Gut Wrenching

The greater-than-expected downward revision to first quarter GDP was a shocker (even more of a surprise than Spain, Italy, and Portugal not making it out of group play in the World Cup). However, investors were willing to dismiss the bad first quarter performance. An inventory correction and a wider trade deficit subtracted 3.2 percentage points from 1Q14 GDP growth. Poor weather and a few other anomalies were also factors. Moreover, the 2.9% GDP contraction was at odds with almost every other piece of economic data. The bigger concern is the soft consumer spending data for April and May. Weak growth in real wages and geopolitical worries should lead to doubts about a strong pickup in economic growth in the second half of the year. However, that may not be bad news for the stock market.

Let’s begin with a little GDP arithmetic. Last week, the Fed projection of 2.1% to 2.3% for 2014 GDP was equivalent to a 3.1% to 3.4% average pace of growth for 2Q14 to 4Q14. That was with a -1.0% annual rate in 1Q14. The -2.9% pace in 1Q14 GDP means that we’d have to average nearly a 5.0% annual rate over the final three quarters of 2014 to get to 3.0% for the year as a whole. We’d have to average 4.3% to get to 2.5%. We’d have to average 3.6% just to get to 2%. Still, a big part of the revised arithmetic outlook is the larger inventory correction and wide trade deficit for the first quarter. Leaner inventories suggest the potential for strong production gains. The wider trade deficit is a mixed bag. Higher imports are a sign of strength, but they have a negative sign in the GDP calculation. On the other hand, weak exports are weak exports. Softer growth abroad means weaker growth in U.S. exports and somewhat slower GDP growth. Looking at the data, it’s better to throw out net exports and the change in inventories. Domestic Final Sales rose at a 0.3% annual rate in the first quarter, a 1.6% increase from a year ago. That’s a bit soft, but we should see domestic demand pick up in the 2Q14 data.

This brings us to the May spending data. Adjusted for inflation, consumer spending declined in both April and May. Figures for January, February, and March were revised lower. Consumer spending on durable goods rose sharply in May, not a surprise given the brisk pace of motor vehicle sales, but spending in other areas was weak. These figures are subject to revision. In fact, they willbe revised, and revised, and revised. We should take them with a grain of salt. Yet, at face value, they suggest a much slower pace of consumer spending growth than was expected just a month ago (about a 1.4% annual rate, vs. the month-ago expectation of 3% or more).

Worries about weak growth in real wage income have moved to the forefront in recent months. Average wages are struggling to keep pace with inflation. That, in turn, limits the pace of improvement in consumer spending growth (where gains are being driven largely by job growth). Now factor in the possibility of higher gasoline prices and hopes for second half GDP growth of 3.0% to 3.5% begin to look tenuous. Increasing political tensions could also leave some U.S. firms more cautious, and less likely to hire new workers and make capital expenditures.

The UM Consumer Sentiment Index has been little changed in recent months. However, while survey respondents generally reported that their financial situation improved in June, they were less optimistic about the future. In particular, most households expected that their income would not keep pace with inflation. Nearly half expected a lower standard of living.

From the beginning of this year, the main risk to the economic outlook was not that we’d fall into a recession. Rather, it was that we’d end up with “more of the same.” That is, a lackluster-to-moderate pace of growth, but with little mopping up of the slack that was generated in the economic downturn. For the stock market, that may not be bad. The economy continues to recover, but not so much that the Fed removes the punchbowl.

© Raymond James

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