Portfolio Strategy Analyst
Once again, the U.S. economy has gotten off to a disappointing start to the year. In a remarkably consistent pattern, real GDP growth over the past five years has slowed two percentage points on average in the first quarter before reaccelerating two percentage points in the second quarter. With the first quarter of this year now effectively a write-off , the question for investors is whether this is another momentary lull in activity that will soon give way to a reacceleration in growth, or whether this time the slowdown will prove longer lasting.
There is no doubt that the economy is facing some real headwinds. Near-term economic activity will likely continue to be impacted by weak capital spending and net exports. The drop in oil prices has driven back investments related to the mining industry, and the stronger dollar is reducing activity in the manufacturing sector. Nevertheless, we view the recent weakness in overall economic activity as primarily temporary, due to one-off factors that mask the economy’s solid underpinnings.
Indeed, most of the economy’s underlying fundamentals remain supportive of at least modestly above-trend growth. The consumer sector, in particular, appears well-positioned to help push growth higher. Households are enjoying strong gains in real income driven by improving labor markets and lower energy prices, but thus far they have been hesitant to take advantage of their greater purchasing power. Consumer spending grew by just 1.9% in the first quarter, ahead of the consensus forecast for 1.7%, but nonetheless a considerable deceleration from 4.4% growth posted in the fourth quarter of 2014. The slowdown in consumer spending is hard to reconcile with the acceleration in real income growth.
We suspect that the weather explains a good deal of this negativity, and the high level of consumer confidence suggests that households will have no trouble spending the windfall from lower gasoline prices now that temperatures have returned to seasonal norms. This would be similar to the rebound following last year’s unseasonably cold winter — and spending may very well extend to bigger-ticket items such as housing and motor vehicle sales, which are also below trend. In fact, with the rate of household formation appearing to be finally picking up, there remains plenty of scope for pent-up demand to kick in more powerfully as labor markets and income prospects further improve.
Encouragingly, financial conditions also remain favorable. The same global forces (low inflation and easing monetary policy abroad) that have pushed the dollar higher have helped hold down long-term U.S. interest rates. Lower borrowing costs are supportive of domestic growth. In a recent survey of households by the Federal Reserve, the likelihood to apply for a loan ticked up across all credit types, indicating that consumers are becoming more comfortable increasing debt levels to support their discretionary spending.
At the same time, fiscal drag is no longer expected to depress overall economic activity. After increasing sharply during the recession, federal outlays stagnated from 2011 to 2012, then, in an unprecedented fashion, fell sharply in 2013. The improvement in the budget deficit, through restrained outlays, was a significant headwind on growth. However, that restraint has now ended and increased spending by all levels of government should provide an additional boost for overall economic activity.
While we are confident that the U.S. economy will soon move beyond the temporary hurdles that have recently restrained growth, concrete evidence of the rebound and sustainability of economic momentum will likely not appear before the Fed decides if they are going to hike interest rates at their June meeting. The other complication is the unresolved crisis between Greece and its creditors. Already, there are signs that the crisis is starting to impede the broader economic recovery across the Eurozone. We expect the impact on the U.S. economy and markets from these events overseas will be modest, but risks have risen and are yet another reason for the Fed to sit on its hands for a little longer. Indeed, we expect policymakers will move slowly and cautiously, giving every chance for fundamentals to further improve and economic momentum to recover in the months ahead.
There is a great deal of uncertainty around when the Federal Reserve will initiate the "lift-off" of interest rates. At the beginning of the year, the general consensus was that it could occur as early as this June. Economic data at that time showed strength: fourth quarter consumer spending was at a robust 4.4%. With the lowering of oil prices, the expectation was that the consumer would be even stronger. Since consumption makes up about two-thirds of GDP, that continued level of growth could help propel GDP growth from a tepid 2.3% level into the greater than 3.0% level that we have witnessed in previous expansions.
However, in the first quarter of this year, GDP growth stalled to just 0.2%. This is a result of a broad-based slowdown of the economy and was driven primarily by mining (reduced fracking), manufacturing (a strong dollar), and construction (harsh weather). As a result, consumer growth slowed down to a rate of just 1.9%. All of this has pushed back the Fed tightening to September, at the earliest (Figure 2).
Despite the disappointing reports, the Fed’s view of the economy is much rosier. First quarter data tends to be weaker than the other three quarters, and the Fed believes this to be the case again this year. This juxtaposition between the data and the Fed’s outlook is not uncommon. The Fed tends to act on its outlook rather than on the economic data that has already passed.
Following 12 consecutive months of strong gains in payroll employment (monthly gains above 200,000), the March employment report had a disappointing downward surprise, with a gain of just 126,000. The two previous months were also revised down. This data fits with the general theme of the first quarter, which had several weaker-than-expected economic releases brought on by the negative impact of bad weather, the West Coast port slowdown, a stronger dollar, and the lower oil prices.
Although the data was weak, it was not a disaster. Clearly, this is not a game changer for the Fed because it does not base monetary policy on just one report — especially since these reports are notoriously volatile. More importantly, as the common axiom goes, "the trend is your friend" — and the trend in the labor market has been a growth trajectory. In fact, the 12-month rolling average has been on an upward trajectory since 2010 (Figure 3). The unemployment rate remained unchanged at a cycle low of 5.5%, and the average hourly earnings remained at a still-slow level of 2.1%.
Prices have been on a downward, yet erratic, trajectory for about 3.5 years. In the past year alone, prices have fallen from the 2.0% range to the 0.0% range, due to a combination of a significant drop in energy prices, the stronger dollar, and unsteady global economies that are not strong enough to support the higher commodity prices.
These pressures are playing out with the consumer price index (CPI), where there has been a significant divergence between the inflation rate for goods versus the rate for services. The goods component, which is almost 40.0% of the index, has fallen 3.3% in the past year and has been in the negative territory since late 2014. This is an extremely volatile component and is currently reflecting the downward trend in global commodity prices. However, the service component of CPI, comprising the remaining 60.0%, is far more steady and has been around 2.0% since late 2011 (Figure 4).
The deflationary pressures from energy and other commodity prices appear to be subsiding as oil prices have stabilized around $50 per barrel. Additionally, the Commodity Research Bureau’s spot price for all commodities has also stabilized in the past couple of months.
Since the depths of the housing crisis back in 2009, there has been an extraordinary slow and unsteady recovery in housing starts. The auto industry - another interest rate - sensitive sector of the economy - has fully recovered back to the sales level that was seen prior to the recession; meanwhile, housing starts have not yet fully recovered (Figure 5). Despite mortgage rates near record low levels, the collapse in the home ownership rate is keeping downward pressure on demand. It had reached a high of 69.0% during the peak of the absurd subprime mortgage era in 2004, but has now migrated down to 64.0% - the level it was for several years prior to the subprime build-up.
We believe the fundamentals for improvement in housing are good. Mortgages are low, there has been a gradual loosening of credit requirements, employment growth has been on a firm upward trajectory for several years, and demand is beginning to outpace supply.
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