The bean counting on second quarter GDP

Marie M. Schofield, CFA, Chief Economist and Senior Portfolio Manager | July 25, 2013

  • Second quarter GDP data looks soft, including a wider trade deficit and cuts in government spending.
  • Positive factors include steady consumer spending and upcoming changes in the way GDP will be calculated.
  • Growth is poised to improve in the second half, but the Fed’s models and forecasts seem overly optimistic.

Final second quarter GDP data reports are trickling in, putting the footprint of economic growth into focus. It looks soft, weighed down by three forces. These include:

  1. The impact of the global growth slowdown on U.S. manufacturing and trade,
  2. The fiscal drag associated with reduced government spending courtesy of the sequester, and
  3. What may be outright inventory depletion.

One added surprise has been slower housing starts, particularly in multi-family, which may dent the stellar gains in residential investment portion of GDP last quarter. All this follows the revision of a promising 2.5% Q1 GDP gain into a rather unspectacular but near-trend 1.8% gain. So far based on economic data to date, the Q2 GDP will likely see growth of 0.5% to 1.0%. This means the year’s first half will grow a meager 1%-1.5%, less than my modest assumptions of 1% to 2% and well below street estimates from earlier in the year. Many economists are just now fudging down their estimates based on quarterly tracking, and this will continue until the GDP report is released on July 31.

The softer reports include a much wider trade deficit, as imports have gained with domestic demand but exports have weakened more on slumping demand from our trading partners. Industrial activity slowed to a crawl, with industrial production up only 0.5% in Q2 with manufacturing production basically unchanged. Purchasing Manager Indexes stalled with the manufacturing index averaging 50.2 in the quarter, the weakest quarter since the recession ended. Government spending cuts have started as the sequester takes hold. Of course, the flip side here is an improvement in the budget deficit, as outlays fell 2.5% in the quarter and the rolling 12 month deficit fell to the smallest amount since 2009. Additionally, inventory change, one of the largest swing factors for the GDP, looks to be soft this quarter. And the risk is that it may actually shrink as it did in 2012’s fourth quarter when GDP growth came in at a paltry 0.4%.

There are also two factors that may lend some support. First, consumer spending has remained relatively firm so far. Many expected the tax hit would cause consumers to cut back, but they remain resilient. Labor markets are producing steady job growth near 200,000 monthly, consumer confidence is improving, and income gains are slightly better. Of course consumption will be softer than the 2.6% advance in Q1, but lower inflation and a dig into savings appears to have helped consumers maintain their purchases of durable goods (think autos) at only a slightly slower pace. This has proved to be an anchor for growth, in that consumption accounts for 70% of overall GDP.

The second factor has to do with changes in the way GDP will be calculated. It will now include intellectual property as a sub-category of private investment. This will entail counting R&D, entertainment, and artistic and literary contributions as capital investment. Additionally, there will be a switch from cash to accrual accounting for defined benefit pension obligations, which should increase personal income measures and the savings rate. These are comprehensive revisions which will adjust past levels of GDP going back many decades and may increase the overall level of GDP by 2% to 3%, improving debt-to-GDP ratios. However, this will change trend rates of GDP growth only modestly, maybe adding 0.3% at most. Also, the revisions are pro-cyclical and will narrow the gap between tolerable job growth and mediocre economic growth.

The Federal Reserve (the Fed) is still crossing their fingers that overall 2014 growth comes in near 2.5%. While I applaud their eternal optimism, if the weak data reads so far in Q2 are correct, economic growth in the second half would have to come in near 4% for the math to sum to their projection. Not that this matters particularly, for their models and forecasts have overestimated growth by a large margin during the entire recovery. As a result, the Fed will be hard-pressed to reconcile a decision to taper asset purchases near term with news of weaker growth vs. forecasts and the miss on their inflation target.

Growth is poised to improve in the second half. The inventory miss last quarter will likely reverse next quarter, and there are tentative signs manufacturing is stabilizing. The fiscal drag will also unwind as we close into year end. While there is still no sign of a capital spending revival, the consumer remains a rock. Growth does look better in the second half, but only against the woeful first half. For the Fed, will it be enough?

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