“U.S. Economy Shrank in First Quarter by Most in Five Years”. Not really the headline one likes to see first thing in the morning. But as we discussed following the first revision to 1Q GDP released on May 29th, the weakness in the first quarter will prove to be anomalous and transitory. Indeed, the stock market seems to be telling us that this will be the case. Despite the downward revision to 1Q GDP, despite the continued negative headlines out of the Middle East, despite the strong gains in stocks over the second quarter (S&P 500 is up over 4% so far in the 2Q), stocks are still holding up quite well and hover near all-time highs. But does the support for stocks reflect the expectation for an acceleration in GDP growth above the 2% trend since the recession, or does it simply represent hope for an extended period of monetary support from the Fed? Only time will tell.
The Bureau of Economic Analysis reported this morning that the first two estimates of 1Q GDP were far too optimistic. The second and final revision for 1Q GDP growth came in at -2.9%, down sharply from the first revision of -1.0%. The BEA attributed the majority of the variance between the first and second revisions to a slowdown in health care spending. Growth in consumer spending on services, which is a component of Personal Consumption and includes health care spending, was revised downward to +1.5% from the prior estimate of +4.3%. The reduction in spending on services, combined with a downward revision to spending on goods, is not particularly good news for an economy heavily dependent on consumer spending. But alas, we have excuses for the weakness. Better weather, future inventory building and increases in health care spending are expected to contribute to a 3.5% increase in 2Q GDP (according to a Bloomberg survey of economists). What, we wonder, will be the excuses if the 2Q falls short of estimates as well?
Ambiguous data in recent weeks continue to cloud the economic outlook. Better data on some fronts (manufacturing, consumer confidence, auto sales, etc) are being largely offset by a continued weak labor market, lackluster income growth, and a slowdown in housing. At the same time, there are some indications that higher inflation may become an obstacle to continued Fed monetary support. As a result, we see no reason to change our base-case assumption that there is a ceiling on our economic growth potential over the next few years. Economic activity may have picked up recently as weather improved and interest rates fell sharply from their highs at the beginning of the year. But the prospect of higher interest rates driven by signs of inflation, better economic growth, or simply a reduction in monetary support, will ultimately act as a stiff headwind at some point. In addition, we are now faced with another big potential drag on growth: higher gas prices.
The preponderance of evidence, for better or worse, continues to suggest more of the same. A conservative, defensive posture remains prudent as we continue along in this sixth year of the bull market. Do things look incrementally better than they did a few months ago? Yes, but investors need to determine whether or not the economic progress justifies the huge run we’ve seen in stock prices. From where I sit, valuations are now discounting a couple things that may or may not happen: 1) an acceleration in economic growth beyond the ~2% levels since the recession; and 2) a flawlessly executed termination of the biggest monetary experiment in history.