- Seven-factor model estimates 0.3% Q1 GDP growth. A decline in real retail sales or further declines in stocks could tip the estimate negative.
- 0.3% is a big gap from other forecasts: Atlanta Fed GDPNow at 3.5%, the Blue Chip Consensus is 2.7% and the Wall Street Journal at 2.9%.
- Even if Q1 comes in negative it will probably not be the start of a recession. With 42% of data available, the model estimates Q2 will bounce back to 2.7%.
- The stock market decline should remain just a correction and not the start of a bear market.
- Trump’s tax cut likely leads to stock market strength, but not economic strength.
The Model attempts to find the combination of seven indicators or influences that work together to best predict GDP. It estimates the relationship of quarterly GDP growth with the quarterly change of the seven factors over rolling 11-year periods. Quarterly changes are plotted as annual growth rates. The lead time of the factor with the highest correlation is used in the model. As time moves on factors may come or go from the model. There were no factor changes or significant weighting changes in the last quarter.
The Seven Factors
The S&P 500 (purple line and dots, lagging 2 weeks) I’m estimating the 13 weeks 1/17/18 through 4/11/18 which associate with Q1 GDP growth will have an average price of 2748. This would be a 17.7% annualized rate of increase from the 2634 average of the previous 13 weeks. The six weeks of data so far available have averaged 2749. For purposes of the model, the baseline is that stock prices from here will rise through the second quarter at an annualized rate of 10%. If the stock market correction continues during the next seven weeks, which I think is quite possible, those declines could pull the model estimate for Q1 to the negative side.
Real retail sales (Orange Line, concurrent) Sales shrunk 0.8% in January. This was the largest decline since January 2014 and second biggest decline since 2009. We could look at this as putting the growth rate of real retail sales back on the trend line of the last 7 years.
The baseline estimate for the monthly data points we don't yet have is that sales will grow at an annualized rate of 2.5% through the second quarter. However, if real sales decline in one of the next two months, it could pull the Q1 GDP estimate to the negative side.
Cass Freight Index TM From Cass Information Systems, Inc. (Black line and dots, Leading 2 months) Shipments corresponding with Q1 GDP were flat compared with the previous quarter when normally there is a substantial drop. The seasonality of this index doesn’t appear to be included in seasonal adjustments to quarterly GDP since this series improves the model of GDP more without adjusting for its seasonality. I expect the next three months of the index will have the strong seasonal boost typical of this index.
Industrial production (green line and dots, leading two months) The months indicating Q1 GDP surged at a 7.1% annual rate despite January having a slight decrease. This was the strongest quarterly advance since 2010. For the purpose of estimating Q2 GDP, I’m guessing industrial production advances at the more normal annual pace of 2.8% for the next three months.
Real 10 Year Treasury Yield (brown line and dots, leading 10 months) The real yield has been trending weaker for a couple of years and its lowest point in five years corresponds with first-quarter GDP. The real yield signals a modest rebound in the second quarter.
Real private inventory (blue line, leading 5 quarters) Inventory joins industrial production as the only data in the model suggesting Q1 will strengthen instead of weakening. It then estimates growth will drop in Q2.
Oil (Gold line and dots, leading 21 months) The 26% price spike (251% annualized rate) back in 2016 suggest Q1 2018 will be very weak. While it has never seemed reasonable to me that the lead time with the best statistical fit to GDP growth should be 21 months, previous oil price spikes have corresponded with weak quarters 21 months later. The first quarters of 2011 and 2017 are examples.
Q4 2017 Recap: GDP grew at 2.5% downwardly revised from 2.6% - well below the model's estimate at the time of 3.2%. Downward revisions of the model’s data also moved the model’s estimate lower to 3.1%.
Q1 Estimate: In January when I last shared growth estimates, Q1 was estimated at 1.1% growth with 58% of the data available. The main factor pulling it down since then was the January 0.8% decline in real retail sales. The stock market correction was also steeper than expected. In the last article I did actually call for a stock market correction in February. The current GDP estimate at 0.3% is the weakest model reading since the -0.2% reading in Q1 2016 when we had the previous stock market correction.
The current expansion is 104 months old, assuming we have not started a recession. In June, it will likely become the 2nd longest expansion in history.
Even if Q1 has negative growth it will probably be a continuation of the declining growth trend since 2015. The two 3% plus quarters of growth in 2017 were not enough to reverse the trend of a declining growth rate.
The committee that dates expansions and recessions looks at four indicators: real retail sales, industrial production, real personal income and nonfarm jobs. Real retail sales and industrial production declined in January. Real personal income grew at a scant 0.02%. Jobs had normal growth.
If all four indicators rolled over into a sustained decline in the next six to nine months it is possible a recession would be declared to have begun in January, particularly if there were downward revisions to January data. If such a downturn occurred, the 58% of the data not yet in for the model’s estimate of Q2 GDP would turn the Q2 estimate negative too. However, it is much more likely a weak first quarter is just a fluctuation and growth continues fluctuating around a growth rate that declines into recession perhaps in 2019.
At least a couple of indicators that normally predict recessions may not give signals this time. The yield curve may fail to signal while the 3-month T-bill yield is below 2%, just as if failed to signal the four recessions between 1936 and 1955. Initial jobless claims may be thrown off by 10,000 baby boomers reaching the age where they retire or want part-time work instead of full time. With current demographics it’s easy for businesses to manage their workforce with attrition rather than layoffs.
Tax Cuts No Guarantee of Growth
President Trump’s tax cut does not assure growth this year any more than Reagan’s big tax cut and George W. Bush’s first tax cut. Both those cuts corresponded with recession. President Reagan’s tax cut became law in August 1981 which is the month the 1981-82 recession began. A year later the stock market was down about 20%; the unemployment rate which had ticked down to 7.2% at the time of the tax cut had risen to 9.8%, on its way to 10.8%. The budget deficit was exploding. Reagan was pushing a tax increase through Congress which would take back a significant portion of his tax-cut, but would also leave the top rate at the reduced 50%.
His tax increase, called the Tax Equity and Fiscal Responsibility Act (TEFRA), cleared the conference committee between the House and Senate working out their differences on Friday, August 13, 1982. This was the first up-day for stocks in the powerful bull market of the 1980s. The low of the bear market had been the day before. The market also soared when the House and Senate passed TEFRA and when Reagan signed it into law on September 3, 1982. The recession ended two months later and a powerful recovery and expansion began in December 1982.
A year after the tax-increase, stocks were up about 62% and the economy was soaring. After the expansion peaked, it was the second-longest in history - or, as Republicans called it at the time, the “longest peace-time expansion ever.” Currently, that expansion is the 4th longest. Despite our fondness for tax cuts, the great bull market and powerful expansion of the 1980s appear to have begun with a tax increase.
President Bush’s first recession started in April 2001. While his first tax cut didn’t become law until two months later in June, the sustained decline, particularly in jobs and industrial production, which established it as a recession, occurred after the tax cut.
The great confidence of Trump’s supporters in the tax cut spurring GDP growth above 3% or 4% may get dented in the first quarter. With the old age of the current expansion, record debt to GDP ratios and the personal savings rate near the lowest levels in history, the GDP growth rate will likely continue fluctuating on a downward path that will not turn upwards in a sustainable way until after a recession.
The Surge in Stocks
While it’s conceivable a recession and bear market started or will start in the first quarter, it appears more probable the expansion and bull market continue, even if the correction takes prices lower in the next month or two.
In the late stages of an economic expansion, the feeling of prosperity often leads business owners to pull a larger share of revenue out of their business as personal income. Some of this money is used to bid asset prices higher. Corporations often use funds for stock buybacks. A smaller share of business revenue is used to actually grow businesses. In this environment, the pace of economic growth slows even as stock prices often have an above-average performance.
I believe we are in the late stages of the expansion which by itself could lead to above average stock market (SPY) performance. The Trump tax cuts on personal income likely will encourage even more business revenue to come out as personal income. So even though I expect the economic growth rate to trend down, 2018 should have good and perhaps banner stock market returns.
A bear market is coming, my best guess now, in 2019. I reserve the right to revise the guess as new data arrives.
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