U.S. Chartbook: A Longer Recovery

• GDP expansion in the final quarter of 2009 looks stronger, but at the price of growth early this year.
• The Fed will keep rates low to foster a self-sustaining recovery.
• The housing market recovery, like the overall recovery, is off to a weak start.

The rather robust turnaround in the economy suggested by the Conference Board's index of leading indicators is unlikely to play out. A more likely story is coming from the associated index of coincident indicators. The recovery was sparked by what turned out to be an excessive slowdown in inventory cuts by manufacturers after a surprising pickup in consumer spending, but final demand will need to solidify before the growth becomes self-reinforcing.

Manufacturing growth had triggered the recovery over the summer, but its outsize pace is settling down to something more sustainable. The Philadelphia Federal Reserve's latest manufacturing survey showed a downshift, although the details remain positive for future growth. The gap between new orders and inventories narrowed, and the employment component rose to its highest level in nearly two years.

These signs, combined with other data over the past few weeks, prompted us to upgrade our forecast to 4.1% GDP expansion, from our prior outlook for 3.3%. Much of the strength at the end of 2009 stemmed from an inventory boost, growth that is not sustainable in the coming quarters. Therefore, the stronger fourth quarter forecast has translated into slightly weaker growth in the first quarter of 2010. Consumption has yet to rebound significantly. As labor and credit market conditions ease, the fading inventory boost to GDP will be replaced by higher final sales.

Financial markets have been on a steady upward trend since the second quarter of 2009, consistent with equities' role as a leading indicator of economic conditions. However, as the most recent week showed, the improvement will be bumpy. Stocks started the holiday-shortened week rising solidly as investors took heart from the outcome of Massachusetts' special Senate election. The likely changes to a national healthcare bill boosted healthcare stocks. However, equities sank for the next three days.

Market jitters were sparked by mixed economic and quarterly corporate earnings data—particularly outlooks for ensuing quarters—but were also fueled by news out of Washington. On Thursday, President Obama proposed regulations to bar commercial banks from proprietary trading, an announcement that weighed heavily on financial shares. The next day, the prospect that Federal Reserve Chairman Ben Bernanke might not be confirmed for a second term worried investors. The Standard and Poor's 500 and Dow Jones Industrial Average posted their largest one-day declines since October; the NASDAQ fell by its largest margin since June. The declines are unlikely to be extended, and volatility will not be a longer-run issue.

As investors speculate about Bernanke's fate, the FOMC is preparing for its first meeting of the new year. Over the weekend, the political landscape seemed more favorable for reconfirmation, but regardless of the news in the coming days, the political process will not influence the group's two-day meeting. Indeed, Wednesday afternoon's FOMC statement is unlikely to show any major changes. Although signs of recovery are growing, the Fed remains aware that substantial downside risks remain. Given that worries about commercial real estate and tight credit conditions for small business are still at the forefront, the FOMC's forward-looking stance will mean it will hold the target rate at its historical low. We expect that strong GDP growth last quarter will be the exception, not the rule, in the coming quarters, and inflationary pressures will remain subdued. This will mean the FOMC is unlikely to raise rates until the latter half of 2010.

Worries about the near-term economic trajectory are, of course, not unique to the U.S. Several euro zone countries face hurdles in the coming months, putting downward pressure on the single currency. Concerns about sovereign debt in several member countries have dogged the euro over the past two months and materialized again in the latest week. The health of the euro zone will play into the U.S. macro outlook. The euro's slide halted late last week, but a strong rebound is not likely to materialize in the coming days or weeks.

The housing market's struggles are gradually being erased. Residential construction remains under pressure, but the latest report's headline figure exaggerates its weakness. The unexpected drop in housing starts in December was accompanied by a rise in single-family housing permit applications, which bodes well for early 2010. While the declines—particularly in single-family starts over the final three months of 2009—point to slight drag on GDP, housing starts had bounced along a flat trend over the entire year. Homebuilding will resume growing strongly over the year.

The National Association of Home Builder's housing market index also hints at a slow recovery for residential construction. From its most recent apex in September, the homebuilders' confidence metric has edged lower but remains noticeably above the sour note on which it began 2009. As flat-lining construction returns to life—initially boosted by the extended federal homebuyer tax credit and eventually by a broadening economic recovery—homebuilder confidence will follow suit.

Following a modest and decidedly temporary boost related to the tax credit in the fall, the Mortgage Bankers Association's mortgage applications index has tumbled. Downside risks, including distress sales following foreclosures, are lingering, but we think sales hit bottom in mid-2009. The road back to housing market health, as in the broader economy, will be long, but the first step has been taken.