The outlook for real GDP, which was thought to have stabilized near a lackluster 2% annual rate, has worsened. The trend will dip to 1% in the second half of the year and could go negative.

Recent Trends

The table below shows the annualized rate of real GDP growth by quarter over the past three years. Since the end of the recession in the second quarter of 2009, quarterly real GDP has increased at an average annual rate of just 2.2%.

Growth has been extremely poor the past two and one-half years, particularly considering the depth of the recession of 2008-2009. Growth has reached the long-term trend of 3% in only two of the past twelve quarters.

These quarterly numbers translate into year-over-year growth of just 2.4% for 2010, and 1.8% for 2011, suggesting that the growth trends weakened slightly last year.

That weakness continued this year, with the first two quarter of 2012 averaging just 1.8% annualized growth.

The trends are about to get even worse.

Second Half Forecast

Our GDP model forecasts third quarter real GDP growth at a meager 0.3% annual rate.

The fourth quarter is projected at just a 1.3% annual rate of growth.

The Problem

The reduction from the already dismal rate of growth will be the result of a slowdown in growth of consumer spending, and to a lesser extent, to further restraint in business investment.

The slower rate of growth in these key components of the economy will be due to an increased level of economic, political, and labor market uncertainty. The chart below shows uncertainty as measured by Economic Policy Uncertainty (www.policyuncertainty.com).

Uncertainty has been elevated since the 2008 recession began. It has spiked higher recently. Consumers and businesses face a much higher degree or risk than normal, and in these circumstances, spending will be restrained.

Uncertainty and anxiety are not just theoretical concepts. They have real-world implications.

The chart below shows the US personal savings rate since 2005. The savings rate has increased in 2012 and has spiked higher the past few months. The savings rate is well above the rates of 2005-2007 when consumer spending was fueling solid GDP growth.

Consumers are showing an increased preference for savings relative to consumption. However virtuous this is in the long run, in the short run it reduces the math of GDP accounting and slows economic growth.

There is little doubt that the increase in savings is due to heightened anxiety about the near-term future. The job market remains weak (despite Friday’s better-than-expected July payroll figure), there is a possibility of higher taxes in January, and the news is filled with fears of the approaching Armageddon in Europe.

Consumer confidence measures don’t reveal any panic, but the indices are at extremely low levels. The Conference Board’s consumer confidence index ran at 100 to 110 from 2004 through 2007, before plunging in the 2008-09 recession to the mid-50s, and is now only back up to what is still a very low historical level of about 65.

Until there is greater clarity on the economic outlook, consumer spending will remain below the rate of growth needed to push real GDP growth back above 2%.

Business Investment

Businesses are also taking a more cautious approach to the future, and perhaps with better reason than consumers.

Profit growth is sacrosanct for large companies, and the outlook for earnings growth is bad.

Second quarter profits for the S&P 500, excluding the financial sector, were flat to slightly negative. Guidance for the third quarter indicates that aggregate profits will be down.

The profit growth problem is rooted in a lack of revenue growth. Revenue growth for the S&P 500 in the second quarter will come in about 3%. It may drop to zero for the third quarter.

Flat revenue trends mean that the only way to avoid the projected declines in profits in the third quarter is to cut costs – and that means a slower rate of growth in business investment.

Cost constraints, including restrained business investment spending, will result from the lack of revenue growth and the need to prevent significant declines in profits.

Forecast Breakdown

The table below delineates our forecasts for personal consumption expenditures and business investment for the second half of 2012.

The forecast for these two combined components is lower than the growth posted in the first half of the year. That is a major reason growth in the second half of the year will be trending lower.

There are also other problems.

Inventories added to first and second quarter real GDP growth. That was partly due to an unwanted buildup in inventories due to slower sales. Orders will be cut back in the third quarter, and the inventory calculation will subtract from GDP. In fact, a heavy swing in inventories could produce a decline in real GDP for the third quarter.

Government spending, which has fallen for eight straight quarters, will also continue to decline slightly in the second half of the year and drag down overall GDP growth. Net exports are also forecast to produce a slight drag on GDP due to weak overseas economies.

In sum, government and exports will stay weak, while slower growth in consumer spending and business investment will push real GDP down to a depressingly low 1% annual rate of growth in the second half of the year.

Not All Bad

The current high level of uncertainty and anxiety is the basis for our forecast that second half real GDP will be even less than the dismal results of the first half of the year.

Yet, there is reason to believe these conditions will eventually change for the better.

Households have significantly reduced their debt-to-asset ratios. Businesses are sitting on massive amounts of cash. Neither is likely to be willing to pull the trigger on increased spending over the near term, but once the situation in Europe settles down and the elections pass (hopefully establishing a clearer policy and tax outlook), economic activity will pick up.

Our quarterly forecasts call for real GDP growth to bounce back up to a 2.5% annual rate in the first quarter of next year, and to trend at that level or higher through next year (with upside potential if overall confidence improves and there is no fiscal cliff debacle in the US or a major policy-induced disaster in Europe).

What it All Means

There is the very real risk of negative news on the economic front the next several months. A very low third quarter real GDP growth number is likely.

Consumer and business spending is simply not going to accelerate until fears of a fiscal cliff are addressed, European conditions settle down, and labor market conditions improve.

A negative third quarter real GDP number is even possible, particularly if inventories are cut back significantly.

The outlook for fourth quarter GDP is also poor. That means there is a possibility that that bearish economic views will take center stage, and talk of recession is possible.

The bears will have their say when the stock market hits a downdraft, some bad economic data is released, or another near-crisis hits Europe.

There is even the risk that the economic outlook worsens. It is not inconceivable that the political stalemate in Washington D.C. could lead to bad policy or that an implosion occurs in Spain or elsewhere in Europe. Unfortunately, there isn’t a lot of cushion for such exogenous shocks to global growth. There are downside risks even to the forecasts presented above.

Sluggish economic growth through the end of the year will remain a headwind for the stock market until uncertainty declines from current high levels.

The Big Picture will be “gone fishing” next week and will return on August 20.

Dick Green
Founder and Chairman, Briefing.com