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First Quarter GDP – Markets Smarter Than Economists

Date Posted: April 26, 2019

First Quarter Real GDP Increased More Than Expected
The advance estimate of first-quarter gross domestic product (GDP) showed real gross domestic product increased at an annual rate of 3.2%. This growth compares to 2.2% in the preceding quarter of 2018. The results significantly exceeded economists’ forecasts which recently increased to a consensus of about 2.5%. The result compares starkly to forecasts of less than 1% growth forecasts early in the first quarter. Equity markets proved smarter than economists.

Inventory Build – Lower Trade Gap Contributed to That Surprise
Contributions to better than expected growth included inventory build, a reduction in the trade gap, and increased state and local government spending. The most surprising number, in our view, came from the nearly 0.7% increase in business inventories. The reason for our surprise reflects the inventory buildup going into the first quarter. That inventory build reflected U.S. importers efforts to beat the then expected increased tariffs on imports from China. In fact, most economists assumed that inventories would decline during the first quarter and reduce GDP growth. Continuing first quarter inventory build ultimately must be worked down. How negative the impact on growth for the remainder of the year will depend importantly on the strength of consumer spending.

Related to the late inventory buildup last year, the trade gap narrowed which also contributed to first quarter GDP growth. Specifically, goods exports increased while goods imports declined by over 4%. We suspect the decline in imports reflects the fourth quarter buildup. Therefore, a lower trade gap will likely disappear as the year moves on.

The Important Final Sales Figures Showed Weakness
As we always do, we look below the headline figure to Final Sales to Domestic Purchasers. This figure represents, in effect, sales going across the counter. In the first quarter, that figure came in at 1.3%-nearly 2% below the headline GDP growth rate. Weakness in consumer spending, roughly two-thirds of GDP, contributed to that weakness. In the quarter, Personal Consumption Expenditures increased only 1.2% or half of the increase shown in last year’s fourth quarter.

Consumer Spending – One Key to the Full Year 2019 Growth
In our view, one key to growth for the remainder of 2019 will be consumer spending. With consumers fiscally fit, the key question is, will they open their wallets? With the economic headlines now more favorable and a strong labor market producing wage increases exceeding inflation, we expect their wallets to open. As evidence, the final April University of Michigan’s Consumer Sentiment Index and Expectations Component increased more than expected.

Business Investment Outlook — China Trade War Resolution Important
Also hurting first-quarter growth, business investment increased 2.7% or half the rate in the fourth quarter. In our view, whether business increases its investment spending will depend in part on the final resolution of the trade war with China. With expectations for a settlement likely before the end of the second quarter, a pickup in business investment could occur after Labor Day, if not sooner.

Housing May Show Life in the Second Quarter
Finally, the first quarter spending on housing showed a decline but less so than the fourth quarter. Lower interest rates since the fourth quarter and financially strong consumers should produce increased purchases during the traditional spring home buying season. If this proves correct, then expectations for second and third quarter growth will benefit.

Investment Conclusions
With the surprising inventory build, many economists will likely lower their second-quarter GDP forecasts for that reason. Again, an offset to that may be higher consumer spending and a stronger housing market. Whether business investment spending increases more rapidly will likely await the conclusion of the trade negotiations. Our view remains that the economy shows little excesses that typically proceed with an economic decline. By moving to a dovish policy, investors will find out whether the Fed limited the economic slowdown to just that and not a recession — a soft landing. If so, that would likely prove a first. Finally, with the presidential election year and a half in full stride, expect the Administration to make “hay” out of the headline numbers.

Equity markets since the first of the year proved smarter than economists. The next question will be whether the markets discounted that good news or whether investors expect more for the year. Certainly, the expectations of a recession this year seems no longer a concern for most investors. We continue to expect some economic slowing in the second half. At the same time, if the trade war becomes history, non-U.S. economic growth should perk up. If that proves the case, global U.S. companies should benefit from improved non-U.S. earnings and a likely stable U.S. dollar.