Q2 GDP Growth Likely Just 1.2%

Friday's Q2 GDP report will offer the most comprehensive picture of how quickly economic conditions have deteriorated, just days ahead of the Federal Reserve's next policy meeting.

Economists were predicting a second-quarter pace above 2% annualized a few months ago, but the consensus is now 1.2%. That would be the weakest in more than a year and down from 1.9% in Q1 and nearly 3% in Q4 2011.

Aside from that year-end pop, Q2 should mark the fifth quarter in six with a sub-2% growth pace. The U.S. needs to grow at least 2%-2.5% to keep up with population and productivity gains and thus prevent the unemployment rate from rising over time.

Friday's report will include benchmark revisions going back to Q1 2009. Those changes may alter the official trajectory for the 3-year-old expansion — and how much the economy is decelerating now.

Consumer spending, which accounts for about 70% of total economic activity, looks to lead Q2 weakness.

Retail sales fell in all three months of the quarter. Last week's unexpectedly dismal June report triggered a round of Q2 GDP forecast cuts: to 1.4% at JPMorgan, 1.1% at Goldman Sachs and 1% at Deutsche Bank.

Government spending will remain a drag as state and local governments slash budgets. Federal fiscal policy also is tightening and will contract sharply at year end if the fiscal cliff of tax hikes and spending curbs kicks in.

Recent trends suggest overall government spending fell in Q2 below the pre-recession level seen in Q4 2007, though federal spending will stay above its equivalent mark.

Businesses have been reluctant to hire and invest throughout the economic recovery despite sitting on huge cash reserves.

The Q2 GDP report may reveal what effect fiscal cliff concerns are having on investment.

"It's beginning to kick in on capital investment," said David Shulman, senior economist at UCLA Anderson Forecast, who initially predicted 1.9% growth for Q2 but now thinks it could be closer to 1.5%.

Europe's debt crisis is also weighing on outlays for equipment and software. An earlier expiration of an investment tax break hasn't helped, he adds.

Durable goods orders rose 1.6% in June on strong aircraft demand, the Commerce Department said Thursday. But they fell 1.1% outside the transportation sector. Core capital goods orders sank 1.4%, the third drop in four months, another sign of faltering business investment.

But Jordan Levine, director of economic research at Beacon Economics, doesn't see a sharp pull-back in business investment. The uncertainty may even prompt firms to invest in productivity-enhancing equipment.

"This is one way they can meet that demand, which is in fact growing, without bringing in tons of workers," he said, putting Q2 growth at 1.5%-1.7%.

Quarterly corporate revenue so far this earnings season has been disappointing, and commentary on conference calls has been downcast, notes Paul Nolte, managing director at Dearborn Partners.

He also cites Cisco Systems' (CSCO) announcement this week that it will ax 1,300 jobs, a year after saying it would cut 11,500 positions. For-profit educator DeVry (DV) also said it will eliminate about 570 jobs.

Uncertainty over the fiscal cliff and future tax policy will make it harder for those laid-off workers to find new work.

"If I hire you tomorrow, I don't know how much you're going to cost me over the next year, year and a half," Nolte said.

The housing sector could be a bright spot, though its gradual recovery isn't expected to offset weakness elsewhere in the economy.

While the trend has been improving, the latest reports on existing-, new- and pending home sales all declined.

Friday's GDP report will no doubt factor into the Fed's July 31-Aug. 1 meeting as policymakers look for ways to reverse further stagnation. Some kind of action is increasingly likely, but the timing and form it will take are unclear.

A few key central bankers have expressed some doubts about how effective a third round of quantitative easing, or bond buying with newly created money, would be.

Other options Fed Chairman Ben Bernanke has mentioned include keeping rates near zero past the current timeline of late 2014, cutting interest rates paid to banks on reserves parked at the Fed, and some kind of action via the direct-lending discount window.