Risks Grow for Slow but Steady U.S. Expansion

By: Jon Hilsenrath and Nick Timiraos

August 24, 2015

The U.S. has been the tortoise in a global race for economic growth, plodding out a slow but steady expansion while China signals exhaustion and the rest of the world wobbles. Now, market turmoil and China’s troubles threaten to undermine the already unspectacular U.S. outlook.

The U.S. has been the tortoise in a global race for economic growth, plodding out a slow but steady expansion while China signals exhaustion and the rest of the world wobbles. Now, market turmoil and China’s troubles threaten to undermine the already unspectacular U.S. outlook.

Few economists see a U.S. recession. In fact, some recent developments, including lower oil prices, will help U.S. consumers and businesses.

But an uneven global growth outlook is pushing the value of the dollar higher, making U.S. goods more expensive overseas and harder to export. That could restrain the U.S. economy in the months ahead. Stock-market declines could further hurt U.S. consumer sentiment and spending, if the drops are sustained, and they make businesses even less willing to invest.

Federal Reserve officials now need to decide if they should alter their planned course on interest rates. Officials have been signaling for months that at least one increase in short-term rates is likely this year, possibly as soon as September.

Now, Fed officials might rethink the timing and pace of their plans, thanks to an uncertain growth and inflation outlook. In futures markets, investors put the odds of a rate increase in September at just 24%, according to the Chicago Mercantile Exchange; a week ago, it was rated a tossup.

The stakes are high. Asset values could tumble without the support of continued low rates. Investors also worry policy makers lack tools to intervene in the economy should it sink again.

Atlanta Fed President Dennis Lockhart, who said earlier this month he was inclined to move rates up in September, said in a speech on Monday that he sees an increase this year, but he avoided attaching a date to it.

“The Fed should not be raising rates,” said Lawrence Summers, a Harvard University professor and former Obama administration adviser, in an interview. “It should be thinking about its contingency plans if financial distress becomes serious. It should signal that it won’t be raising rates until and unless it sees clear evidence of inflation breaking above 2% or clear evidence of euphoria in financial markets.”

Such views increase public pressure on Fed Chairwoman Janet Yellen to stand pat. Merely talking about rate increases in the absence of inflation or a financial boom would be counterproductive at this point, Mr. Summers said.

Investors, struggling to make sense of a resilient U.S. economy buffeted by threats from abroad, went both ways on Monday. The Dow Jones Industrial Average dropped more than 1000 points at its open, reversed course, drifted lower again and closed down almost 600 points.

“People are scratching their heads how the economy is doing better as markets are doing worse,” said David Rosenberg, chief economist at money-management firm Gluskin Sheff & Associates. “The markets and the economy don’t always have to correlate at any given point in time.”

The U.S. has managed 2.1% annual growth since emerging from recession in 2009, rarely veering much above or below that pace, even when China slowed and Japan and Europe experienced secondary downturns.

The sluggish U.S. expansion has unfolded amid unprecedented support from the Fed, which has kept its benchmark federal-funds rate pinned near zero since December 2008 and launched several rounds of bond-buying programs to boost investment.

Economists surveyed by The Wall Street Journal expect the Commerce Department to report later this week that U.S. economic output expanded at a 3.3% annual rate in the second quarter, faster than previously reported.

Recent reports on retail sales and housing investment suggest output is expanding at a pace of 2.4% in the third quarter, according to analysts at Macroeconomic Advisers, a research firm.

The modest rebound Fed officials expected earlier in the year for now at least appears to be playing out. Weighing against threats from abroad are domestic sectors like autos and housing. Sales of previously owned homes are running at their highest levels since 2007, and home prices have rebounded strongly.

Home Depot reported last week that sales at stores open at least one year rose 4.2% in the second quarter and 5.7% in the U.S. The company raised its earnings guidance for the second time this year, and executives last week called out improvements in their division that caters to contractors, which they said reflected the continued rebound in home prices.

“When consumers believe their home is an investment and not an expense, they spend differently, and we’re seeing that spend pattern,” Carol Tomé, the company’s finance chief, told analysts.

Meantime, falling gasoline prices have delivered a boost to restaurants and bars, which have reported their best sales growth in years, and are ramping up hiring amid increased competition for workers. Chipotle Mexican Grill Inc. announced plans Sunday to hire 4,000 employees in a single day next month, around 7% of its workforce.

Falling gasoline prices are more meaningful than Wall Street’s gyrations to most working-class Americans, “who don’t care where Apple stock is trading,” said Andy Puzder, chief executive of CKE Restaurants Inc., which operates the Carl’s Jr. and Hardee’s burger chains. He said the closely held company plans to add a substantial number of restaurants in the U.S. this year.

Many U.S. companies find themselves trying to navigate a two-tiered global outlook, marked by small gains at home and new worries in China and Asia, a stark contrast from China’s boom days of a few years ago.

Examples of the global disconnect were ample in recent U.S. company earnings reports:

Attendance at Disney parks in the U.S. rose a steady 4% in the quarter ended in June, while it declined in Hong Kong.

Ford Motor Corp.’s North American revenue rose 4.1% in the first half of the year, while it dropped 14.5% in Asia.

At Wynn Resorts, the global gaming company, gamblers cut back 27.6% in slot-machine use in Macau, China, in the latest quarter, while inching up their use by 1.6% in Las Vegas.

“In Las Vegas, we are enjoying a comfortable business. I think that is the right word for it,” said Steve Wynn, the chief executive of the gaming company, in a conference call with analysts last month. His big bets on Macau, meanwhile, were “more of a question than a certainty.”

China by itself is not an obvious threat to the U.S. economy. China accounts for 21% of U.S. imports of goods and services. That gives it big influence on U.S. consumer prices and wages. However, it accounts for only 7% of U.S. exports. Because exports themselves aren’t a big driver of U.S. growth, the hit from a slowdown of sales to China is bound to be small. But broader spillovers from China’s slowdown could pose challenges for U.S. companies and the economy.

Many companies are still investing heavily in the world’s second-largest economy. Wynn, for example, is planning to open a $4.1 billion, 1,700 room hotel called Wynn Palace in Macau in March. Disney recently announced plans to open a new theme park in Shanghai. If growth doesn’t materialize in these and other ventures, it could knock the profitability of multinationals.

Then there is the U.S. dollar, which has appreciated nearly 8% against a broad basket of currencies so far this year, according to the Fed. The move was amplified earlier this month, when Beijing allowed the yuan to depreciate.

Economists at Goldman Sachs estimate a worsening U.S. trade position will subtract 0.75 to 1.00 percentage point from the already slow U.S. growth rate in the coming year, worse than the 0.6 percentage point that trade pulled from growth in the past year. That is not enough to short-circuit the recovery, but it is enough to keep restraining it.

A stronger dollar also holds down inflation by restraining the price of imported goods, which were down 10.4% in July from a year earlier. Besides the 2007-2009 global financial crisis, declines of that magnitude haven’t occurred in government records going back to 1982.

The Fed has said it won’t raise short-term interest rates until officials are “reasonably confident” that inflation will rise toward 2% after running below it for more than three years. The stronger dollar and falling oil prices are bound to undermine that confidence.

The timing of an interest-rate increase is only one variable officials must consider in the weeks ahead. Another is the pace of rate increases the central bank plans for the years ahead.

In forecasts released in June, Fed officials estimated the benchmark Fed funds rate would be 1.625% by the end of 2016 and 2.875% by the end of 2017. Yields on two-year Treasury notes were 0.601% on Monday, suggesting investors don’t believe officials will move nearly as much as projected.

But keeping rates low carries its own set of risks. One is that it could stoke a new financial bubble.

The U.S. stock market, now in correction territory, is hardly screaming bubble. But other sectors look stretched. U.S. regulators, for instance, have expressed concern recently about commercial real estate. “Now is not the time to be overly aggressive in bidding,” said Chris Finlay, CEO of Lloyd Jones Capital, a boutique firm in Miami that invests primarily in multifamily properties.

In a note to clients, Mr. Finlay warned that too much capital was chasing apartments. The firm recently bid on a distressed $6 million apartment complex in Tallahassee, Fla., that was just 85% occupied. The sale drew 21 bidders—normally such a sale would draw around five or six, he said—and the winning bid offered a $500,000 nonrefundable cash down payment before conducting due diligence.

“That’s just not good business sense,” said Mr. Finlay.

Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Nick Timiraos at nick.timiraos@wsj.com

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