The advance estimate of gross domestic product (GDP) released by the Bureau of Economic Analysis last Friday showed that the U.S. economy grew at an annualized rate of 2.5% in the first quarter, below expectations of an increase of 3.0%. Despite the decent first quarter advance, year-over-year gains in nominal and real GDP are largely unchanged from the prior quarter at 3.4% and 1.8%, respectively. While growth rates at this slow pace in these measures have typically heralded recessions, they appear stable but also underscore a critical problem—the failure to generate escape velocity. In addition, the quarterly GDP reads have seesawed giving a mixed picture of growth with many false starts. As a result, it is best to take an average of the last two quarters to gain a sense of underlying trends. With Q4 GDP at 0.4%, the two quarter average rounds the growth trend to 1.5% annualized—meaning the economy remains stuck in neutral.
In the first quarter, positive contributions from personal consumption expenditures (PCE), fixed investment and inventories were shaved by negative contributions from net exports and government expenditures. PCE increased 3.2%, much due to strong household consumption services. However, the larger spend was on household utilities due to cold weather and therefore not sustainable. The ongoing fiscal drag from sequestration and cutbacks from military spending manifested itself in a 4.1% contraction in government expenditures, led by an 8.6% decline in Federal spending (mainly defense) which has contracted in 10 of the last 11 quarters. Net exports were also a drag as imports (a negative for the GDP accounts) grew at a faster pace than exports—the latter likely hurt by the strong U.S. dollar and the spreading global slowdown. Fixed investment increased 4%, as residential investment (housing) grew 12% in Q1. This has been rising between 10% and 15% seasonally adjusted annualized rate (saar) for the last few quarters. Housing remains the good news in this report. Non-residential fixed investment grew only 2% on a soft 3% gain in business equipment & software (capital expenditures) and an outright decline in investment on plants/structures. Capital investment gains have slowed materially in the last year and they have not been that robust during the recovery. Pent-up demand here must be building, but businesses remain loath to make long term commitments. With the regulatory and policy climate clearer now, this represents a potential positive for second half growth. Businesses did add to inventories after the drawdown in Q4. This added 1% to growth, but will not repeat. Real final sales (GDP less inventories) slowed, increasing only 1.5%.
The main takeaways are what the report says about the economy going forward. The GDP data certainly had weak internals, and we are in what will be the weakest quarter of the year. For instance, we now know that March consumption (when it is reported on Monday) contracted, and ended the quarter on very weak footing which continued into April. The tax hikes are now denting consumer spending. The sequester cuts will be more keenly felt in Q2, leading to another large drop in government spending. Inventory gains will be more muted and capital expenditure remains on hold. The housing story remains encouraging and will continue to help stabilize growth. This quarter’s weaker economic data will temper views of the Fed backing away from quantitative easing (QE) sooner rather than later. There are bright spots in the report—just not enough of them at this point. Growth trends still appear range-bound near 1% to 2%, but we expect 2013 will end on a slightly stronger note as these risks abate.
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