Smith Faculty Opinion Article	October 27, 2006
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

GDP Increases 1.6 Percent in Second Quarter Resilient Consumers,
Business Investment Stave Off Recession

Today, the Commerce Department reported that GDP grew at a 1.6 percent annual rate in the third quarter, down from 2.6 percent in second quarter. The consensus forecast was 2.1 percent.

The housing sector and the growing trade deficit were the main culprits. The flagging housing sector and ballooning imports subtracted from growth 1.1 and 1.3 percent, respectively.

Confounding naysayers, consumers and business investment continued to stave off the recession that the housing adjustment and the tide of imports could easily cause.

Consumer spending grew 3.1 percent, faster than the 2.6 percent second quarter pace. Considering the much touted effects of higher gasoline prices in July and August and the housing adjustment, this was a very respectable showing. Despite a fall off in new home sales and sluggish auto demand, durable goods sales were up 8.4 percent.

The reason is quite simple. Homeowners still have considerable equity. Even with the modest adjustment in existing home values, home equity is still up about 50 percent over the last five years.

Overall, private investment was down 2.0 percent in the third quarter, as compared to a 1 percent gain in the second quarter, because of the housing sector.

Residential construction contracted 17.4 percent, while business investment in new structures, equipment and software was up 8.6 percent. Commercial construction was a bright spot, increasing 14.0 percent. Investment in equipment and software was up 6.4 percent, after retreating 1.4 percent in the second quarter.

The trade deficit continued to drag down growth. Real imports grew 7.8 percent, even after adjusting for the higher price of oil, while exports expanded only 6.5 percent. Chinas undervalued yuan and export subsidies continued to boost sales at Wal-Mart and other purveyors of inexpensive consumer goods. Meanwhile, steep tariffs and other trade barriers continue to limit U.S. exports to China, India and other fast growing Asian markets. The trade deficit will continue to drag down potential growth through 2007 thanks to inaction on these problems.

Looking forward, growth should pick up. Falling oil prices and the stock market rally are boosting consumer confidence, and fourth quarter retail sales growth should outperform the third quarter. Although residential construction is flagging, most components of commercial construction are likely to remain robust. Industrial capacity is reaching its limits, and investments in new structures, machinery, technology, and software are likely to remain robust. In 2007, further efforts to streamline and improve supply chain management will be a key driver.

The economy will likely expand at about a 3 percent annual rate in the fourth quarter.

Good corporate profits growth and improvements in household savings performance should sustain the stock market rally. With housing prices leveling off, consumers will be able to both spend more on retail items and save a bit more. Homes will no longer be viewed as a good near-term speculative investment, and individuals will put more cash into equities.

The stock market rally should continue through the fourth quarter, and the gains scored by the large caps should spread to the mid-cap and smaller stocks.

Firms making producer durables and services that boost productivity should do particularly well. Specifically, firms selling goods and services that improve supply chain management, collaborative technologies, and substitute communications for travel will do well, as will firms making fixtures for new commercial structures and manufacturing and office equipment.

Overall, the prospects are good for moderate, healthy growth and a strong stock market in 2007.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.