Headwinds Intensity

Economic activity still appears to be holding up at a pace that is consistent with at least modest economic growth. This week had a relatively light economic release schedule but the reports that were released tended to come in stronger than expected. Major reports include the ICSC chain store sales figures, which came were up 4.3 percent year-to-year. Chain store sales are clearly being bolstered by tax rebates. Most of the impact has been at discount stores and warehouse clubs. Department stores and most specialty apparel chains reported declines for the month. Furniture sales were absolutely awful. The major electronic chains and home improvement centers did not report sales. We suspect spending has held up at electronics chains, which should be one of the largest beneficiaries from rebates. Home improvement stores may also see another strong month for the same reason, with tax rebates trumping the drag from the housing slump.

First-time claims for unemployment insurance fell sharply during early July. Jobless claims probably are not as good as the drop suggests.

The Heat Is On

Weekly jobless claims tend to bounce around quite a bit during the summer months, as the labor department often has some difficulty seasonally adjusting annual plant shutdowns for model year changeovers at the domestic auto manufacturers. We could easily see a gain next week that matched this week's decline.

Friday morning brought more good economic news. The nation's trade deficit narrowed much more than expected during May, falling to $59.8 billion. The improvement was even greater after adjusting for inflation. In real terms, the trade gap fell $3 billion to $43.6 billion. All of the improvement was in energy, where higher prices appear to be curbing the appetite for imported oil. Non-petroleum imports actually increased during the month. The improvement in the trade deficit means second quarter real GDP may come in much stronger than expected. If the real trade gap remains at its current level next month, trade will add about 2 percentage points to second quarter real GDP. Our current forecast, which calls for a 2.2 percent rise in second quarter GDP, assumes only a 0.5 percentage point improvement from trade. Later in the morning, the University of Michigan released its consumer sentiment index for July, which showed its first gain (albeit small) since January.

All of this better than expected economic news did little for the financial markets. Rumors about the viability of the two largest government sponsored mortgage firms along with a resurgence in oil prices sent stocks much lower at the start of trading on Friday. Treasury Secretary Hank Paulson attempted to cool off some of those rumors by making a statement of support for Freddie Mac and Fannie Mae later in the morning, but concerns about the financial sector continue to be a major wildcard for the economy. Right now the risk appear to be greatest for shareholders but disruptions in the secondary market for home mortgages will also likely lead to an even wider spread between mortgage rates and the 10-year Treasury. This is the last thing an already stressed housing market needs right now, if affordability comes back down, look for the housing woes to extend even further.

While equities swooned, especially in the financial sector, on Friday morning crude oil extended Thursday's gains and reached new all-time intraday highs. The early part of the week had brought a fleeting hope that some of the energy price pressures the economy was facing would diminish in coming weeks. Another round of energy price increases could again lead economists to lower forecasts for economic activity late this year and into 2009.

U.S. Outlook

Retail Sales • Tuesday

With consumers downtrodden due to rising gasoline costs, lower home prices and a tightening credit environment, little hope of relief was given to the May retail sales report. But in fact, the report showed strong gains across the board. Excluding gasoline, retail sales were up a solid 0.8 percent with notable gains in building materials, general merchandise and eating & drinking establishments. It appears the tax rebate checks are having a positive impact.

While weak motor vehicle spending will weigh heavily on total retail sales, gains may be seen in electronics and home improvement. Consumer spending is holding up admirably given the current environment but will diminish later this year when the effect of the stimulus package fades.

Previous: 1.0% Wachovia: 0.1%
Consensus: 0.3%

Consumer Price Index • Tuesday

Primarily due to rising gasoline and food prices, headline inflation has been accelerating in 2008. In the first quarter, headline CPI rose at a 4.2 percent annualized pace. Based on the April and May data and our expectations for June, headline CPI is on track to increase 4.6 percent year over year.
As energy prices continue to climb to record levels, we should see further acceleration in the headline CPI in June. Core CPI is expected to remain better behaved as softer motor vehicle prices, apparel and shelter costs help offset increases in medical care and airline tickets.

While inflation should weigh on real economic growth in the second half of the year, we anticipate the Fed will remain on hold with short term interest rates for the remainder of the year. Rising inflation expectations, however, remain a major concern and could force the Fed to tighten rates sooner than anticipated.

Consumer Price Index • Tuesday
Primarily due to rising gasoline and food prices, headline inflation has been accelerating in 2008. In the first quarter, headline CPI rose at a 4.2 percent annualized pace. Based on the April and May data and our expectations for June, headline CPI is on track to increase 4.6 percent year over year.
As energy prices continue to climb to record levels, we should see further acceleration in the headline CPI in June. Core CPI is expected to remain better behaved as softer motor vehicle prices, apparel and shelter costs help offset increases in medical care and airline tickets.
While inflation should weigh on real economic growth in the second half of the year, we anticipate the Fed will remain on hold with short term interest rates for the remainder of the year. Rising inflation expectations, however, remain a major concern and could force the Fed to tighten rates sooner than anticipated.

Housing Starts • Thursday

While we expect total starts will contract further in June, down 1.9 percent to an annualized level of 950K, it is important to note that the pace of deterioration is slowing. This is important in the calculation of real GDP. The April-May second quarter average is down only 4.8 percent to an annualized level of 991.5K. That's down from the -8.5 percent and -11.3 percent pace of the first and fourth quarters, respectively.

While tightening credit conditions, increasing foreclosures, and a more sluggish economy will lengthen the housing recovery, most of the reduction in new construction and home sales is behind us. Housing should become sequentially less of a drag on overall economic growth as the year progresses.

Previous: 975K Wachovia: 950K
Consensus: 968K

Wachovia Corporation
http://www.wachovia.com

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