US feeling the pinch

Serious Money:The economic slowdown that began in the United States more than a year ago is over and the expansion is back on track - that's the verdict of financial markets and the majority of commentators concur, writes Charlie Fell.

Economic growth at a rate of less than 1 per cent year-on-year during the first quarter almost ground to a halt, but data for the latest three-month period suggest that the rate accelerated to 4 per cent.

The economy's revival has seen expectations of interest rate cuts in 2007, which appeared imminent just weeks ago, disappear and it is now widely believed that growth will remain above-trend through this year and into 2008. The financial markets now foresee no reductions in interest rates until next spring at the earliest and some commentators believe the next move by the Federal Reserve will be a further tightening of monetary policy.

But is the economy really on course to record a sustained period of vigorous growth? The answer is no. The rationale for above-trend growth is hard to justify and the US economy will actually record sub-trend growth for the first half of 2007 despite the recent rebound.

The headwinds apparent today suggest that performance is unlikely to get any better through the remainder of this year. The economy should continue to disappoint in 2008 if current interest rate expectations are realised.

The economic expansion has been driven largely by America's "have now, pay later" consumer, but the seemingly irrational decisions made by households will have material and far-reaching consequences.

Americans continue to spend more than they earn and have become increasingly dependent on asset gains to fund current needs. Excessive borrowing against capital gains has seen outstanding debt reaching record highs relative to the market value of assets, while liquidity has dropped to all-time lows.

The ultra-low interest rates engineered by Alan Greenspan following the worst downturn in stock prices since 1974 precipitated a housing boom.

Combined with years of financial deregulation, this enabled households to use their homes as an ATM. However, the severe housing recession has seen the monies extracted decline from an annualised rate of more than $700 billion (€521 billion) in 2005 to less than $200 billion in the first quarter of this year - a drop of roughly 6 per cent of disposable income.

Given that house prices are on course to decline for the first time since the 1930s and that one in three homeowners has little, if any, equity, the impact on consumption could be material and prolonged. Additionally, roughly $1 trillion in outstanding mortgages are set to re-price at higher rates over the next 18 months.

The impact of the housing recession on household spending has been compounded by the sharp rise in food and gasoline prices since the start of the year.

Unfortunately, American spending habits will not be deterred and the "have now, pay later" mentality continues as US households have turned to their ultra-expensive credit cards to fund outgoings.

The year-on-year increase in balances outstanding has surged by nearly four percentage points over the past 12 months to more than 7 per cent. Outstanding credit-card debt is more than $7,500 per household; if current trends persist, it surely won't be long before consumers are maxed out.

Furthermore, employment growth is slowing, as reflected in non-farm payroll numbers, which have experienced a monthly average rate of increase of 130,000 so far in 2007, as against an average of 190,000 for all of last year. The unemployment rate remains stubbornly low, but this is a function of a declining participation rate and not a robust labour market.

The seemingly unsinkable US consumer has so far proved extraordinarily resilient in the face of growing pressures. However, recent consumer surveys indicate that households are beginning to feel the pinch.

Economic data suggest that personal consumption spending advanced at a 2 per cent rate over the past three months, down sharply on the first quarter. The consumer slowdown has only just begun.

Corporate America is unlikely to come to the economy's rescue. The national income and product accounts show that domestic profits increased by less than 4 per cent in the first quarter while data from Standard & Poor's confirm that return on equity has peaked. Capacity utilisation is only marginally above its long-term average, while year-on-year growth in industrial production has slowed sharply.

The US economy is on course for an extended period of sub-par growth at best and monetary easing is still likely before the end of the year. Treasuries look attractive at current levels while stocks are ripe for a setback.

Investors should focus on large-cap growth issues with above-average dividend yields, which should prove to be a winning combination in the current environment.