Smith Faculty Opinion Article	July 27, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

Second Quarter GDP Increases 3.4 Percent Stock to Recover

Today, the Commerce Department reported that GDP grew at a 3.4 percent annual rate in the second quarter of 2007, up from 0.6 percent in the first quarter. This exceeded the consensus, which was 3.2 percent.

Stronger second quarter growth reflected robust jobs creation, improvement in the trade deficit, increased government spending, and the vitality of business investment and inventory rebuilding. The economy should continue to perform well for the rest of the year.

Domestic consumption contributed 0.89 percent to growth, less than the 2.56 percent recorded in the first quarter.

Business investment contributed 0.49 percent to growth. Nonresidential construction added 0.66 percent to growth, after adding 0.22 percent in the first quarter. Equipment and software pitched in 0.17 percent, up from 0.02 percent in the first quarter.

Inventory investment added 0.15 percent to GDP in the second quarter, after subtracting 0.65 percent in the first quarter.

Government spending contributed 0.82 percent after subtracting 0.09 percent in the first quarter.

An improved real trade balance added 1.18 percent to GDP. A weaker dollar against the euro and several other key currencies boosted exports and cut non-oil imports. However, the real trade gap is likely to again increase and subtract from growth if China does not substantially revalue its currency. The real trade deficit with China is growing again, and it will dominate the real non-oil trade deficit going forward. Only so much can be accomplished without a major revaluation of the yuan.

Outlook for the Second Half

Despite all the chatter about the stalled housing market and subprime woes, consumers continue to hold up the economy.

Consumer spending grew 1.3 percent in the first quarter, down from 3.7 percent in the first quarter and 3.8 percent in the fourth quarter of last year. The latter figures were exceptionally high for two quarters back to back, and some adjustment in consumer spending was inevitable. Going forward, consumer spending should advance between 2.5 and 3.0 percent in the second half and lead the economy upward.

This should surprise no one. Housing prices are up over 50 percent over the last five years. Sale prices for existing home, which constitute 85 percent of the market, rose every month since January and are up year over year. The pace of existing home sales may be slower than in recent years but it is still respectable. Homes are contributing positively to consumer wealth.

Wall Street prognosticators are too focused on the woes of large builders. Large builders have an inventory or large homes in the wrong places, but the overall housing market remains healthy. Realignment is coming in the new home industry but we have seen the worst of the new home market decline. Many overpaid executives are in from some rude awakenings.

With existing home prices rising again, homeowners have adequate liquidity, and this makes consumers confident about the future. In fact, homeowners looking to sell have exhibited more nerve than Wall Street financiers in the wake of the recent upheavals in the subprime market.

Going forward, expect consumers to remain resilient. Residential construction will stabilize, and commercial construction growth will slow but not turn negative. Investments in new equipment and systems, especially on computers and software, are on the upswing.

Growth in the range of 2.5 to 3 percent is likely in the third and fourth quarters.

Stronger Growth and Rising Stock Prices Ahead

The outlook for second half GDP growth is solid and the fundamentals for the stock market remain strong.

We have likely seen the worst of things in the residential construction sector. Further contraction should be modest. Along with continued strength in business investment, consumers should power the economy up. Look for growth of about 2.5 to 3.0 percent in the third and fourth quarters.

Higher global oil prices will continue to push up U.S. inflation but the Federal Reserve can do little to dampen these pressures by raising short-term U.S. interest rates. With moderate growth ahead, look for the Federal Reserve to stand on the sidelines until the end of the year.

Overall the interest rate environment will be positive for stocks. Treasuries are currently overbought. The long end of the treasury yield curve will rise as the subprime scare subsides, freeing up additional cash for solid mortgages and enterprises with sound business plans.

Mortgage financing will remain readily available at reasonable rates, especially for creditworthy borrowers with stable, verifiable incomes. Less creditworthy borrowers will continue to find financing; however, risks will be better assessed and more fairly priced into mortgage rates, and investors will be more appropriately rewarded for accepting attendant risks.

Profits growth will be strong and continue to outperform the U.S. economy. Most large U.S. companies earn a good deal of their profits abroad. The combination of strong growth in Asia, coupled with moderate growth in the United States, is good for their bottom line.

A weaker dollar makes U.S. equities a particular bargain for foreign investors, especially in Europe and Japan. Large U.S. multinationals earning significant shares of their profits in Asia will prove a great play for European and Japanese investors who sit on strong euros, pounds and yen but have few good investment options at home.

Moderate GDP growth, favorable interest rates, profits advancing strongly, and robust foreign demand for U.S. equities should power up U.S. stock prices. The market should regain its footing, and stock prices should recover nicely and move up further.

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