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Economic Tone Better Than The First Quarter GDP Headline Number Suggests

Date Posted: May 2, 2017

The “Advance” estimate for first-quarter Gross Domestic Product (“GDP”) showed an annual growth rate of 0.7%.  More importantly, real final sales—very simply, what passes over the sales counter—grew 1.6%.  In our opinion, this stronger figure provides a better sense of the economic tone than the GDP headline number.    In effect, reducing inventories by 0.9%, instead of increasing production by the same amount, helped supply part of the final sales increase while reducing GDP growth.  

First Quarter Advance GDP Number Gives Little Direction for the Year

Each year, the advance estimate for first-quarter GDP reflects distortions caused by the seasonal adjustment formulas used by the government.  Merrill lynch economists label it “Grossly Distorted Product.”  Last year the advanced first-quarter GDP number showed annualized growth of 0.5%.  In comparison, the government’s final estimate for that quarter showed growth of 1.1% or more than double the original estimate.  More recent first-quarter data releases suggest we may experience a similar directional change this year.

Second Quarter Outlook

If Second Quarter Final Sales Show Similar Strength As In The First Quarter, That Increase Will Likely Be Met By Production Increases Rather Than Reducing Already Depleted Inventories.  In Addition, Further Production Strength Will Likely Result In Order To Rebuild Those Depleted Inventories.   The Quarter Should Also Benefit From Surprisingly Strong New Home Sales—More Than The Normal Seasonal Impact—As Millenials Move On With Their Lives.    One Major Offset May Be Continued Softening Of Vehicle Sales From Peak Levels.   Bottom-Line, Second Quarter Gdp Growth Will Likely Come In Well Over 2%.  The Blue Chip Economists Second Quarter Gdp Forecasts, As Gathered By The Atlanta Fed, Range Between Roughly 2.2% And 3.3%.

Economy—Where Are We In The Cycle?

In Our April 6, 2017 Commentary, We Pointed Out That The Downward Turn In Vehicle Sales Suggests A Shift Of The Business Cycle Further Into Its Maturing Expansionary Phase.  With That Shift, There Would Be Greater Investment Focus On Industries That Benefit From This Change.  One Of The Industries We Emphasized Was The Basic Metals Industry.  Confirming This Observation, A Major Global Mining Equipment Company Recently Reported Strong Results For The First Quarter As A Result Of Growing Demand From The Mining Industry.

Full Employment Numbers Also Signal The Maturing Of The Business Cycle.  The Recent Unemployment Rate Of 4.5% Compares To About 5% During A Similar Business Cycle Period At The End Of 2005.   The Wage Growth Tracker Of The Atlanta Fed Shows Wage Growth Of About 3.4%.   Estimating Unit Labor Costs Proves Very Difficult Because Productivity Estimates Remain Unclear.  Nonetheless, The Resulting Rising Wage Pressure Combined With Relatively Modest Pricing Inflation Will Likely Bring Further Pressure On Corporate Profit Margins.  Rising Labor Cost Pressures Reflect A Normal Pattern As The Expansionary Business Cycle Phase Matures.  Not Surprisingly Investors Will Seek Out Companies With Modest Labor Costs Or Those That Supply Systems That Reduce Such Costs.  Technology Companies Come To Mind, Not That They Need A Further Boost.

The Fed

In Our View, First Quarter Gdp Results Should Not Slow Down The Fed’S Program To Raise Rates 2-3 Times More This Year.  Based On The Tone Of The First Quarter Numbers And The Full Employment Levels, The Probability Of An Increase In June Likely Rose Somewhat.  In Addition, The Fed Will Likely Begin To Passively Reduce Its Over $4 Trillion Of Balance Sheet Holdings Around The End Of The Year.  With The Resulting Higher Rates At The Long End, The Yield Curve Will Likely Steepen.   In Our Opinion, These Actions Will Move The Fed Past The Inflection Point Of Accomodative Monetary Policy.  Of Course, This Outlook Assumes  Economic Growth Remains On Track.  

Investment Conclusion

With The Possibility Of Two-Three Fed Funds Rate Increases This Year And The End Of Qe By Year-End, The Fuel That Powered The Financial Markets Over This Decade Will Diminish.  If This Outlook Proves Correct, Once These Actions Become Clearer, How And When The Financial Markets React To This Major Shift Will Be The Key Question Investors Will Face.  To Repeat From Our Prior Commentary, The Last Decade Positively Reinforced The Familiar Warning—- “Do Not Fight The Fed.”   That Warning May Still Hold True, But In Reverse, If A Less Accomodative Policy Takes Hold.