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Economic Research:

U.S. Economic Forecast: A Mighty Wind


Credit Market Services: Beth Ann Bovino, U.S. Chief Economist, New York (1) 212-438-1652; bethann.bovino@standardandpoors.com

Table Of Contents
A Hard Rain's A-Gonna Fall When The Levee Breaks Who'll Stop The Rain? Bridge Over Troubled Water

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Economic Research:

U.S. Economic Forecast: A Mighty Wind


Hurricane season is in full swing in the U.S. and it will almost certainly carry with it an abundance of hot air on Capitol Hill. Amid higher taxes and no end in sight for the sequestration cuts that have blown across the world's biggest economy, two other storms are brewing in Washington: the expiration at the end of September of the continuing resolution that sustains funding for government agencies, and the point when the Treasury reaches the debt ceiling, which will come soon after. Overview The BEA revised 2012 GDP growth up from just 2.2% to a more favorable 2.8%. But a larger fiscal drag brings our 2013 GDP growth forecast down to 1.7% from our July forecast of 2.0%. We now expect GDP growth of 2.9% in 2014. Although the August jobs data will matter, we still expect the Fed to start tapering in December, given fiscal headwinds amid low inflation.

The private sector has so far effectively battled the two-headed beast of higher taxes and sequestration. But the resulting deceleration in economic growth has been sharper than we'd like to see at this stage of a recovery. Still, U.S. GDP grew 1.7% in the second quarter, according to the advanced estimate from the Bureau of Economic Analysis (BEA). That's stronger than the 1.1% rate in the first three months of the year, partly because of a surprisingly firm round of government spending and business inventory data. We also saw a pick-up in business investment activity and fairly stable consumer spending. Additionally, the BEA's advanced estimate makes a lot of assumptions about information that wasn't known at the time. The estimate didn't include the uplift from increased construction spending in June (year over year) or a report that showed the U.S. trade gap narrowed to a 3 1/2-year low that month. Given this, the BEA's next second-quarter GDP growth estimate may have outpaced our July estimate of 2.1%, after all.

A Hard Rain's A-Gonna Fall


While it's nice to see the economy growing at a faster clip than many in the markets feared, it has come after steep downward revisions to first-quarter expansion. We brought our forecast for 2013 GDP growth down to an annualized 1.7% from 2.0% on greater fiscal drag than we earlier expected. Just 162,000 jobs were created in July, according to the Bureau of Labor Statistics (BLS). And downward revisions the prior two months make the soft July gains look a bit worse. But given that GDP growth is averaging 1.4% in the first half of the year, it's not surprising to see that the strong pace of monthly jobs gains earlier in the year has slowed. The unemployment rate did drop 0.2 percentage points to 7.4% because some people left the jobs market, but even more

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Economic Research: U.S. Economic Forecast: A Mighty Wind

people landed jobs. That payrolls expanded at all was even more of a surprise, given GDP growth is so soft. At the same time, mixed June housing reports have given way to some improvement in July, with rising mortgage rates not yet damping the recovery. Because consumer sentiment readings were pointing to happy households and the labor market was still expanding, we indicated at the time that June was more likely to be a hiccup than a trend. Construction firms agree, and this month's National Association of Home Builders (NAHB) homebuilder sentiment index rose three points, adding to July's jump of five points and pushing the index to 59, an eight-year high. It suggests that some of the road blocks are starting to be removed.

When The Levee Breaks


Meanwhile, it now looks as if Congress won't soon compromise to reverse sequestration. No action through year-end would mean another year of subpar growth--just 1.7%, according to our forecast. There are also scant signs that lawmakers will find a way to sit together and hammer out a solution before the continuing resolution and debt ceiling events play out. Together with the still-fragile labor market, it seems unlikely that the Federal Reserve would begin tapering its bond purchases next month; we are sticking to our December forecast. And if the jobs numbers soften further, we think the Fed would wait until next year (as per our initial forecast). The chance that the central bank would need to increase purchases, while still low, has risen. Much of the debate about the U.S. economic rebound centers on whether the strong jobs data we saw earlier this year would trigger faster growth, or we need stronger growth to create more jobs. The lackluster July data increased worries that improvement in the labor market won't last, given that GDP growth hasn't been as robust as new hiring for the past several months. This scenario calls to mind Okun's law--named for American economist Arthur Okun (1928-1980)--which suggests that because of continued increases in the size of the labor force and the level of productivity, real GDP growth needs to be near its so-called potential growth to keep the unemployment rate steady. In other words, to bring unemployment down by a percentage point over a year, real GDP would have to grow approximately two percentage points faster than potential in that period. However, the unemployment rate dropped 0.8% year over year to 7.9% in December 2012, while the GDP rate in 2012, at 2.0% fourth quarter over fourth quarter, remained well below trend growth. More recently, unemployment dropped 0.9% year over year, to 7.4%, in July, while real GDP growth was up by just 1.4% from second-quarter 2012 to second-quarter 2013, and well below trend. Why have we seen an average of about 200,000 monthly job gains this year but consistently tepid economic growth? Part of this disconnect is probably because businesses were playing "catch-up," to quote Fed Chairman Ben Bernanke, after sharp job cuts during the recent recession. Businesses slashed their workforces so dramatically during the downturn, and kept staffs smaller as the recovery began, that even modest gains in growth have been enough to spark new hires. In short, while job gains surpassed what Okun's law requires, they only helped the economy get back into

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Economic Research: U.S. Economic Forecast: A Mighty Wind

balance (see chart 1).


Chart 1

Another reason may be because the many hires are for part-time positions. Businesses may be trying to minimize the effects of the Patient Protection and Affordable Care Act and its mandates for providing health insurance to full-time employees. Or, perhaps, businesses aren't confident that the economy is strong enough to merit taking on full-time workers. The surprising jump in part-time employees in the BLS' household survey supports this. Still, we haven't seen a significant decline in the workweek.

Who'll Stop The Rain?


At any rate, the effect of federal spending cuts on government jobs is often overlooked. In fact, the economic slowdown is particularly concentrated at the government level. The economy has barely grown, expanding 1.1% and 1.7% in the first and second quarters, respectively, after just getting above zero in the final three months of last year (up 0.1%). And most of the drag has come from the government, which lopped off 2.2 percentage points of GDP during that period. If government spending had been flat, growth in those quarters would have been 1.4%, 1.9%, and 1.8%, respectively.

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Economic Research: U.S. Economic Forecast: A Mighty Wind

In the seven months through July, the federal work force shrank by about 53,000 positions. That was, in part, because federal offices have instituted hiring freezes and taken other steps to ratchet down their spending. Many more federal workers are seeing their hours cut through mandatory furloughs and bans on overtime. But that data isn't really showing up in the jobs report. Furloughed workers aren't counted as unemployed, and the data on hours worked is for private-sector employees, not public-sector ones. That the pace of jobs growth will continue in the face of sequestration is unlikely. The government is already trimming contracts with private firms, and businesses are beginning to pull back on investment plans as the year continues. We expect furloughs to take a significant bite out of income and consumer spending. That means diminished revenue for private businesses and so less need to hire employees. The jobs market is now climbing higher but has gained back only two-thirds of the 9 million jobs the economy lost during the recession. Indeed, we have often said that the number of people who stopped looking for jobs distorted the drop in the unemployment rate--they are no longer considered part of the work force and so aren't counted as unemployed. In July, the labor participation rate in the U.S. remained near a three-decade low, where it has been for more than a year. Some analysts have argued that the shrinking work force is just a function of people moving ahead with their retirement plans. We doubt this explains the whole story. Last year, the Chicago Fed estimated that retirements accounted for only about one-quarter of the drop in labor force participation since the recession began. The BLS July data back this up, showing that the labor participation rate (non-seasonally adjusted) for people age 65 years or older increased since January 2008 but decreased by 4% to 70.8% for younger people, a 41-year low (it's the lowest rate since July 1972).

Bridge Over Troubled Water


The number of people applying for disability insurance has also surged in recent years, and applicants came in at a much higher rate than during and after previous recessions. So have student loans, which makes sense. If you spent months sending out resumes to no avail, you might quit looking and go back to school. But is it possible to have too many college graduates? For years, the conventional wisdom has been that those with higher education will earn more over their lifetimes, boost the nation's economic productivity, and build the stock of human capital. But the developed world finds itself now in a peculiar situation in which college attendance is generally rising, while economic growth is slow or even nonexistent. More young people are going into the college pipeline and coming out to face unemployment or underemployment, often settling in the short term for lower-paying jobs that traditionally haven't required college degrees. Nonetheless, the recent cohort of college graduates will still do better than their noncollege peers as they age and move into the white-collar and professional jobs generated by a healthier economy, according to a recent study by the New York Fed. As students move through their 20s and early 30s--often the most unsettled years their lives--their underemployment declines dramatically. From 2009-2011, a 22-year-old had a better-than-even chance of being underemployed. But by the time a college-educated person was 35, the chances of underemployment had fallen to

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Economic Research: U.S. Economic Forecast: A Mighty Wind

approximately one-in-three (see chart 2).


Chart 2

To be sure, a student's chances of finding a good job are probably greater if they've studied in an in-demand field--the petroleum engineer with a bachelor's degree will likely have stronger career prospects than the French major. And while the cost of getting an education may temper any graduate's full potential, students everywhere are working to reduce those costs and boost the returns on their educational investments by seeking cheaper ways to go to school--including taking classes online, earning a less expensive two-year degree at one school and finishing their education at another, and, in some instances, even leaving their home country altogether for a lower-cost education. Some relief in costs may also be in sight. In the U.S., the total average cost of college for students has declined since 2009-2010. Meanwhile, with student debt a large concern, total family borrowing in the 2011-2012 school year stabilized at the same rate as the year before. In both academic years, student and parental educational loans averaged 27% of the cost of college, according to a recent Sallie Mae study. The positive long-term prospects for college grads, however, are complicated by policy issues. A rising tide may lift all boats, but higher--or lower--levels of employment can still depend on government action that is as tied to political decisions as it is to educational ones. In the U.S., immigration reform may yet prove to have a noticeable educational

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Economic Research: U.S. Economic Forecast: A Mighty Wind

impact. While most of the political focus has recently been on developing a path to citizenship for illegal immigrants and border security, one of the most pressing concerns for new college grads is the resolution of the scope of immigrants allowed in with H1B work visas. In addition, Congress seems to be on the verge of deciding how expensive students' educational loans will be--and the answer seems to be that they will cost more. Higher interest rates on college loans may affect who can afford to go. Sallie Mae found, for instance, that middle-income families typically fund more of college costs through borrowing than either poor or wealthy families. Standard & Poor's Economic Outlook
August 2013 2012 Q4 (% change) Real GDP Real final sales Consumer spending Equipment investment Nonresidential construction Residential construction Federal government S&L government Exports Imports CPI Core CPI Nonfarm unit labor costs Nonfarm productivity (Levels) Unemployment rate Payroll employment (mil.) Federal Funds Rate 10-year Treasury note yield 'AAA' corporate bond yield Mortgage rate (30-year conventional) Three-month Treasury-bill rate S&P 500 Index S&P operating earnings ($/share) Current account (bil. $) Exchange rate (major trade partners) Crude oil ($/bbl, WTI) Saving rate Housing starts (mil.) Unit sales of light vehicles (mil.) Federal surplus (fiscal year unified, bil. $) 7.8 134.5 0.2 1.7 3.5 3.4 0.1 1,418 23.15 (409) 94.0 88.17 6.6 0.90 14.9 (293) 7.7 7.6 7.4 7.4 9.3 130.9 0.2 3.3 5.3 5.0 0.2 947 56.86 (382) 100.0 61.69 6.1 0.55 10.4 9.6 129.9 0.2 3.2 4.9 4.7 0.1 1,139 83.77 (449) 97.0 79.41 5.6 0.59 11.6 8.9 131.5 0.1 2.8 4.6 4.5 0.1 1,269 96.44 (458) 91.0 95.07 5.7 0.61 12.7 8.1 133.7 0.1 1.8 3.7 3.7 0.1 1,380 7.5 136.0 0.1 2.3 4.1 4.0 0.1 1,624 7.1 138.5 0.2 2.7 4.5 4.4 0.1 1,767 6.5 140.8 0.4 3.1 4.9 4.8 0.4 1,823 0.1 2.2 1.7 8.9 1.2 0.2 2.3 1.6 1.7 1.3 1.8 4.1 6.8 13.5 (1.5) 0.3 5.4 9.5 (0.0) 1.4 1.4 0.9 3.4 3.3 3.0 9.5 7.7 12.7 (1.6) (0.3) 3.3 2.0 2.7 1.7 0.0 1.4 3.2 2.9 3.2 14.0 4.2 13.8 (2.2) 0.6 6.2 9.3 0.5 1.7 1.4 1.2 (2.8) (2.0) (1.6) (22.9) (18.9) (21.4) 5.7 1.6 (9.1) (13.7) (0.3) 1.7 (2.0) 3.2 2.5 1.0 2.0 15.9 (16.4) (2.7) 4.3 (2.7) 11.5 12.8 1.6 1.0 (1.2) 3.3 1.9 2.0 2.6 12.7 2.1 0.4 (2.6) (3.6) 7.1 4.9 3.1 1.7 2.0 0.5 2.8 2.6 2.2 7.6 12.7 13.1 (1.4) (0.7) 3.5 2.2 2.1 2.1 1.2 1.5 1.7 1.7 2.1 4.6 (0.9) 14.0 (4.5) (0.4) 2.0 2.3 1.5 1.8 1.2 0.0 2.9 3.0 2.8 9.7 4.7 18.3 0.2 0.4 4.9 6.6 1.5 2.0 1.9 0.9 3.2 3.3 2.4 7.5 6.0 19.6 (0.7) 0.6 5.6 4.1 1.7 1.9 2.2 1.2 Q1 2013 Q2 Q3e Q4e 2009 2010 2011 2012 2013e 2014e 2015e

17.6 (25.7) 20.1 (13.9) (1.0) 1.1 (3.1) 2.2 1.7 11.8 (1.7) 12.6 (8.4) (1.3) (1.3) 0.6 1.4 2.1 (4.2) (1.7)

135.1 135.7 0.1 2.0 3.9 3.5 0.1 0.1 2.0 4.0 3.7 0.1

136.3 136.9 0.1 2.6 4.3 4.3 0.1 0.1 2.6 4.3 4.3 0.1

1,515 1,610 25.77 26.43 (425) 96.0 (388) 98.0

1,668 1,704 26.39 26.84 (375) 99.0 (378) 98.0

96.82 105.43 110.85 121.91 (440) 95.0 94.21 5.6 0.78 14.4 (392) 98.0 96.43 4.0 0.94 15.6 (701) (395) 99.0 90.43 4.9 1.23 16.1 (736) (406) 98.0 89.53 5.6 1.56 16.3 (670)

94.35 94.22 100.29 96.86 4.0 0.96 15.2 (307) 4.5 0.87 15.5 $91 3.8 0.92 15.8 (191) 3.8 1.01 16.1

(234) (1,416) (1,294) (1,297) (1,089)

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Economic Research: U.S. Economic Forecast: A Mighty Wind

Standard & Poor's Economic Outlook (cont.)


e--Estimate.

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