Final Q1 GDP Signals Fed To Stop

J.G. Collins profile picture
J.G. Collins
2.52K Followers

Summary

  • Fed signalling of higher rates is slowing growth.The Fed is moving too hawkishly on rate increases based on nebulous and even misleading data points.
  • The mediocre final 2 percent print of 2018Q1 GDP included 50 bps of Intellectual that affects only a small part of the economy relative to, say, personal consumption expenditures.
  • Investors should beware a sudden stop in developing markets, as well as the broader market.

The release of the third and final assessment of 2018 GDP for the first quarter ("2018Q1") last week should give the Fed pause in pursuing its plan for additional rate increases in 2018.In the final estimate, the Bureau of Economic Analysis (BEA) said that GDP printed at just 2.0% growth in the first quarter. That's down 30 basis points from its original estimate in April. The biggest losers, as you can see from the chart below, was net exports and personal consumption expenditures, which reduced by 24 points and 13 basis points, respectively, from the first estimate of 2018Q1 (2018Q1E1) and the final estimate (2018Q1E3), which printed at the lowest figure in five years.Final 2018 Q1 GDPSource: The Stuyvesant Square Consultancy from BEA data

But another element of GDP rescued what would otherwise be a more dismal print of around 1.5 percent. That number was an increase in investment in intellectual property, at 0.51 percent in the final GDP print. IP is a relative newcomer to the GDP estimate, put in place as a revision during the Obama Administration. In the short term, it tends to affect a much smaller segment of the economy than, say, personal consumption expenditures.

Risking a "Sudden Stop"

But mediocre or even poor GDP growth is not the only problem with the Fed rate tightening. The other fear is that by deleveraging its balance sheet and simultaneously funding the Federal budget deficit from the Trump tax cuts, the Federal Reserve could cause a sudden stop in emerging markets.

A sudden stop occurs when liquidity tightens suddenly because investors can obtain a higher risk-free rate from U.S. Treasuries than by investing in more risky emerging markets. It makes it difficult for emerging market economies to function, to pay for foreign trade, and to finance projects. It also tends to make emerging market central bankers raise their own rates to defend their currency, further exacerbating liquidity.

Regular followers know that we have been very supportive of Prime Minister Modi's economic policies in India, and particularly his efforts last year to unwind India's byzantine interstate tax system for a VAT-style nationally imposed Goods and Service Tax (GST). We have also applauded his social reforms, infrastructure plans, and other policies generally.

But we now see higher risk to India because the Fed policy to tighten rates risks a sudden stop spillover effect in India and other emerging markets. For India, it means cheap, abundant, capital could possibly dry up as it seeks a higher return on risk-free US Treasury bonds. That could have calamitous effects on not only India, but other emerging markets in Asia, Eastern Europe, and Latin America.

Narrowing Spreads

We're also concerned about the volatility in the Libor/OIS spread. While it has narrowed from the early part of the year, we're concerned that banks like Deutsche Bank (DB) and others have expressed a willingness to engage in veritable speculation with Indian creditors, even as Deutsche Bank's U.S. subsidiary failed its recent stress test and others, including Goldman and Morgan, were found to be unable to distribute capital and State Street had shortcomings in its risk management and analysis. Similarly, we are concerned about our measure of the yield curve narrowing to just 85 bps. (We use the 3 month vs. the 10 year as the "canary for the coal mine", because Fed policy mechanism affects the 3 month more decidedly and quickly than the 2 year), During the holiday season last year, we warned about the precipitous decline in the yield curve to below 100 bps as well as its volatility. The decline to 85 bps should be read by the Fed as a "caution ahead" sign for the Fed and for investors.

Low Unemployment? Really?

Finally, the Fed should take a more nuanced view of the near record-low U.S. unemployment rate. While low, the US Labor participation rate is also at a near-record low, and more than 300 basis points below what it was prior to the Great Recession. It is at its lowest point since January, 1978, when women were still relative newcomers to the workforce and "working woman" was still a common phrase. For all of these reasons, the Fed should slow its upward march of rate increases for 2018 until such time as U.S. GDP can be reasonably assured to continue in the range of 2.5 percent to 3.5 percent, consistently, over at least four consecutive quarters. The Fed uses Real PCE, or Personal Consumption Expenditures, less food and energy, inflation to judge whether the economy is at risk of inflation, and sets its inflation target at 2 percent. But Real PCE was only 1.2 percent in 2018Q1. It hit 2.0 percent in May, and had run above 1.80 percent in the two prior months, but it is a volatile index, so raising rates based on even less than a full quarter's data seems to us premature.

Summary

We see nearly all of the aforementioned risks from what we view as a radical interpretation of data by the Fed; we believe it slowed the economy by at least 40 basis points in 2018Q1's final measure. Were the Fed to back away from their hawkish sentiment, and simply maintain rates at their status quo, and signal that they will require at least a full quarter of 2 percent inflation before another rate increase, the aforementioned risks would dissipate.

Despite relatively good data of late, we see risk to the broader market, the economy, and especially to emerging markets. We suggest either taking profits on emerging markets or a hedge, as well as a hedge against a broader market downturn.

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Author's note: Our commentaries most often tend to be event-driven. They are mostly written from a public policy, economic, or political/geopolitical perspective. Some are written from a management consulting perspective for companies that we believe to be under-performing and include strategies that we would recommend were the companies our clients. Others discuss new management strategies we believe will fail. This approach lends special value to contrarian investors to uncover potential opportunities in companies that are otherwise in downturn. (Opinions with respect to such companies here, however, assume the company will not change).

This article was written by

J.G. Collins profile picture
2.52K Followers
Before establishing The Stuyvesant Square Consultancy, J.G. Collins spent some 30 years building a career in executive and consulting financial roles, with a particular emphasis in business taxation. His experience spans work for Fortune 100 companies, one of the former “Big Eight” international accounting firms, and client service for large middle-market public accounting firms. He has advised domestic and foreign clients in the tax-efficient structuring of legal entities, effective tax rate planning, mergers and acquisitions, corporate reorganizations, treasury operations, financial instruments, international taxation, tax accounting under GAAP, state and local taxation, and sales and miscellaneous taxes. He has managed countless federal and state tax audits to successful resolutions for clients. His experience spans a diverse array of industries, including private equity, motion pictures and music entertainment, fashion, real estate, publishing, technology development, retail, and oil and gas. Mr. Collins conceived and branded the specialty industry entertainment practice of one of the nation’s leading accounting firms and oversaw the business tax marketing program for business enterprises of another large regional firm. Mr. Collins’ marketing collateral and published articles have been extraordinarily well received because of his ability to present intricate and complex aspects of tax, business, policy, and politics in clear, concise, easily understandable prose devoid of jargon and irrelevant detail. An astute, data-driven observer of business, politics and economics, Mr. Collins has advised political candidates and public officials on campaign, political and policy matters for more than two decades, and has twice been a delegate to his political party’s national quadrennial convention to nominate the American president. His expertise as a champion debater and orator in his student days, along with his savvy marketing expertise, has allowed Mr. Collins to coach private and public sector executives and candidates on public speaking, speech writing, message development and successful business presentations. Campaign collateral he developed for political campaigns has been used in university courses as an “excellent example of persuasive campaign advertising”. Mr. Collins holds degrees in Economics and Accounting from the Stern School of Business, New York University. His elective coursework included a number of political science courses, including International Politics, International Organizations, European Politics and other more basic political science courses.
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