Second Half Slowdown: Here's What to Expect

By Morgan Housel
July 2, 2010


Keep this in mind when sifting through the end-of-the-world headlines: This, too, will pass.

Passing through the second half of 2010, however, may feel like a firm kick to the face.

Don't act like you didn't see this coming. By and large, the now-evident second-half slowdown is not a factor of European fallout or the Gulf oil spill (although neither helps). It's the retrenchment in stimulus spending and housing credits, both of which end in very predictable, well-telegraphed, and even written-into-law ways. This slowdown shouldn't surprise anyone.

Could have seen it coming
Take the impact of stimulus spending, courtesy of the American Recovery and Reinvestment Act (ARRA, aka the $787 billion stimulus package). The effect this program has on GDP peaked in Q2 2010, and will fade over the next few years.

The slowdown isn't insignificant, either. The Congressional Budget Office's most recent estimates of ARRA's quarterly impact show a second-half GDP drag of somewhere between 0.5%-1% compared with the first half. That might not sound apocalyptic, but Q1 GDP growth registered just 2.7%. That makes a 1% drag nothing to sneeze at. It's also worth noting that ARRA's effect on 2011 GDP should be roughly half that of 2010, but we'll cross that bridge when we get there.

Last week, Larry Summers, President Obama's lead economic advisor, said, "A year ago the question was about a free fall, it was about depression. Today the questions are about the pace of recovery. That's a much better kind of question to hear."

He's right -- today is unquestionably less awful by comparison. But questioning the pace of the recovery shouldn't be pooh-poohed. Consider that the economy needs to grow roughly 2% per year just to keep unemployment from rising. If a recovery is measured by job creation -- and it should be -- then the second half will feel recessionary for millions of Americans, regardless of what the GDP numbers say.

Housing's last hurrah
Housing will be the other major drag on growth. Since the homebuyers' credit expired at the end of April, the housing market has been perfectly derelict, with new home sales collapsing to the lowest levels ever recorded.

This, too, should surprise no one. When you pay people to buy homes, as the housing credit did, you pilfer future demand. That's obvious. The question is how much demand the credit's existence stole.

Alas, that's tough to quantify, and I won't insult you with a guess (although many others will). This credit has been around in one form or another since mid-2008, so it's been a while since we've had a normal market to use as a comparison. Just eyeballing the spike in home sales before the credit expired in April shows that its ability to frontload demand was quite potent. Ironically, the more successful the credit was during its existence, the more violent the hangover will be in its absence. We're now experiencing that hangover, and the cast of Animal House would be impressed with its severity.

An offshoot risk here is that the credit's short-term success gave homebuilders a false sense of optimism, leading to a pickup in construction. As wretched as most housing headlines have been lately, residential investment was actually one of the largest contributors to GDP growth late last year, and housing starts experienced a burst of growth early this year that devoured expectations.

Why is that dangerous? Given the excess overhang of unsold homes -- estimated at more than 7 million units -- any itch to built seems positively crazy, and the chickens may soon come home to roost for megabuilders such as KB Homes (NYSE: KBH), Lennar (NYSE: LEN), and DR Horton (NYSE: DHI). Just listen to DR Horton's February conference call, where CEO Donald Tomnitz warns, "We're focusing on reducing our inventory post March to comply with the expiration of the tax credit." That's appropriate medicine for the housing market, but it'll be a sledgehammer on second-half production and construction.

Morning in America?
Amid it all, there's room for optimism. You just have to look hard and be creative. Much of what will be wrung out during the second half are artificially supported excesses that encumber a sustainable recovery. For housing in particular, you'll never see a real recovery until prices fall to appropriate levels, which they've struggled to do under stimulus package after stimulus package. The headlines you should cheer for are the ones that say, "Housing Starts Grind to a Halt," and "Prices Fall off a Cliff." That's when recovery can begin -- and those are the headlines that likely await the second half.

Scary headlines are also best friends with opportunity. The Dow Jones has fallen for eight of the last nine trading sessions. Is this justified? Maybe. People are terrified. Dreams are shattered. But it's presented some nice entry points. A few possibilities I like are ExxonMobil (NYSE: XOM), Philip Morris International (NYSE: PM), and Patriot Coal (NYSE: PCX), all three of which have been brutalized in recent months and trade for compelling, if not mouthwatering, valuations.

What should you expect out of the second half? Lots of bad news, probably. It was bound to happen. But it's that same bad news that plants the seeds of a recovery -- a real, true recovery this time. In that sense, now's the time to be optimistic.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Philip Morris International. Philip Morris International is a Motley Fool Global Gains recommendation. The Fool has a disclosure policy.

(Blogger's note: Of course all these are happening only in America! We are on the way to recovery already. This year alone, Bank Negara has raised interest rate by 75 points, showing confidence that we are pedalling out of the recession.)