Second Quarter 2016 GDP Growth Disappoints

by: Douglas Adams

Summary

Second quarter GDP growth surprised to the downside, returning 1.2% growth annualized for the period, well below the 2.5% consensus projections.

Consumer spending turned in a robust 4.5% growth spurt for the quarter, driven by automobile purchases and household services. Residential spending took a surprising 6.1% hit during the quarter.

Corporate fixed investment spending has declined for three consecutive quarters, the worst showing since the 1st quarter of 2010. The decline in inventory spending subtracted 1.16 points from GDP growth.

GDP growth in the 2nd quarter surprised to the downside from consensus estimates that projected annualized growth levels as high as 2.5%, as weak and uneven global growth and oil prices falling into bear territory combined to fall short of market expectations. While the quarter's 1.2% was indeed an improvement on the disappointing final posts in both 1st and 4th quarter of 0.8% and 0.9% respectively, achieving above-trend economic growth - above the average 3.1% annualized growth levels on data from 1960 through the end of 2015 - remains stubbornly elusive. Average annualized GDP growth for the duration of the recovery period that officially started in June of 2009 has been well below trend at 2.15%, while the average GDP growth since December of 2007, the official beginning of the Great Recession of 2007, has been even weaker at 1.2%. Current economic growth is now weaker than in any post-WWII expansion.

By far and away, consumer spending was the brightest star in the otherwise gloomy report. Spending rose sharply during the quarter with a 4.2% gain over the 1st quarter, contributing the largest percentage to GDP growth since the 4th quarter of 2014. Final sales to domestic purchasers, which isolates the domestic equation of consumer spending by eliminating corporate inventory stock spending and the influences of a strong dollar from export sales, jumped 2.1% on the 1st quarter, placing domestic spending at the fore of the quarter's posted growth increase to date. The purchase of durable goods jumped 8.4% for the quarter as auto sales topped 16.66 million units through the month of June. While down from the record setting pact of 18.24 million units set in October 2015, demand remains strong. Credit remains both available and cheap, while a 241 million barrel surplus inventory of gasoline in the US continues to exert downward pressure on pump prices. Household contractor improvement services, summer air conditioning, and meeting rising healthcare costs all kept consumer spending levels elevated.

Consumer spending continues to be bolstered by average real earnings growth that hit 2.50% year over year in both April and May only to slip in June to 1.50%. Yet with the slide of West Texas Intermediated (WTI) crude from a peak of $52.31/barrel on the 8th of June to $41.38 market close on Friday (29 July), US oil prices crossed into bear territory, down 20.89%. Gasoline prices, slower on the down-take, have fallen just over 9% since the week ending the 13th of June to $2.182/gallon through the end of the 25th of July. Gasoline prices have fallen over 20% since the end of July 2015. Falling energy prices directly increase discretionary spending in the greater economy, which rose to $13.916 trillion during the quarter, up 0.77% on the quarter. Consumer credit activity through May was up 6.2% to $3.624 trillion, a new record. Credit card debt increased 3% during the month to $953.3 billion while non-revolving debt jumped 7.3% to $2.670 trillion, also a new record.

Housing spending, however, took an unusual hit in this first go-through of the data. Spending on residential housing dropped 6.1% for the quarter - the first decline since the 1st quarter of 2014. Existing home prices peaked only in January at 5.66% year over year in the 20-metropolitan areas covered by the S&P Case Shiller Home Price Index, falling slightly to a 5.23% increase in the three-month running average through May. The national average is twice the average real earnings growth of 2.5% through May and three-and-a-half times June's average real earnings growth. A full 13 of the 20 metropolitan areas exceeded the national average with Portland leading the nation with a whopping 12.54% year-over-year increase, followed closely by Seattle's 10.69% increase. Still, existing home sales in June managed to hit an annualized 5.57 million units during the month, the highest post since February 2007, while new home starts produced at a 1.189 million unit annualized pace during the month, the best post since February.

Figure 1: Median Headline PCE Inflation, Summary Economic Projections (SEP)

2016

2017

2018

Longer

June 16

1.4

1.9

2.0

2.0

Mar. 16

1.2

1.9

2.0

2.0

Dec. 15

1.6

1.9

2.0

2.0

Sep. 15

1.7

1.9

2.0

2.0

Click to enlarge

Figure 2: Median Core PCE Inflation, Summary Economic Projections

2016

2017

2018

Longer

June 16

1.7

1.9

2.0

Mar. 16

1.6

1.8

2.0

Dec. 15

1.6

1.9

2.0

Sep. 15

1.7

1.9

2.0

Click to enlarge

The inflation conundrum remains perhaps the key stumbling block for Fed monetary policy. A new estimate of the natural rate of inflation by the Federal Reserve Bank of San Francisco places the measure at 0.4%. Using the Federal Reserve's PCE deflator, headline inflation clocked in at 0.9% through the end of the 2nd quarter - unchanged from the first three months of the year, but sharply up from the average medium post of 0.33% through the four quarters of 2015. Adding the two measures together, headline inflation through the end of the 2nd quarter stood at 1.13% - well short of the Fed's 2% target. Core PCE inflation, which excludes both food and energy and is a better gauge of prices in the general economy, places inflation at 1.6% for the same period. The average medium core PCE inflation reading across the four quarters of 2015 came to 1.38%. Both measures are on the rise signaling a snail-like reprise from the debilitating and downward pressure across the economy by decline of energy prices. Adding in the natural rate of inflation brings the core rate to 2%, which means today's rates are at best mildly stimulative. The Fed's own projections of headline PCE inflation have been slowly falling over the past four SEP surveys to a median reading of 1.4% as of June (see figure 1, above). Likewise, the Fed's core inflation projections have been rising, settling at 1.7% in June's SEP survey (see Figure 2, above). With the current slide in energy prices from the 8 June peak could very well reverse both headline and core inflation measures in subsequent reports as energy prices worldwide continue to tumble. At Friday's market close (29 July), the yield on the 10-year Treasury note fell to its second lowest post of the year at 1.452%, while the yield on the 2-year note fell to 0.659% for a resulting spread of 0.79 percentage points - the second lowest spread of the year which further impedes a Fed move on interest rates. The 10-year Bund slipped to negative at -0.118%. Meanwhile, the probability of a federal funds rate increase by December fell to 20% in the aftermath of July's GDP report release. Interestingly, there is stone silence on the CBOE VIX front, which scratched out a new low reading of 11.87 for the year to date.

While the hollowing out of energy prices have contributed to falling rates of inflation in the greater economy, falling labor productivity levels, an aging workforce, not to mention a continuing stream of geopolitical events worldwide, all undermine the decision-making process around the investment of today's dollars for tomorrow's future income streams. Corporate fixed investment has now declined for three consecutive quarters. The last such string of falling investment started in the 3rd quarter of 2007 for ten consecutive quarters before bringing the blood-letting to a close in the 1st quarter of 2010. Investment in plant, equipment, labor saving devices and capital goods are all making downside history in the current recovery period as the spinoff from mothballed exploration and drilling activity since June of 2014 has cut far deeper into the order books of manufacturers and energy support companies than otherwise expected; companies already reeling from the impact of a strong dollar in world markets. Inventory spending subtracted 1.16% from GDP growth for the quarter, the worst showing since the 1st quarter of 2014. Inventory spending has declined in each of the five past quarters. And to add insult to injury, corporate earnings are facing down their fifth consecutive year-over-year decline at the half-way point of the 3rd quarter earnings season according to data from FactSet. Through the end of the 1st quarter, corporate profits with inventory valuation and capital consumption adjustments came to $2.034 trillion, down from $2.177 trillion logged through the end of the 1st quarter 2015. Share buy-back programs and enhanced dividend payouts continue to be the primary dynamic behind stock appreciation, fueled by an almost unlimited amount of historically cheap financing throughout the developed world, courtesy of central bank monetary policy initiatives. The debt level of some S&P companies continues to soar, which could create unintended problems when interest rates do start adjusting upward. Meanwhile, the S&P Buyback Index is up 5.96% year to date through Friday's market close (19 July).

Despite the global attraction of dollar-based assets, net exports of goods and services actually contributed 0.23 percentage points to overall GDP growth for the 2nd quarter - the second quarter running. Import prices were up 0.2% in June for the fourth consecutive monthly increase, driven exclusively by a 6.2% increase in fuel prices for the month - on top of a revised 14.9% increase in May. Import prices are now down 4.8% on the year. Non-fuel import prices were more reflective of a strong dollar in world currency markets as import prices fell 0.3% on the month and fell 1.8% on the year. Export prices rose 0.8%, driven mainly by rising dollar-denominated agricultural prices in world markets which rose 2.4% for the month on top of a 2.9% increase in May. Year over year, export prices remain in negative territory down 3.5%. Non-agricultural prices rose more modestly at 0.5% for the month, but are still down 3.8% on June 2015.

Government spending was also a disappointment for the first estimate of GDP growth in the 2nd quarter, subtracting 0.16 percentage points from overall growth. On the federal side, defense spending drove overall spending down alone subtracting 0.12 percentage points from GDP growth for the quarter. Capital goods new orders contracted for the second consecutive quarter and have come up on the negative side of the ledger in eleven of the past fourteen quarters. Non-defense capital goods new orders fell flat for the quarter. State and local government spending also fell negative for the quarter, subtracting 0.14 percentage points from overall GDP growth. Gross investment also fell negative for the quarter.

The overriding message from the first glance of GDP growth in the 2nd quarter is one of jilted expectations: That somehow US economic growth could stand apart from the continuing downward spiral of Japanese growth, could throw off the stunning populist rejection by Britain of a 40-year relationship with the EU, or even ignore anemic economic growth in the eurozone. Sustainable economic growth in the US remains stifled by the glaringly conscious investment decisions of both the public and private sectors not to commit current dollars to future income streams. US economic growth will continue to suffer until the mindset reverses.

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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.