Washington's political feuding over the deficit has damaged business and consumer sentiment in an already weak economy, but what remains unclear is whether growth will be constrained in the third quarter or reaccelerate as economists have been expecting.
Economists expect to see that second quarter GDP grew at a pace of 1.8 percent when it is released Friday. That would be just below the tepid 1.9 percent growth in the first quarter, a level of activity too sluggish to promote job growth. But now some are also looking to potentially trim third-quarter growth, concerned that forecasts of around 3 percent or more may be too high.
Meanwhile, Congress has been struggling to find a deficit reduction plan that satisfies both Republicans and Democrats, and as of Thursday, the House and Senate each had their own separate bills. Some piece of legislation must be agreed in order for Congress to vote to lift thedebt ceiling ahead of the Aug. 2 deadline.
"It's impossible to say with certainty because we don't really know but anecdotally, when you listen or talk to executives, they're telling you there's a level of uncertainty that's been introduced here, and that affects the economy," said Dan Greenhaus, chief global strategist at BTIG.
Greenhaus expects GDP for the second quarter to be 1.5 percent and he notes economic data continues to be spotty. "I expect it to be closer to 1.2 (percent) than 2, " he said. "Right now, I'm staying at 3 percent for the second half of the year, but the risk is to the downside."
Greenhaus said there are some signs sluggishness could continue into the third quarter. For instance, June durable goods orders showed weakness in future orders of non-defense capital goods, and that order slowdown could show up in third-quarter GDP. "Those are big ticket items and they are a proxy for business spending," he said. Nondefense capital goods orders, excluding aircraft, fell 0.4 percent, after a 1.7 percent rise in May.
In a report, Bespoke listed company after company in a variety of industries that mentioned the uncertainty surrounding the debt debate on their earnings conference calls in the last several days. Sealed Air, for instance was quoted as saying people are waiting to see what Washington does before making decisions, and CMS Energy said high gas prices, and the federal deficit debate appear to be dampening consumer confidence.
"A recessionary downturn is not our base case, but the U.S. debt ceiling debate has probably already gone on too long, to the extent that it is depressing consumer confidence," wrote Strategas economist Don Rissmiller, in a note.
"There is already some evidence that damage is being done because of the inability to pass a U.S. fiscal package and the distraction that it is causing: the FAA has shut down airport work in several markets, Maryland pulled a state bond offering because of too much political uncertainty, and T-bill yields have been volatile," he wrote.
Citigroup economist Steven Wieting agrees the economy may have already been affected by the uncertainty but it's hard to measure since so many other factors combined to create the soft patch, including the Japanese earth quake and tsunami and high energy costs.
"You can't see it in even the most timely data other than confidence readings. There's been some anecdotal reports on firms holding off on investment decisions," Wieting said. He pointed to the 16 percent decline in the consumer approval of government economic policy in the latest consumer sentiment data. It was the biggest one month drop ever, he said.
Wieting said the worse case for the economy would be if Congress does not raise the debt ceiling, and the government defaultsand cuts back on payments such as Social Security, pay to military families and contractors. But that scenario has not been given big odds by Wall Street, as it would likely trigger a financial crisis and global recession.
Some traders and analysts worry the expected cuts to spending would hurt the economy just as it is struggling to regain momentum.
"We are not counting on much more severe fiscal drag," said Wieting. "I don't think the plans that have been presented so far present an overwhelming fiscal drag." Wieting said it depends on how the ultimate plan is constructed. "There are ways of cutting down the growth rate of future spending where I think could reasonably see there would be minimal impact," he said. For instance, he said health care expenditures could be capped to grow at the same rate as the rest of the economy.
The Republican plan, pushed by House Speaker John Boehner, would raise the debt ceiling and cut spending in two stages, starting with a $900 billion increase in the debt limit and cuts of $917 billion over 10 years.
"The problem with the plan is it's perpetually here," said Greenhaus. He said the cuts are not big enough and they will continue to be debated. There is also a good chance ratings agencies could cut the U.S. AAA credit rating by a notch because the cuts aren't deep enough.
"So the uncertainty, instead of being transitory, would become entrenched," he said.
Deutsche Bank's chief U.S. equities strategist Binky Chadha does not blame the debt talks in Washington for the uncertainty. "It's another scape goat. I think it has more to do with the 2.8 percent GDP growth we've had for the past two years," he said.
Besides GDP at 8:30 a.m. ET Friday, the employment cost index is also released at 8:30 a.m. Chicago PMI is released at 945 a.m. and consumer sentiment is at 9:55 a.m.
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