Nation

Real GDP rose a revised 5.8% in the first quarter, up slightly from initial estimates. An increase in inventories accounted for the bulk of the strength, however, which sets the stage for weaker growth going forward. Grains in household spending, equipment spending, and construction remained strong. The trade deficit deteriorated sharply.

Preliminary data suggest that growth slowed in the current quarter. Retail sales, home buying, and construction activity all declined in April. Recent shipment data suggest that equipment spending remained robust, however, and inventories continued to build. On net, real GDP is expected to rise 1.7% in the second quarter, less than one-third the pace of the first quarter.

The remainder of this special report takes a closer look at the outlook for a slowdown in the second half of the year. Strong gains at the start of the year likely borrowed strength from later in the year, allowing the Fed to return to the sidelines. Financial market overshooting is the greatest risk.

The Second Half Outlook
Growth Slows

Real GDP is expected to rise a moderate 1.9%, half the pace of the first half of the year:

--Household spending is expected to slow;
--Unseasonably strong gains in construction are expected to play out;
--Inventories are expected to drain;
--Business investment is expected to moderate (slightly); and,
--The trade deficit is expected to widen.

The slowdown in household spending is expected to be particularly dramatic. The kick from lower mortgage rates has pretty much played out, tax refunds have been spent, and problems with consumer balance sheets have returned. Compensation growth remains constrained, while debt has soared to new highs.

Risks--Recent equity market gains could provide an unexpected boost to spending. Wealth effects tend to be small, however, and continue to be tempered by personal real estate losses. An overwhelming majority of consumers still rank their homes, which have not appreciated much in the 1990's, as their largest asset.

Inflation Remains Relatively Benign

The consumer price index is expected to slow to a 2.2% year-on-year rate of inflation by year-end:

--The slowdown in growth is expected to ease capacity pressures; --Recent investments are expected to add to existing capacity; --Senior managers remain committed to holding costs (largely compensation gains) in check; and,
--The recent accumulation in inventories is likely to trigger additional discounting.

The Fed Returns To The Sidelines

The federal funds rate is expected to remain at 5-1/2% through year-end:

--The slowdown in growth is expected to ease inflation fears among the more pre-emptive members of the Federal Open Market Committee (largely regional Fed presidents); and,
--Inflation is expected to remain surprisingly benign. We are in an extremely gray area when it comes to policy making, however, and market uncertainty about Fed actions is expected to remain high for the balance of the year.

Long-Term Bonds Rally

The 30-year bond yield is expected to drop below 6-1/4% by year- end:

--A slowdown in economic growth and persistently benign inflation is expected to ease inflationary fears;
--The Fed is expected to return to the sidelines; and, --Growth in Japan and Germany is expected to remain weak. Foreign Exchange Rates Fluctuate In Range
Uncertainty about European Union and U.S. political pressures to depreciate the dollar are expected to hold the yen and the DM in a wide trading range through the balance of the year. The DM is expected to end the year at 1.71 DM/$, and the yen is expected to end the year at 110 yen/$.

Equity Prices Remain Buoyant

Low inflation and on-going efforts to cut costs suggest that profits, and hence equity prices, should remain relatively buoyant through year-end. The upside on financial gains is limited, however, as much of this year's good news has already been priced into the market. Any significant moves above recent market highs could set the stage for a correction.

Not A Repeat Of 1987--Equity values remain more closely aligned with fundamentals than they were in the spring of 1987, and the risks of aggressive Fed tightening remain remote. Fears of a 1987- style crash appear unfounded.

Great Lakes

The Great Lakes Index (GLI) rose a revised 5.9% in the first quarter, slightly above real GDP growth. Gains were widespread in household spending, equipment spending, and construction.

Inventories were also built, however, as GM pushed to recoup strike losses in Canada.

Data on the current quarter is not as encouraging. U.S. strikes at GM and Chrysler continued to take a toll on light vehicle production and heavy rains caused delays on many construction projects. Seasonal spending was also off for the period, and home buying appears to have hit a plateau. The only major offset was equipment spending, which showed signs of accelerating. On net, the GLI is expected to rise 1.5% in the second quarter, slightly behind the pace of real GDP growth.

The remainder of this special report lays out the translation of the second half outlook for this region. A catch-up in production associated with earlier strikes, continued strength in equipment spending, and a pickup in exports are expected to temporarily return the premium that this region earns on growth. Tight labor markets remain a constraint, however, and labor shortages could worsen in the months ahead.

A Translation of the Second Half Outlook

A Temporary Premium Returns

The GLI is expected to rise 2.2% in the second half of the year, 0.3% ahead of growth for the nation:

--Light vehicle output is expected to pick up, supported by a strike-related catch-up in production, and an acceleration in exports (largely to Canada and Latin America);
--Heavy truck production is expected to remain relatively strong, now that Latin America is coming into its own (trucks are a primary means of transporting goods south of the border);
--Equipment spending is expected to moderate from the robust pace of the first half, but continue to outpace (by several multiples) the overall pace of economic growth; and,
--Exports are expected to accelerate, with gains in Canada and Latin America providing offset to persistent weakness in Japan and Western Europe.

The prospects for trade south-of-the-border are especially good. The recovery in Mexico has solidified, and the push to extend NAFTA to Chile, Argentina, and, most recently, Brazil suggests that opportunities in South America are expanding. Trade agreements are helping to institutionalize market reforms in Latin America, providing investors with some assurances that the move toward free market policies is a permanent one.

Competitive Risks

Lags in the dollar, and the push by Japan and Germany to re- establish themselves as export platforms, suggest that import competition will also accelerate during the balance of the year. It typically takes two years for the full effects of a dollar shift to show up in prices, which means that the worst price competition is yet to come for the Big 3. The dollar hit a trough against the yen in 1995.

The bulk of foreign market share gains, however, are likely to go to the transplants--Japanese and German owned plants in the U.S.-- rather than producers abroad. This will do little to alleviate competitive pressures for the Big 3, but will help to buoy area production as those pressures intensify. About half of all Japanese transplant capacity is located in the Midwest.

Moreover, there are signs that the dollar has (at least temporarily) peaked. Political pressures both at home and abroad have threatened a market intervention to depreciate the dollar, bond yields are expected to drop, and uncertainty about European Union remains high.

Larger Issues

Labor markets tightened dramatically in the first half of the year and we are running out of people to employ. The unemployment rate dipped below 3% in some parts of the region. Conditions in the manufacturing sector are especially tight. Older manufacturing workers are beginning to retire, and the current pool of entry level workers have neither the skills nor the numbers to replace them.

An uptick in in-migration would help to alleviate the situation, but movement to the region has been limited. Retirees continue to flock to the more temperate South (can you blame them?), and an improvement in the economies of the coasts has stemmed the flow of younger workers from those regions.

Finally, productivity growth could accelerate. This seems more likely given recent gains in equipment spending, the latitude created by the UAW contracts, and the on-going consolidation in the auto industry. The efficiencies associated with last year's supplier mergers are still ahead of us. Productivity growth has already accelerated sharply, however, and recent gains will be tough to beat.

The Bottom Line

NAFTA and the prospects for similar trade agreements in South America have essentially picked up where the weak dollar left off in guaranteeing a trade advantage for the heavy industries of this region. Labor markets have tightened, however, and could limit the extent to which our producers can exploit those advantages going forward. We are beginning to hit our heads on a growth ceiling.

June 12, 1997
Diane C. Swonk
First Chicago
The First National Bank of Chicago
One First National Plaza,
Chicago, Illinois

Consensus National Futures and Financial On Line Index

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