By Joseph G. Carson
This week's U.S. gross domestic product (GDP) data paints a bright picture for the second quarter and a less gloomy first-quarter decline than first published. As impressive as the rebound looks on the surface, we think it's still understated.
Wednesday's initial report on second-quarter real GDP showed 4% annualized growth and an upward revision to the first-quarter's decline, from -2.9% to -2.1%. The report also revised GDP for the past three years, revealing a much stronger underlying growth trend starting in the second half of 2013.
Impressive Growth, but Likely Understated
The report shows U.S. growth being propelled by relatively strong gains in key cyclical private sectors, such as GDP goods (manufacturing) and GDP structures (construction). Gains were especially strong in the second quarter, as GDP goods increased by 10.5% annualized and GDP structures increased by 8%. Those results more than offset the first-quarter weather-related declines of 8.5% and 3.8%, respectively.
As impressive as the second-quarter rebound looks on the surface, we think the data still understates the recovery. There are two fundamental reasons why we think reported growth in the second quarter-and the entire first half of 2014-looks too low: a sharp decline in the unemployment rate and a rebound in second-quarter corporate earnings.
A Major Drop in First-Half Unemployment
History shows that real GDP growth is highly correlated with substantial changes in the civilian unemployment rate. During the first half of 2014, unemployment declined by 0.7 percent-a feat only duplicated 13 times since 1960. It's not surprising that those other major declines happened during the fast-growth phases of prior economic upturns.
The average GDP growth during those 13 periods was 6%-7%, which puts the first half of this year well below the norm-according to the current estimates (Display). Of course, GDP for the second quarter and first half is still preliminary, but the jobless rate is hard data-and never revised. So, the sharp decline in the jobless rate suggests that GDP data will be upwardly revised-maybe substantially.
Strong Earnings Reports
The second reason we suspect upward revisions ahead is corporate earnings. Implied operating profits for the second quarter show a year-over-year decline of 3%. That slump runs counter to incoming earnings reports.
Based on reports from 320 of the 500 companies in the S&P 500 Index, operating earnings are running 6% to 7% higher than a year ago. If this gain holds up once all company reports are in, the growth in nominal gross domestic income (GDI) in Q2 would equal about 9% annualized. That's far above the 6% annualized growth reported for nominal GDP.
It's hard to fathom the possibility of an upward revision to nominal GDP of three full percentage points, but we think GDI has historically been a more accurate predictor of significant shifts in economic growth rates than GDP has. And GDI points to continued strong gains in the second half of 2014-if not beyond.
Diminishing Economic Headwinds
The much-improved economic performance hasn't been overlooked by U.S. Federal Reserve policymakers-the official statement after the July 29-30 Federal Open Market Committee meeting noted the rebound. It also pointed out that economic headwinds from fiscal policy were diminishing and that downside risks to inflation had "diminished somewhat."
In the past, this type of Fed comment has been a telltale sign of an upcoming policy shift: we wouldn't be surprised to hear stronger signals of a possible change in monetary policy in upcoming speeches. This includes the late-August Jackson Hole, Wyoming, symposium hosted by the Federal Reserve Bank of Kansas City, with Fed Chair Janet Yellen a featured speaker. Based on the signals we're seeing, the Fed will have a stronger economic growth trajectory to address.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Joseph G. Carson is Director of Global Economic Research at AllianceBernstein.