 0.9% annual rate 
compared to double-digit gains during the previous four quarters. New 
data suggests the estimates of structures investment could be revised 
upward. If it is, real GDP growth during the second quarter could be 0.2 
or 0.3% higher. 

The sector which is now showing clear signs of recovery after a long 
period of depression is housing. Real residential investment grew at a 
9.8% annual rate during the second quarter compared to 20.5% during the 
first quarter and 12.1% during the fourth quarter. Housing starts rose 
6.9% in June to 755,000, or the highest level since October 2008. Single 
family starts are up 21.7% from one year ago while multifamily starts 
are up 28.5%. New home sales were at an annualized rate of 350,000 
during June compared to 304,000 one year ago. Sales of existing homes 
rose 5.4% during June from levels one year ago. The number of homes sold 
to investors rose 65% in 2011, and they accounted for 27% of all sales 
compared to 17% in 2010. Investors often pay for their homes in cash. 
Foreigners also have played a role in the property recovery. They spent 
$82.5 billion, or about 9% of the $928 billion spent on residential real 
estate during the twelve months through March. This was a 24% increase 
from what they spent during the previous twelve months. There is still 
concern about a shadow inventory resulting from foreclosures, but the 
mortgage delinquency rate is falling. As a result of the increase in 
housing demand and limited inventory of new homes for sale, house prices 
are showing signs of firmness. The Case-Shiller Composite Price Index 
for twenty cities rose 2.2% in May compared to April levels. The largest 
price gains were in Chicago (4.5%), Atlanta (4.0%), San Francisco 
(3.9%), and Minneapolis (3.1%). CoreLogic's home price index showed that 
prices rose by 6% in the second quarter, which is the largest increase 
since 2005. It now appears that the housing sector is embarking upon a 
steady recovery which could drive housing starts over one million by 
2014. As the economy lost over two million construction jobs during the 
recent downturn, the revival of homebuilding has the potential to create 
several hundred thousand jobs during the next two years. 

The government's employment report for July came as a positive surprise. 
There was a 163,000 gain in total employment and a gain of 172,000 in 
private employment. The job gains were also broad-based. The 
manufacturing sector added 25,000 jobs because of strength in the auto 
sector. Business services created 49,000 jobs. In the leisure and 
hospitality sector, food services and drinking places added 29,000 jobs. 
Construction lost 1,000 jobs despite the uptick in housing starts and 
has gained only 5,000 jobs during the past year. The government sector 
again shed 9,000 jobs. The household survey lost 195,000 jobs after 
large gains during the past three months, which boosted the unemployment 
rate to 8.3%. There was no change in the workweek or factory overtime. 
There was an upward revision of 10,000 jobs in the estimates of May 
employment and a downward revision of 16,000 jobs in the June data. The 
ADP survey showed a job gain of 163,000 during July compared to 172,000 
during June. ADP estimates small companies created 73,000 new jobs while 
larger employers added only 23,000 jobs. The government data and the ADP 
survey confirm the economy is still growing at close to its trend rate 
of 2.5%. It is not yet clear if uncertainty about tax policy and Europe 
will jeopardize this trend, but such uncertainty looms as the major risk 
during the next three months. 

The July ISM index suggests the manufacturing sector was static during 
July. The index rose to 49.8 from 49.7. The new orders index edged up to 
48.0 from 47.8, but the new export orders index fell to 46.5 from 47.5. 
The employment index dropped to 52.0 from 56.6 while the production 
index rose to 51.3 from 51.0. The ISM index suggests the manufacturing 
sector is still growing at a sluggish pace, but well below the high 
growth rates which prevailed during the first quarter. The year-on-year 
growth of industrial production during June was 4.7%. The gain in auto 
output was 19.4% while high tech was down 2.1% and other sectors 
advanced by 4.3%. The auto sector accounted for over half of the 
economy's growth during the first quarter. If we make comparisons 
between current levels of industrial production and their previous 
cyclical peaks, the total level of industrial production is still 3.2% 
below the 2007 peak. Autos and transit equipment have risen to a new 
high while business equipment has regained its previous peak. Other 
sectors, such as appliances, non-durable consumer goods, and information 
processing equipment, are still below their former cyclical peaks. 

The June durable goods report provides further confirmation that demand 
for capital goods has weakened. The key gauge for capital spending, 
nondefense capital goods orders excluding transportation, fell at a 1.4% 
annual rate. During the past year this measure of capital goods has been 
flat, which suggests that firms are becoming more cautious about 
investment because of concerns about government fiscal policy and the 
global economy. Capital spending also benefited from 100% first-year 
depreciation allowances on new equipment spending last year. 

The growth rate of nominal consumption slowed to only 2.2% during the 
second quarter from 4.9% during the first quarter, but as the personal 
consumption expenditure (PCE) deflator fell to 0.7% from 2.5% real 
personal consumer spending rose by 1.5%. Real disposable personal income 
(DPI) grew by 3.3% during the second quarter compared to 3.4% during the 
first quarter and declines during the previous two quarters. The 
increase in real DPI did not bolster consumption because the household 
sector boosted its savings rate to 4.4% in June from 3.6% during the 
first quarter. It is unclear why the household sector boosted its 
savings rate after reducing it during the past year. The Conference 
Board survey of consumer confidence rose to 65.9 in July from 62.7 in 
June after peaking at 68.7 in April. Consumers were more confident about 
the intermediate term outlook despite a decrease in the number of 
respondents saying jobs were plentiful. There was an increase in the 
number of respondents who plan to purchase an auto and appliances, but a 
decline in the number who plan to buy a home. Department stores have 
reported better-than-expected gains in retail sales during July, so 
consumption could increase during July unless there is a decline in 
demand for services. 

The July non-manufacturing ISM index rallied to 52.6 from 52.1. The 
business activity index (the non-manufacturing equivalent of the 
production index) rose sharply to 57.2 from 51.7. The new orders index 
rose to 54.3 from 53.3. The employment index, by contrast, eased to 49.3 
from 52.3. There were eleven non-manufacturing sectors which reported 
growth during July while seven contracted. The weak sectors included 
agriculture and forestry, construction, health care, transportation and 
warehousing, and wholesale trade. 

FED MAY HOLD OFF ON FURTHER ACTION UNTIL THE FISCAL CLIFF IS RESOLVED 

The Federal Reserve declined to make any policy changes at the late July 
FOMC meeting. The committee reiterated its willingness to pursue new 
policy changes if conditions deteriorate further. It said, "the 
committee will closely monitor incoming information on economic and 
financial developments and will provide additional accommodation as 
needed to promote a stronger economic recovery and sustained improvement 
in labor market conditions in a context of price stability." It is 
possible that the committee could decide to act in September if data for 
employment and consumer spending falter during the next two months. It 
is unlikely that the new data will show signs of recession, but it could 
show the economy stalling at a growth rate in the 1.0-1.5% range with 
unemployment still at 8.3%. The Fed could also decide to delay a 
decision on new quantitative easing (QE) moves until it sees how 
Congress and the White House resolve concerns about the projected fiscal 
cliff at year end. If Congress and the White House fail to stop the 
projected tax hikes, the economy could slide into recession, which would 
provide ample justification for a new round of QE. The level of interest 
rates has fallen so low that it will be difficult for any new QE policy 
to have a major impact on the economy. As in the past, a return to QE 
could have an impact on the stock market, the dollar, and commodity 
prices. The Fed could defend a new QE policy in 2013 on the grounds that 
the threat of a new recession justifies taking any action possible which 
might help to stabilize the economy. 

One sign that monetary policy is having some effect on the economy is 
the recovery in bank lending. Commercial and industrial loans rose 1.5% 
during June and have increased at an 11.8% annual rate during the past 
year. Total bank lending has increased at a 4.0% rate during the past 
year. Business surveys indicate that most firms have no problems 
obtaining access to credit. The improvement in lending suggests the 
economy is no longer experiencing a liquidity trap. Firms simply need an 
incentive to increase their borrowing in order to finance new investment 
or inventory accumulation. 

There is no further visibility on how Congress and the White House will 
attempt to resolve disagreements about fiscal policy after the election. 
Both the House and Senate have offered different options for extending 
the Bush tax cuts. The House wants to extend the cuts for all income 
levels while the Senate wants to limit the renewal to only the first 
$250,000 of per annum income. There appears to be a growing consensus 
that neither side will propose extending the payroll tax cut. Such a 
decision would lead to an immediate $90 billion tax increase in January. 
The fact that both Republicans and Democrats agreed to a continuing 
resolution for funding the government through next March does indicate 
that fiscal compromises are possible. In this case, the Republicans did 
not want to take the blame for possibly shutting the government down 
immediately before the election. What remains unclear is how the two 
sides will justify compromises to achieve a new consensus on the tax 
cuts. At the current time both parties are aware of the danger that 
letting the economy fall off the fiscal cliff could drive the economy 
into recession during the first quarter of 2013. Neither side wants to 
take responsibility for a new recession, but it is unclear what tradeoff 
they might accept in order to avoid the recession risk. 

The CPI inflation rate was flat in June because of a 1.4% decline in 
energy prices. The index for all items less food and energy rose 0.2% 
for the fourth month in a row. The index for shelter posted its smallest 
increase since September despite declining vacancy rates for apartments. 
The index for medical care posted its largest increase since 2010 while 
there were also large gains for apparel and recreation. The recent 
uptick in grain prices has not yet affected the CPI, but it could push 
the inflation rate for food into the 3-4% range by year end compared to 
2.7% in June. The slowdown in the economy since last year's fourth 
quarter and the persistence of high unemployment should hold the core 
inflation rate close to 2.0% during the next few quarters. The Fed will 
be prepared to accept such an inflation risk if it decides to embark 
upon another round of quantitative easing. 

FINANCIAL AND FOREIGN PROFITS WEAKEND IN THE SECOND QUARTER 

In its revision of historical GDP data, the Commerce Department lowered 
its estimates of profit growth during the past three years. Before tax 
profits were revised down $15.2 billion (1.1%) in 2009, $3.2 billion 
(0.2%) in 2010, and $42.2 billion (2.3%) in 2011. Profits with inventory 
valuation and capital consumption adjustments declined to $1,900.1 
billion during the first quarter from $1,953.1 billion during the fourth 
quarter. There was a modest uptick in nonfinancial profits, but 
financial profits declined. Foreign profits also declined to $631.5 
billion from a previous peak of $658.5 billion during the second quarter 
of 2011. Four-hundred-and-six companies have now issued profit reports 
for the second quarter. Sixty-four percent beat analysts' forecasts, but 
only around two-fifths of them exceeded their sales forecasts. Analysts 
are projecting that earnings will rise to $25.56 during the second 
quarter from $24.24 during the first quarter. They expect a modest dip 
in third quarter profits and then a rebound to $27.07 during the fourth 
quarter. They expect profits to weaken during early 2013 and then climb 
to $30.60 during the fourth quarter. These forecasts suggest that 
investors are expecting profits to remain on a gradual upward track 
during the next eighteen months despite occasional seasonal wobbles. The 
profits of multinational companies are at greater risk because of their 
exposure to the European recession and slower growth in some large 
emerging market economies. 

THIRD QUARTER GROWTH IN 2012 SHOULD BE MORE ROBUST THAN LAST YEAR 

The economy experienced a major slowdown during the second quarter of 
2011 because of rising energy prices and the impact of the Japanese 
earthquake on auto manufacturing. There was a sharp decline in business 
and household confidence during July and August because of the political 
impasse over the US debt ceiling. The newspapers carried stories that 
the US Treasury might default on its debt. The situation at the current 
time is quite different. Energy prices have fallen sharply since April 
and boosted real income growth. The auto industry has no supply problems 
and accounted for over half of first quarter real GDP growth. The 
Congress recently agreed to a continuing resolution for funding the 
government through next March. 

Consumer confidence has declined from its peak a few months ago, but it 
has not plunged the way it did last year. The stock market has been 
resilient despite concerns about potential profit weakness later this 
year. The major uncertainties with the potential to depress confidence 
are the risk of large tax increases and spending cuts at year end and 
the recession in Europe. There is no way to quantify precisely how these 
dangers may play out, but they are the factors with the greatest 
potential to hold the economy at a stall speed over the next two 
quarters. 

EUROZONE WEAKNESS HAS BREACHED THE CORE 

The European economy continued to show signs of a prolonged recession 
during the second quarter. The Markit Flash eurozone PMI rose negligibly 
to 46.5 during July from 46.4 after contracting during the previous ten 
months. Manufacturing output fell at the steepest rate since May 2009. 

Germany's Markit PMI fell to 47.5 from 48.1, the sixth report in a row 
showing a decline. The manufacturing sector was especially weak and saw 
its fastest rate of decline in new export orders since 2009. Germany's 
IFO business index also declined to 103.3 in July from 105.2 the 
previous month. There were declines in both the current assessment and 
expectations components. The IFO index has been declining steadily for 
several months, and suggests that German output growth may have been 
negative during the second quarter. 

The European Commission's Economic Sentiment Indicator (ESI) has also 
been in decline. In July, the index for the euro area fell 2.0 points to 
87.9. It reflected declines in both the service and manufacturing 
sectors. The ESI fell 3.7 points in Germany, 2.3 points in France, and 
1.4 points in Spain. There were rallies in the UK (+1.7), Italy (+1.3), 
and Holland (+0.6). Consumer confidence also declined 1.8 points because 
of growing concerns about job security. 

The euro area unemployment rate remained stable at 11.2% in June, but is 
well above its level of 10% one year ago. The highest unemployment rates 
in Europe are in Spain (24.8%) and Greece (22.5%). The lowest are in 
Austria (4.5%), the Netherlands (5.1%), and Germany and Luxembourg 
(5.4%). 

The weakness apparent in various indicators suggests that euro area GDP 
is likely to have contracted by 0.5% during the second quarter after 
being flat during the first quarter. Consumer spending will probably 
decline 0.5% this year while gross fixed investment could fall 2-3%. 
There will be a decline in inventory accumulation equal to nearly 1.0% 
of GDP, but net exports could increase by even more as the recession 
reduces imports. What remains unclear is how Europe will emerge from 
recession. The downturn could bolster real income by reducing inflation 
to 1.2%, but unemployment could rise to 11.9% next year and constrain 
nominal income growth. The European economy may not show positive growth 
again until the second half of 2013. 

THE PLIGHTS OF SPAIN AND ITALY ARE INCREASINGLY WORRISOME 

There is now a great debate stirring about the role of the European 
Central Bank in helping to contain the debt problems of Spain, Italy, 
and possibly other countries. ECB President Mario Draghi helped to 
enliven this debate with a speech in London promising to take any 
actions necessary to save the European currency. The markets' immediate 
interpretation of the speech was that he would favor intervention in the 
Spanish and Italian debt markets to cap their interest rates at lower 
levels. After the latest ECB policy meeting, Mr. Draghi did not offer 
any clear-cut policy proposals to move decisively. He instead suggested 
that countries needing help should turn to the European Financial 
Stability Facility and obtain their support in return for accepting 
conditions on their economic policies. Spain and Italy have been 
reluctant to seek outside help on such terms because they have already 
enacted fiscal austerity and structural reform programs which are highly 
unpopular. In fact, IMF Managing Director Christine LaGarde has said 
that Spain has already enacted most of the measures which an IMF program 
might require. Mr. Draghi has to proceed cautiously in outlining 
proposals for action because the Bundesbank has opposed the ECB engaging 
in large-scale debt purchases. The Bundesbank has only one vote on the 
monetary policy council, but it has great moral influence because of its 
long tradition as a strong central bank strenuously restraining 
inflation. 

Spain is the country most in need of external assistance. It is 
experiencing large-scale capital flight. There was a capital outflow of 
€41.3 billion during May as a result of domestic banks sending money 
abroad, foreign banks pulling out cash, and foreign investors selling 
domestic assets. In the first five months of 2012, the capital outflow 
was €163 billion, or a sum close to one-sixth of GDP. Foreign investors 
owned 51% of Spain's government debt near the end of 2011. This share 
has now fallen to 32%. The share owned by local banks, by contrast, has 
more than doubled to 41%. 

Spain has already sought up to €100 billion of help from the eurozone 
rescue funds in order to help recapitalize its banking system. It is now 
awaiting a ruling from the German constitutional court on the legality 
of the European Stability Mechanism directly recapitalizing troubled 
eurozone banks. In the meantime the government has announced a third 
fiscal austerity program in order to demonstrate its resolve to achieve 
various fiscal targets by 2014. The new package calls for a hike in the 
value-added tax (VAT) to 21% from 18%, higher excise duties, reduced 
unemployment benefits, suspension of the year-end civil service bonus, 
and elimination of various employment subsidies. The government is also 
seeking to impose tougher conditions on excess spending and borrowing by 
provincial governments. Spain has found it difficult to achieve various 
EU deficit reduction targets because of the severity of its recession. 
Domestic demand has fallen by 13% in real terms since 2008. The downturn 
has helped to produce a major improvement in the trade account by 
reducing import demand. During the boom years before 2007 the import 
share of GDP had risen from 31% to 41% of GDP. Real incomes have fallen 
by 10% since 2009, but consumption has remained close to 2009 levels 
because the household sector greatly reduced its savings rate. 

Italy has the second largest public debt in the eurozone, but it hopes 
to achieve a primary fiscal surplus this year of 3% of GDP. Italy has 
had such surpluses in the past and could use them again to reduce its 
debt-to-GDP ratio. Italy's ratio of private debt to GDP is only 140% 
compared to an average of 170% in the eurozone. Despite the progress 
achieved in containing its deficit, Moody's announced a downgrade of 
Italy's debt rating from A3 to Baa2 because of concern about funding 
costs and rising unemployment. It pointed out that Italy has refinancing 
needs of €415 billion in 2012-13, and that foreign investors may no 
longer be willing to buy Italian debt because of worries about potential 
currency risk if Italy leaves the monetary union. The major risk in 
Italy is politics. The term of Mr. Mario Monti as prime minister will 
end next April, and there is no visibility on his successor. The polls 
suggest a potentially fragmented parliament. Mr. Monti became prime 
minister last November because of a loss of confidence in the previous 
government. He has since used his authority as a technocratic leader to 
carry out various reforms which ordinary politicians found difficult. 
The markets fear that when he leaves, Italian politics might again 
become hostile to reform. If Mr. Monti wanted to limit a future 
government's freedom of action, he could decide to obtain a loan from 
the EU and IMF in order to implement a multiyear program which would set 
clear goals for Italy. There is no sign that Mr. Monti wants to pursue 
either an IMF or EU loan, but if Italian interest rates are pushed 
higher by political uncertainty he may reconsider his position. 

Both Italy and Spain are paying interest rates in the 6-7% range on 
their ten-year bonds. The high interest rates on government debt have 
also helped to magnify the upward pressure on private borrowing costs. 
Local banks have to pay more than 400 basis points above LIBOR to obtain 
private funding whereas German and Dutch banks have a spread of only 
10-20 basis points. These higher capital costs are one more factor 
depressing the growth prospects for both countries. The ECB regards the 
high yields as a sign that the monetary transmission process has broken 
down. The ECB believes that interest rates should be the same throughout 
the monetary union. Investors demand a higher yield from Italy and Spain 
because of the danger they may return to their former currencies. 

CORE EXPOSURE TO PERIPHERY THREATENS CREDIT RATINGS 

Moody's has cut the outlook on the triple-A credit rating of Germany, 
the Netherlands, and Luxembourg to negative because of concern about how 
developments in the monetary union might affect their liabilities. As 
the largest economy in the eurozone, Germany has to assume the largest 
share of the burden for propping up troubled countries. German and 
French banks also have significant exposure to credit risk in the 
troubled peripheral countries. 

The Target2 balances of the European Central Bank system are a proxy for 
potential liabilities in the event that the monetary union broke up. The 
Target2 balances reflect the adjustments occurring in the balance of 
payments of the member states as a result of current account positions 
and capital flows. Since April 2011 the Spanish deficit in the Target2 
balances has increased from €44 billion to €372 billion. Italy has 
shifted from a surplus of €12 billion to a deficit of €274 billion. The 
Greek deficit has grown from €83 billion to €106 billion. The surplus 
countries are Germany and the Netherlands. The German surplus has grown 
from €309 billion to €729 billion while the Dutch surplus has grown from 
€38 billion to €143 billion. The Target2 balances are regarded as an 
accounting item to resolve payment imbalances, but if a country left the 
monetary union its deficit could turn into a real liability for the 
central bank serving as a counter party. 

WILL DECLINING UK INFLATION DRIVE GROWTH IN 2013? 

The UK economy contracted by 0.7% during the second quarter, and has now 
declined for three quarters in a row. British economists are shaving 
their forecasts for output growth this year to zero. Such a forecast 
would leave real GDP 4.5% below its pre-crisis peak five years ago. The 
UK outlook is clouded by concerns about the European recession's impact 
on trade and investment. The UK sends over half of its exports to 
Europe. The one positive in the outlook is falling inflation. It could 
drop to 2.0%, and allow the first improvement in real disposable 
personal income since 2010. The recovery in personal income should allow 
a moderate rebound in output growth next year. The government may also 
try to give the economy a boost by accelerating some infrastructure 
projects. 

JAPANESE NEAR-TERM CONSUMPTION OUTLOOK IS STRONG 

Japan's real GDP probably grew by over 2.4% at annual rates during the 
second quarter compared to 4.8% during the first quarter. There was a 
rebound in private capital investment after weakness during the first 
quarter while government spending on earthquake reconstruction rose 
sharply. The growth rate of consumer spending moderated after large 
gains during the first quarter. The outlook for consumption has improved 
because the real total compensation of Japanese employees has risen to 
its highest level since 1997, or nearly ¥260 trillion. The lower house 
of the Japanese Diet has approved the government's proposal to hike the 
VAT from 5% to 10% during 2014 and 2015. The last time Japan hiked the 
VAT there was a surge of spending on housing and other goods followed by 
a plunge when the tax took effect. The new legislation gives the 
government the power to defer the tax if it deems the economy to be too 
weak. It is not clear, though, how the government will define the 
conditions for reaching such a conclusion. The foreign trade sector 
continues to be subdued while the cost of oil imports is producing a 
trade deficit this year equal to ¥4.5 trillion. The current account 
should still produce a surplus of ¥5.0 trillion because of Japan's large 
investment income. The current account surplus last year was ¥9.6 
trillion. The Bank of Japan currently has policy on hold, but it could 
make changes this autumn if the Federal Reserve embarks upon a new 
quantitative easing program. 

CHINESE DECELERATION CONTINUES, BUT HOUSING WEAKNESS MAY BE ABATING 

The Chinese economy has slowed for six quarters in a row and reached a 
growth rate of only 7.6% during the second quarter. The slowdown 
reflects a cooling of both external and domestic demand. China's export 
growth slowed to 9.2% during the first half of 2012 from over 20% during 
the first half of 2011. The government has imposed measures to restrict 
real estate lending in order to curb rising property prices. These 
measures have slowed the growth rate of fixed asset investment to 20.4% 
from 25.6% in 2011. The slowdown, coupled with strong wage growth, has 
produced a sharp decline in corporate profits. They contracted by 2.4% 
during the first five months of 2012 compared to a growth rate of 28.7% 
one year ago. The profit squeeze is dampening investment and starting to 
curtail new hiring. China's purchasing agent index eased 0.1 points to 
50.1 in July. The new orders index eased 0.2 points to 49.0 while export 
orders declined 0.9 points to 46.6. The stock of finished goods index 
fell 4.3 points to 48.0. The PMI data confirm that China's manufacturing 
sector is going through an inventory adjustment in response to the 
economic slowdown. 

There was a recent meeting of the Politburo which reviewed economic 
policy. It advocated more policies to bolster the economy's growth rate. 
It called for more fiscal stimulus and easier monetary policy. It also 
promised more support for national investment projects and encouraged 
private capital to enter sectors hitherto dominated by the public 
sector. There have already been a variety of policy changes to bolster 
the economy. The PBOC has reduced reserve requirements three times and 
cut interest rates twice. The National Development and Reform Commission 
has been accelerating infrastructure projects. The government has 
introduced tax incentives to buy energy efficient home appliances. It 
also has cut in half the income tax on small enterprises with taxable 
income below 60,000 rmb ($9,430). 

There are signs that the property market is improving after a long 
period of restraint. The latest data from Soufun (a leading online real 
estate platform) reports that average property prices rose 0.33% during 
July, with seventy cities registering gains and thirty showing declines. 
According to data from the National Bureau of Statistics, total floor 
space sold was down 3.3% year on year in June compared to 9.3% in May. 
There has been an uptick in sales to first-time buyers during the past 
two months. China needs more final demand to stabilize the property 
sector because the growth of real estate investment has fallen from 
27.9% year on year in 2011 to 16.6% during the first half of 2012 and 
11.8% during June. A recovery in the property sector will have positive 
spillover effects on sectors which supply building materials such as the 
steel industry. 

The IMF is projecting that Chinese output will grow 8% this year. The 
IMF is concerned about headwinds in the global economy, but believes 
that the government has adequate policy tools to stimulate domestic 
demand. It notes that the fiscal deficit is only 1.5% of GDP and that 
lower inflation gives the central bank more room to cut interest rates. 

The Chinese oil company CNOOC has announced a $15.1 billion takeover bid 
for the Canadian oil company Nexen. This company will provide CNOOC with 
exposure to assets in Canada, the UK, West Africa, and the Gulf of 
Mexico. It is the largest acquisition the Chinese have made of a Western 
company, and it comes after China has already invested over $14 billion 
in the Albertan tar sands. CNOOC made a $19 billion bid for Unocal in 
2005, but it was blocked by US political opposition. As Canada wants to 
welcome Chinese investment and develop China as a market for Albertan 
oil, there is unlikely to be any opposition from Ottawa to the deal. The 
deal is one more confirmation of China's immense need for raw materials 
and its desire to own the sources of those raw materials. 

CHINESE AND EUROZONE SLOWDOWNS PUMMEL ASIAN EXPORTS 

The economies of East Asia are now suffering a trade downturn because of 
the recession in Europe and slowdown in the Chinese economy. In 2011 
Europe took 13% of East Asia's exports compared to 12% for the US, 7% 
for Japan, 13% for China, and 39% for intra-regional trade. The 
countries where trade with Europe exceeds 5% of GDP include Singapore, 
Thailand, Taiwan, Malaysia, Korea, China, and Hong Kong. There is also 
concern about how European bank deleveraging could affect the region. 
European banks account for 15.8% of foreign bank claims in China, 10.3% 
in Hong Kong, 18.7% in India, 13.5% in Indonesia, 14.6% in Korea, 15.2% 
in the Philippines, 17.1% in Singapore, and 7.9% in Taiwan. During the 
past year, European banks have been reducing their exposure to the 
region while American and Japanese banks have been doing the reverse. 

The Bank of Korea cut its lending rate by 25 basis points during early 
July for the first time since February 2009 and held it steady at its 
August meeting. The Bank indicated concerns about the global economy and 
believes that Korea will have a negative output gap for a considerable 
time going forward. Real GDP during the second quarter grew by only 2.4% 
year on year. There was a 1.2% year-on-year gain in private consumption, 
but gross fixed capital formation fell 1.5%. China accounts for 24% of 
Korea's exports compared to only 10% for Europe, but Korea is vulnerable 
to the effects of the European downturn on its exports to China. As a 
result of this loss of momentum, the central bank could ease one more 
time by year end. 

Taiwan's economy contracted by 0.16% compared to one year ago during the 
second quarter. Fixed asset investment fell by 8.4% year on year while 
exports fell 1.7%. As private analysts now believe growth could be as 
low as 1.0% this year, there is speculation the government could pursue 
new fiscal stimulus to bolster investment. 

India's economy expanded at its slowest pace since 2004 during the first 
quarter of 2012 with real GDP increasing only 5.3%. The slowdown was 
broad-based and reflected a variety of factors. There was significant 
monetary tightening during 2010 and 2011 to contain inflation. The 
government has been unable to pursue structural reforms which might 
attract foreign investment. There have been major scandals inhibiting 
domestic investment. The Reserve Bank has cut interest rates once, but 
is reluctant to move aggressively because of the persistence of high 
inflation. The government has little room to use fiscal policy because 
the central government has a deficit equal to 5.8% of GDP. The 
government is too weak to pursue big bang reforms, but it could pursue a 
variety of policies which would be positive for confidence, such as 
direct tax reform, a pending land acquisition bill, and easing of FDI 
regulations on insurance, aviation, and multi-brand retailing. There 
will also be a new five-year plan later this year which could promise a 
large increase in infrastructure investment ($1 trillion). India is 
currently suffering from a weak monsoon. The monsoon is critical for 
agriculture as irrigation is 70% rain fed. The bad monsoon will curtail 
farm output and increase the inflation rate for food. The higher 
inflation will further limit the ability of the Reserve Bank to reduce 
interest rates. 

The drought now gripping the American Midwest has led to large price 
increases for corn, soybeans, and wheat. These price increases could 
bolster Asian inflation rates later this year. The food sector has a 
much higher weight in the CPI of Asian countries than in the developed 
countries. Food accounts for 45.6% of the CPI in China, 36.1% in 
Indonesia, 49.7% in India, 30.3% in Malaysia, 41.0% in the Philippines, 
33% in Thailand, 26.1% in Taiwan, 22.1% in Singapore, and 13.6% in 
Korea. Grains have a modest weight in every country except India and the 
Philippines, but grain can also bolster the cost of meat. The good news 
for Asia is that rice prices have recently been declining, and thus 
could offset some of the upward pressure on prices resulting from 
drought in North America. 

AUSTRALIA HAS SCOPE TO CUT INTEREST RATES FURTHER 

Australia's real GDP is now 10% higher than it was at the beginning of 
2008. In Europe, the UK, and Japan, output is still below the pre-crisis 
peak. The factor which has driven Australia's outperformance is the 50% 
increase in China's real GDP since 2008. Australia has been experiencing 
a resource boom which has boosted the terms of trade and encouraged more 
mining investment. The upward surge of mining investment has accounted 
for 45% of the output growth since 2008. Rising commodity prices have 
produced a 15% increase in real gross national income. 

The Reserve Bank cut interest rates twice during the second quarter 
because of concerns about the international situation, especially 
Europe, and signs of weakness in the non-mining sectors of the economy. 
Recent data for retail spending has been positive, but confidence 
surveys reveal widespread pessimism. The household sector still has a 
debt-to-disposable income ratio of 150% despite a slowdown in new credit 
growth from 15% during 2000-08 to only 5.9% since then. The household 
savings ratio has also increased from negative numbers early in the last 
decade to 9%. The Australian inflation rate rose by 0.5% during the 
second quarter, and is now 1.2% above its level one year ago. The 
inflation rate for tradable goods has declined 2.0% during the past year 
while the inflation rate for the non-tradables sector has increased 
3.3%. The core inflation measure which the Reserve Bank prefers is 
increasing at a 2% annual rate. The benign performance of inflation will 
give the Reserve Bank cover if it perceives a need to stimulate the 
non-mining economy with further interest rate cuts during the next two 
quarters. The great surprise in the markets during recent months has 
been the resilience of the Australian dollar in the face of declining 
commodity prices and Reserve Bank easing. Until recently the exchange 
rate had a strong correlation with iron ore prices, which has fallen 34% 
from last year's peak. As Australia is one of the few countries to still 
offer a triple-A credit rating, more central banks now regard it as a 
safe asset and use it to diversify their foreign exchange reserves. 
Australia also continues to offer much higher money market yields than 
the G-7 countries. If the markets suddenly perceived that China was 
heading for a hard landing, the Australian dollar would fall sharply, 
but if the markets continue to expect only a moderate correction in the 
Chinese economy the Australian dollar could remain resilient. 

CAN A DESTABILIZING HOUSING BUBBLE BE AVERTED IN CANADA? 

The Canadian economy continues to expand at a modest pace which is 
likely to leave monetary policy on hold. Real GDP grew by 0.1% during 
May after a gain of 0.3% during April. The goods producing sector was 
flat as a 0.5% contraction of manufacturing output offset gains in the 
resource sector. The service sector expanded 0.1%, led by a 0.7% gain in 
retailing. Housing starts unexpectedly rose 2.4% during June to 222,700. 
The gain was driven by urban multifamily starts, and reflected strong 
demand in British Columbia and Quebec. The government is concerned about 
a property boom developing in some urban centers, so the finance 
minister has announced new restrictions on the use of mortgage 
insurance. Loans must now have a life of twenty-five years compared to 
thirty years previously. The down payment ratio is being increased to 
20% from 15%. Government-backed insurance will no longer be available 
for loans over one million dollars. The Canadians are proud of the fact 
that they have not experienced a property cycle as severe as that which 
has occurred recently in the US. Canadian banks have been prudent 
lenders and there are no non-recourse mortgages. The recent strength in 
home prices and high levels of consumer debt has made policy makers 
apprehensive about losing control of the property market. The new 
conditions for mortgage insurance are an attempt to use regulatory 
policy to achieve macro prudential goals when monetary policy is on 
hold. The new mortgage rules will give the central bank more flexibility 
in determining when to change monetary policy. 

BRAZIL AND MEXICO ARE HEADED IN OPPOSITE GROWTH DIRECTIONS 

The Brazilian economy is suffering from weakness in foreign trade at a 
time when domestic demand has been more resilient. The volume of export 
growth fell 1.7% during the first half of 2012 while the price of some 
important exports, such as iron ore, declined. Exports to Europe are 
down 6% this year while exports to Argentina have fallen 15.3%. 
Industrial production has declined 5.5% year on year, led by a 15.3% 
plunge in capital goods. Business remains cautious because of rising 
labor costs and uncertainty about the global economy. Retail sales 
increased 8.2% year on year in May. Consumption has benefited from 
falling unemployment and the fact that average real incomes rose 4.8% in 
the twelve months though May. The unemployment rate has fallen to 5.8%. 
The improvement has been broad-based across all regions. The economy's 
growth rate dipped to only 0.8% during the first quarter, so policy 
makers are seeking ways to bolster growth. The central bank has cut its 
lending rate from 12.5% to a record low of 8.0%. In June the finance 
minister announced plans to purchase 8.4 billion reals of capital goods, 
mostly transport equipment. The government has announced several 
measures during the past year to stimulate the economy, including tax 
cuts on durable goods and loans. Banks have been reluctant to pass on 
all of the central bank's monetary easing because of a large increase in 
non-performing loans. The default rate on consumer loans has increased 
from 5.6% to 8.0%. The year-on-year inflation rate fell to 5.0% during 
the second quarter from 7.3% during the third quarter of 2011. Falling 
inflation will give the central bank more freedom to reduce interest 
rates to new record lows in order to bolster growth. It could reduce its 
core lending rate to 7.0% by the fourth quarter. The central bank easing 
should help to bolster domestic demand through increased lending and 
boost growth during the final months of 2012. The goal will be to 
increase output growth from only 2% this year to 4% next year. 

The IMF has increased its estimate of Mexican real GDP growth this year 
to 3.9% despite downward revisions for many other countries. The Mexican 
economy got off to a good start with a 5.3% growth rate during the first 
quarter and appears poised for further steady output gains. Private 
consumption accounts for 65% of GDP, and it expanded at a healthy 4.3% 
year-on-year rate during the first quarter. Investment has also been 
robust and grew by 8.6% year on year during the first quarter. Mexico is 
now encountering global headwinds, and exports declined 0.5% year on 
year in June. Enrique Pena Nieto won the Mexican presidential election 
last month. He will lead the first PRI administration since 2000 in 
December. Presidential transitions have often produced great market 
volatility, but Mr. Pena Nieto's victory had been widely expected, so 
there has been no market response. His great economic challenge will be 
to address the country's falling oil output. It has fallen 25% since its 
peak in 2004, and could decline further. The US Energy Information 
Administration believes Mexico could become an oil importer by 2020. 
Mexico needs to remove the monopoly of Pemex in the energy sector and 
allow foreign oil companies with modern technology to develop new 
offshore fields. Petroleum still accounts for one-sixth of Mexico's 
exports and around 30% of government revenue, so the government has a 
strong incentive to stop the decline in oil output. 

  

SOUTH AFRICAN GROWTH CONTINUES TO DISAPPOINT 

The Reserve Bank of South Africa reduced interest rates by 50 basis 
points during mid-July to 5.0%, the lowest level in three decades. The 
move came at a time when many other emerging market central banks were 
easing monetary policy and reflected concerns at the Reserve Bank about 
trends in the global economy. The Reserve Bank action also coincided 
with signs of weakness in the local economy. The Chamber of Commerce and 
Industry conducts a survey of business expectations six months ahead. It 
fell to 46 in June from 58 in February. The Kagiso PMI—a leading 
indicator of the manufacturing sector—fell 5.4 points in June to its 
lowest level since August 2011, although it did regain some lost ground 
in July. The IMF has reduced its forecast of South African growth this 
year to 2.6% while the World Bank has cut it to 2.5%. All three of 
America's leading credit rating agencies currently have South Africa on 
a negative watch list. With the election for the ANC leadership pending 
this December, they are concerned about the ability of the government to 
control spending or resist other populist policies. The first test of 
the government's ability to control spending is the public sector wage 
negotiations currently occurring. It appears that local governments 
achieved a benign outcome recently by agreeing to a 7% pay hike in the 
current year followed by CPI-plus-1.25% next year and CPI-plus-1% in the 
third year. This outcome will help to restrain public spending after 
2013. One of the major problems in South Africa's economy is the wage 
determination process. There has been a weak link between pay and 
productivity which has eroded demand for labor compared to countries 
with more pay flexibility. South Africa is keen to reduce its high rate 
of unemployment, but the trade union congress has resisted all attempts 
to promote flexibility. The wage settlement agreed with local 
governments will not address these core problems, but it will help on 
the margin by encouraging wage moderation after a long period in which 
public sector pay gains were excessive. 

ADVANCED ECONOMIES FACE DISPARATE CHALLENGES TO CURRENCY POLICIES 

The US dollar rose 0.2% on a trade-weighted basis against major 
currencies during July. It benefited from the weakness of the European 
currency as well modest gains against the Japanese yen and the British 
pound. The dollar will benefit if the US economy shows more signs of 
economic recovery, but could weaken if disappointing data encourages the 
Federal Reserve to pursue a new quantitative easing policy in September. 

The European currency has been driven by market perceptions of how 
policy makers are coping with the EU's debt problems. They rallied when 
ECB President Draghi appeared to advocate more aggressive policies to 
reduce high bond yields in Italy and Spain. The market supports such 
policies because they would lessen the risk of the eurozone breaking up. 
The yen has benefited from safe-haven demand and the lack of any further 
easing moves by the Bank of Japan. There have been occasional rumblings 
from Tokyo about currency market intervention, but there is a reluctance 
to act unless conditions become disorderly. The Australian dollar has 
been remarkably resilient despite weaker commodity prices and Reserve 
Bank interest rate cuts. It appears to have become a safe haven for 
central banks seeking alternatives to the dollar while offering a higher 
short-term yield than the G-7 countries. The price of gold has remained 
in a trading range close to $1,600 because of a lack of visibility on 
new central bank actions to bolster their balance sheets and increase 
global monetary growth. There continues to be steady demand for gold 
from emerging market central banks. They bought 37.4 metric tonnes (mt) 
of gold in April after acquiring 83.1 tonnes in March. Turkey was the 
largest buyer in April, expanding its gold holdings by 29.7 (mt) to 
245.0 tonnes. The Philippines bought 32.13 mt in March and boosted its 
gold position to 194 mt. Other buyers in April were Mexico (2.9 mt), 
Kazakhstan (2.0 mt), and the Ukraine (1.4 mt). It is clear from this 
diverse pattern of buying that the developing countries want to 
diversify out of the dollar and the euro because of a desire to protect 
their assets from potential currency depreciation. 

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Copyright (c) 2012 David Hale Global Economics
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