The preliminary GDP report for the second quarter of 2016 was released this morning, and the overall reported growth of 1.2 percent was significantly below previous expectations of between 2.5 and 2.8 percent. After reviewing the individual component within the report, however, I have a more positive view of actual economic activity during the quarter.
What makes me discount the report to a large extent is that gross changes in various categories displayed a lot of volatility which would have affected the aggregate number reported in the initial report. Notable highlights were that Personal Consumption Expenditures (PCEs) grew 4.2 percent boosted by Durable Goods (a somewhat volatile category) growing 8.4 percent and Non-Durable Goods growing 6.0 percent. Services grew somewhat below the PCE average with a 3.0 percent increase.
A very large offset to the PCE growth was an aggregate decline of 9.7 percent in Gross Private Domestic Investment. The most significant declines in that category were in Non-Residential Structures (Office Buildings, Warehouses, etc.) down 7.9 percent and Residential Structures down 6.1 percent.
A very surprising component in the GDP report was a sharp jump in the price change index of 2.2 percent versus the price change index in Q1 only increasing 0.5 percent. The reason that such a change is significant is that the overall GDP change is in "real dollars" which are adjusted for estimated price changes. As such, an overall point of view could be that the 2.2 percent increase reported for Q2 versus a 0.5 percent increase reported for Q1 would have subtracted 1.7 percent from the Q2 GDP number.
Principal components of the Q2 price change index increase which are interesting were in PCE which increased 1.9 percent (versus 0.3 percent in Q1), Gross Private Domestic Investment which increased 1.8 percent (versus 0.6 percent in Q1), and the price change for Exports which increased 3.9 percent (versus a 5.1 percent decrease in Q1). The reported price changes in Q2 are very surprising to me both in their absolute change and in their volatility, and so I really don't have a lot of confidence that the numbers are actually correct. If the price change numbers are revised down in subsequent Q2 GDP updates (there will be two revisions), the overall GDP number will increase.
As for other possible revisions in future updates, you can see from the volatility both up and down in the PCE and Gross Domestic Private Investment numbers, I would expect both of those categories to moderate to some extent when revisions are released.
Weighted Changes in Individual Components
The numbers described above are absolute changes in individual categories, but I also find it interesting to review how the weighted components contribute to changes in the overall GDP number reported.
For general categories within the 1.2 percent aggregate change, PCE had an increase of 2.8 percent, which was almost equally split between Goods at 1.45 percent and Services at 1.38 percent. Gross Domestic Private Investment then subtracted 1.7 percent, which was split between Fixed Investment declining 0.5 percent and Inventories declining 1.2 percent.
I've always found the Inventory change component GDP to be very interesting as while a decline in one period is subtracted from growth, it can often actually be a healthy indicator for future periods. Such a decline then suggests that there are now lower levels of overall inventories which will set the stage for inventory increases - which will then add to GDP growth in the future.
Other often volatile categories are Exports and Imports, but both of those categories were relatively muted in their contributions in the Q2 report. Exports added 0.16 percent to the overall growth, and imports added 0.06 percent. The import number change, although very small, is a somewhat interesting data point as a positive change in that means that imports are decreasing period to period. That is somewhat counterintuitive in the current period given the strength of the dollar making imports less expensive and so the import decrease is an interesting data point to watch in case it is an early indicator of slowing growth in the U.S.
A final category in the weighted contribution numbers was that Government Expenditures and Investments subtracted 0.16 percent. The main contributor for that category was in State & Local spending, which accounted for almost all of the decrease with a 0.14 percent decline. The government spending numbers can be volatile, however, and so I don't regard them as a significant indicator for or contributor to overall GDP trends.
Conclusions and Investment Implications
In general, the volatility of the initial Q2 GDP report makes it less reliable as a meaningful indicator of current economic activity. The sharp increase of the price index component from Q1 when it was 0.5 percent to Q2 when it was reported at 2.2 percent makes the overall report somewhat dubious in my opinion.
A notable positive aspect of the report was the contribution of Personal Consumption Expenditures at 2.8 percent, which was well above the aggregate number of 1.2 percent. The savings rate also usually decreases when there is an increase in PCE which it did, with being 5.5 percent in Q2 versus 6.2 percent in Q1, but that is still a reasonable savings rate within the U.S. economy. The increase in PCE is probably the most significant and meaningful indicator in the latest report (which had a lot of moving parts) as it does indicate that consumers are comfortable spending in the current economic environment.
The decline in the Private Investment numbers are of less concern to me as that can be a volatile category. Trends in that category will be very important to watch, however, as a decline in one period can be an early indicator in businesses having decreased confidence.
As I've also already described concerning the reported Inventory change number, I don't see that as a current sign of slowing economic activity as inventories were already a bit high in my opinion and a decline in inventories is actually a healthy sign for a more stable environment going forward.
The investment implications of the latest report are probably not all that meaningful relative to current trends in both equities and fixed income. The Federal Reserve would have already had the GDP numbers for its meeting this week and it wasn't expected to raise rates anyway and so the "below expectations" numbers wouldn't have changed the outcome of the Fed meeting. I also don't think that there was anything in the latest report that would have caused the Fed any concerns other than some of the items that I've already mentioned that are worth watching (ongoing trends in Personal Spending and a possible continuing decline in business investing).
For stocks, the GDP report probably doesn't change the environment at all. The Fed's accommodative monetary policy is still providing lots of liquidity and investors have shown that they are happy using such liquidity to buy stocks, even at valuations above historical averages. The growth in PCE indicates that consumers are still spending, but visibility into where (for a possible sector focus) is somewhat limited as the largest increases were in Groceries (up 0.41 percent), "Other Non-Durable Goods" (up 0.37 percent), Housing and Utilities (up 0.52 percent), and Healthcare (up 0.44 percent). There were also no notable declines in any of the PCE categories possibly indicating sectors to avoid.
For bonds, I think the report pretty much signals a stable environment but with a watch for price changes accelerating given the price change increase in the latest report. If the PCE increases continue, that will also tend to support the surprising price change increase reported in the latest report and that is also another possible negative indicator for fixed-income investors.
I don't think the latest GDP report changes the possible Fed schedule for the next interest rate increase which would be very unlikely to be prior to the December meeting if it even happens at all. Revisions to this GDP report will be prior to the September meeting, however, and so depending on any changes in the PCE numbers and price index numbers, it could be an interesting Fed meeting in September.
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