Economic Slowdown Will Get Worse

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (TheStreet) -- The Commerce Department reported the economy grew at a 2.2% annual rate the first quarter of 2012, slower than the 3.0% pace registered the previous period. The consensus forecast was 2.5%, while my forecast was exactly on mark at 2.2%.

GDP growth was powered by much stronger consumer spending -- especially on autos and recreational vehicles -- substantial additions to business inventories and stronger residential construction. Also, business investments in machinery and software contributed a bit too.

Reductions in government spending, nonresidential construction and a slightly widening trade deficit subtracted from growth.

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The deficits on oil and with China account for nearly the entire $621 billion trade deficit -- nearly 4% of GDP. Cutting these in half, through changes in energy and trade policy, would increase GDP, including multiplier effects, by some $500 billion and create 5 million jobs.

Forecasts

Second-quarter growth will likely slow to about 1.6%, as consumers pull back and investments in new inventories slow. Business investment should not be expected to pick up the slack, stabilizing oil prices will likely boost imports a bit and government spending will stay in neutral or decline in the face of tightening fiscal conditions. Without further reductions in adult labor participation, the unemployment rate is not likely to fall much more.

Over the last several months, households have been running down savings to finance the recent surge in consumer spending and households should be expected to pull back on purchases to rebuild balance sheets.

Improvements in the availability of crude oil and anticipated refinery capacity should help lower gasoline prices to about $3.50 per gallon from their early April $4 high. Consumers used credit cards to cope with higher gasoline prices, and much of the additional disposable income created by lower gasoline prices in May and June will be used to pay down those balances.

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Households borrowed to finance the recent surge into auto sales and higher education; however debt-financed growth in those sectors should not be expected to continue.

The potential volume of auto sales is likely close to its peak and young people and parents are becoming dis-enamored with colleges and ever-surging tuition. Undergraduate education is too expensive -- some majors and degrees simply don't pay out well as investments -- and borrowing for higher education may soon plateau or decline. Graduate study is often not a good solution for underemployment among recent college graduates.

Inventory investments accounted for some 26% of the 2.2-point increase in first-quarter GDP. Much of this likely was unplanned stock building -- businesses miscalculating future sales rather than correctly anticipating future growth. Hence, in the second quarter, inventory adjustments and a pullback from stock building should occur.

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Weak durable goods orders indicate businesses remain pessimistic about the vitality and resiliency of the economic recovery, given the present constellation of government spending, tax, regulatory and trade policies. They remain reluctant to expand capacity.

In addition, consumers are becoming more hesitant about big-ticket purchases. Hence, investments in equipment, structures and software and household purchases of computers and other durable goods will not contribute significantly to second-quarter growth, and could indeed subtract from it.

Risks to Recovery

The economy is growing too slowly for it to be considered robust -- adverse development in four areas could derail the recovery.

1. China faces real challenges -- falling property values, questionable accounting standards and state banks burdened with bad loans. Foreign investors cannot ignore the size of its market, and firms like GM GM , Ford F and Apple AAPL will continue to invest toward producing and distributing products in China.

However, rising labor costs and increasing revelations of corruption and intrigue, up to the highest levels of China's leadership, are causing investors to cast a more jaundiced eye on the Middle Kingdom as a place to invest for serving markets in North America and Europe.

A crisis of confidence in China could disrupt both the Chinese and U.S. economies, and such an event has a much higher probability than zero.

2. Dodd-Frank regulations are severely handicapping small and moderate sized banks. Writing conventional mortgages has become an increasingly challenging activity, and securitizing commercial loans quite difficult. Despite the fact that these bank woes pose significant barriers to recovery in the housing sector and jobs creation among small and medium-sized businesses, Washington appears disinterested and smaller banks are selling out to their larger brethren.

Wall Street banks now control more than 60% of deposits nationally. The absence of competition in many markets has driven down CD rates. Seniors are losing a lot of purchasing power as interest on their retirement savings shrink. Wall Street banks are less interested in making loans to Main Street businesses than were the regional banks they absorbed.

3. The European Union is in recession and remains in deep trouble -- fixes for Greece, Portugal and Ireland are inadequate and eventually will need to be reworked. Spain is teetering on crisis -- a failure of its government to meet budget targets or a further spike in unemployment, already about 23%, could set off a contagion beginning with Italy.

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European banks are highly stressed. Those have not used the grace afforded by easy credit from the European Central Banks to properly add to capital and rework loan portfolios. Rather, they have often adopted gimmicks to paint up bad loans or move those into offshore vehicles -- all reminiscent of tactics employed by U.S. major backs when mortgage backed securities became problematic before the financial crisis.

4. U.S. higher education loans -- now more than $1 trillion -- are a ticking bomb. Undergraduates are borrowing too much against future incomes, and many graduate students are borrowing to obtain degrees that will not markedly improve their circumstances.

Most education loans are not dischargeable through bankruptcy and big debt coupled with disappointing pay will become an increasing drag on consumer spending.

In the face of all this, the U.S. private sector is proving remarkably resilient. Neither policy missteps in Washington nor purposeful incompetence in Europe can keep American capitalism down. However, the economy would be doing a darn sight better with better leadership on both sides of the pond.

--

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