Moody's Chief Economist Mark Zandi appeared on CNBC Friday and said second quarter GDP could contract against Q1. Likewise, J.P. Morgan also recently cut its second quarter GDP forecast to 1% growth from 2%. Economists are coming into line with my longstanding view for economic slowing this year, but the Federal Reserve is still not on board. This week's data flow will offer the Leading Economic Indicators Index for the month of June, which may prove shocking to some investors. It would seem Fed representatives have been backing off hawkish arguments of late, which may be due to their special insight into the flow of data. Federal Reserve Chairman Bernanke will have to explain to Congressmen this week why the Fed is cutting back its stimulus as the economy appears to be slowing. So, are you ready for a meaningful change in popular opinion that could make a difference for the prices of investment assets? The economic expectation of investors could switch from one of anticipation of economic recovery to one reflecting real infection from Europe and China. Though, Zandi expects a near immediate bounce back in Q3 GDP and growth through 2013.
Zandi said the second quarter GDP number was tracking slightly positive currently but would likely show contraction in Q2 when all is said and done. He said it was due to the worse than expected damage to the economy from the Sequester spending cuts and the payroll tax break expiration. Sound familiar? It's what I've been pounding the table about against dead ears for most of the year.
We previously showed that the Fed's math did not add up, as it revised its economic forecasts lower, but inadequately so versus the discussion of the Federal Reserve chairman about the impact of sequester spending cuts and the expiration of the payroll tax break at the start of this year. We believe the first quarter did not fully reflect the impact of the spending cuts due to an expectation by some in industry that the legislation would be repealed. At this point it has become clear to all that it will not be so.
Zandi says the impact of the tax hike will fade in Q3, and we agree that it will fade with time. It's really a matter of mathematics that is meaningful for the number comparisons, but not so much so for the lives of real Americans. The aging of the two issues makes for better month-to-month and quarter-to-quarter comparisons as we move forward. Year-on-year, we will face a drag through Q4, but that's not how GDP is reported. In other words, Q3 will be compared against Q2, a relative period with the same tax burden. The first quarter should have shown the hardest impact, but Sequester spending cuts were delayed by many. Also, perhaps people just don't change their spending patterns that quickly. As for the real impact to Americans, by Q2, they have to make ends meet to keep up with bills, and so they spend less. By Q3, they've adapted. What happens is that Americans get used to their lighter paychecks and find ways around it. But there's only so much the majority of Americans living paycheck to paycheck can do to make up for important lost monies. There are only so many garage sales people can throw and odd jobs a person can find; or overtime a person can put in.
The Federal Budget Office forecast a 1.5% impact to GDP this year, and Chairman Bernanke concurred, mentioning it several times publicly himself. However, when the time came for the Fed to publish its economic forecasts, there was relatively no change made to its growth expectations, and so we authored, The Fed's Math Just Doesn't Add Up. This is the reason I believe the market was so shocked by the Fed's tapering plan, given that the real economy would slow. And so, I contemplated that Our Economic Emperor Has No Clothes.
This week is only offering more fodder for pessimists. On Sunday evening, China reported a slower quarterly GDP growth rate of 7.5% for the second quarter, down from 7.7% in Q1. The result was in line with economists' expectations according to television commentary I picked up this morning, but that only makes it even more suspect in my eyes. Furthermore, China's data reporting is highly suspect to begin with, so an in line result that appeases the market and perfectly matches the country's annual forecast is just too perfect a fit to be true; and due to its in line status, it makes me wonder if things are different but worse. No matter though, as hopeful traders will trade the number, true or false.
Later this week, Federal Reserve Chairman Bernanke will appear before Congressmen. He will be tested by testy representatives who will want to appease their constituents back home. He will be asked why the Fed is tapering now, and if it might be too soon, considering what has unfolded in the real estate sector with rising mortgage rates. The reaction of the stock market will likely come up as well. Perhaps he will also be asked, though I think it's a bit early for Congressmen to recognize, whether the Fed's optimistic economic forecast is appropriate given the views of economists like Zandi. Bernanke is excellent at smoothing over questions, because he is mostly competent, but if he and the Fed do not show willingness to backtrack on tapering, stocks will react negatively. I believe he will actually highlight the Fed's data dependency, and so again traders will have what they need to keep bidding.
Since June 18 - Day Before Fed Tapering Announced
SPDR S&P 500 (NYSEARCA:SPY)
SPDR Dow Jones (NYSEARCA:DIA)
PowerShares QQQ (NASDAQ:QQQ)
· Returns adjusted for dividends and splits
Stocks have recovered lost ground since collapsing on interest rate increases post the tapering announcement. That is because of interest rate moderation since the event on Fed speaker appeasement of market concern. This has added a note of hope into valuations that the Fed might not taper. However, I believe they should be taken literally for their public statement and that the contradictory message perhaps crosses a line beyond which the Fed should not tread.
What matters most this week is the economic data flow, as it will do its best to tell the economic truth. The Leading Economic Indicators Index (LEI), which is scheduled for reporting on Thursday, is expected to have increased 0.3% in June. It only increased by 0.1% in May. It will offer Zandi and others some further insight into Q2 GDP. Also, a slew of new housing, manufacturing and other economic data is due, and will show any impact from the factors discussed herein. Already this morning, we have seen a poor Retail Sales data point for the month of June, with sales ex-auto and gasoline falling by 0.1%, versus expectations for an increase of 0.3%.
After my courageously expressed concern ahead of any reported evidence, a couple major economists have now lowered their economic forecasts based on the real data flow. Next could be a market concerning GDP report, especially if the Fed keeps to its formal position about tapering. Such a scenario would be negative for invested capital in equities, and could only be saved by a Fed change. I will continue to closely follow events and data, and welcome investors to follow along with my column here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.