The U.S. Economy In Q1: Slow, Steady And Vulnerable

by: James A. Kostohryz

The preliminary estimate of first quarter (1Q) was GDP 2.2% compared to consensus estimates of 2.6% consensus, and "whisper numbers" of 3.0%. This represents a deceleration of economic activity compared to year-over-year (YoY) growth of 3.0% in 4Q 2011.

Although the numbers were disappointing for the most part, the report confirms that the U.S. economic expansion has been consolidating - albeit at the slowest rate of any cycle since World War II.

The report also highlights the fact that the U.S. economy remains vulnerable to external shocks that could very easily tip the economy into recession.

The Good

Let's get one thing clear from the outset: The single most important item in any U.S. GDP report is personal consumption expenditure (PCE) because it accounts for almost 70% of GDP. In this critical regard, the GDP report was encouraging since PCE accelerated from 2.1% growth in 4Q 2011 to 2.9% growth in 1Q 2012.

Given the weight of PCE in total GDP, as long as the American consumer continues to have the will and the means to increase expenditures, the U.S. economy will tend to continue along a growth path, albeit modestly.

Not So Good

1. Real final sales weak. Real final sales of domestic product, which excludes inventory expansion, only grew 1.6%. This was an improvement over 2011 Q4′s 1.1%, but represents a very weak performance and highlights the vulnerability of the economy to a slowdown in any of the key variables.

2. Investment slowed. The pace of investment contracted for the first time since 4Q 2011. Investment slowed in virtually every category including non-residential structures, equipment and software. Indeed, non-residential fixed investment fell by 2.1% during the first quarter, compared to a 5.2% gain in the prior period. Total investment would have fallen by much more than it did if it had not been for the exceptionally good weather that boosted residential investment by 19.1%.

The weak investment numbers tend to confirm fears that the expiration of the investment tax credit may negatively impact investment in 2012 as many businesses pushed forward to 2011 many investments that would otherwise have been made in 2012. Other factors do not augur well for investment going forward in 2012: Recent weakness in durable goods orders and a normalization of weather patterns (that temporarily boosted residential investment), for example. For these and other reasons, I would expect continued weakness in investment going forward in 2012.

3. Inventory build slowed. Inventories continued to grow and this contributed 0.6% to GDP. However, the pace of inventory accumulation slowed markedly from the pace in 4Q. This suggests that firms may be getting close to being fully stocked. It is important to keep in mind that inventory accumulation is highly cyclical and susceptible to shifts in sentiment. Businesses do not accumulate inventory unless they are feeling optimistic about future sales. The upshot of this is that a sentiment shock supplied by events in Europe, MENA, Asia or the U.S. could easily cause the inventory building trend to reverse. Inventories could easily go to a -0.5%-1.5% negative contribution, which would put the U.S. at the threshold of recession. This is the biggest risk to the U.S. economy.

4. Government spending down. Federal government spending fell by 5.6% and state and local government spending dropped by 1.2% in 1Q 2012. As stimulus plans wind down and state and local governments continue to tighten their belts government spending should continue to be a drag on growth throughout 2012.

5. Exports vulnerable. Exports grew by 5.4% in 1Q up from 2.7% in 4Q 2011, led by manufacturing. Going forward, there is reason to believe that the contribution from exports could be negative. First, the recession in Europe is accelerating and this will undoubtedly reduce exports. Second, about one quarter of the growth in exports was due to a one-off surge in the auto sector that has been recovering from the supply line disruptions caused by last year's disasters in Japan.

6. Growth in personal consumption sustainable? Much of the growth in PCE did not come from rising incomes but from a reduction of the savings rate from 4.5% to 3.9%. Furthermore, a disproportionate amount of the PCE growth came from a massive and unsustainable surge in auto purchases related to the Japanese supply line disruptions. Finally, unusually good weather played a major role in increasing sales across the economy and this factor will not be repeated.


I believe that most investors are not aware of how easily, given the current slow rate of economic expansion, the U.S. could slip into a technical recession.

As long as personal consumption remains relatively robust, there is unlikely to be a recession in the U.S.

However, it needs to be kept in mind that this GDP report was helped by an unusually high number of one-off factors such as weather and Japan supply line normalization. Perhaps most importantly, both inventories and personal consumption are highly vulnerable to shifts in sentiment. Any shocks from foreign or domestic sources could very quickly cause U.S. GDP go from modest growth to contraction. All it would take, for example, would be a 0.5% hit from inventories and a slowdown of PCE growth from 2.9% to 1.5%. Such a scenario for PCE and inventories would be consistent with the sentiment shock experiences of 2010 and 2011.


Unlike other bearish forecasters such as ECRI, it has been my consistent position that the U.S. would not experience a recession in 2012 unless there were a severe exogenous shock to the economy. The latest GDP report that exhibited relatively robust consumer spending reinforces my view.

At the same time, the current GDP report highlights major vulnerabilities in the U.S. economy. First of all, the economy was helped by various temporary factors. Second, the entirety of U.S. GDP growth in 1Q was premised on inventory building and personal consumption. The former is highly fickle. The later was largely driven by a decline in the already-low savings rate and good weather. Most importantly, both of these factors are highly vulnerable to shifts in consumer and business sentiment.

In 2010 and 2011 major sentiment shocks produced major slowdowns in inventory building and personal consumption. However, the economy was bailed out by a combination of government spending, strong private investment and surging exports. In 2012, the U.S. will not be able to count on any of these mitigating factors. To the contrary, I expect government spending, private investment and exports to represent significant drags on GDP in 2012. Therefore a turnaround in inventories and consumption could very quickly throw the U.S. into a technical recession.

If you believe that the coast is clear in Europe and the rest of the world, the U.S. economy will do fine. Under such a scenario, stocks such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Exxon (NYSE:XOM) will continue to perform well. However, if you believe that the probabilities of global disturbances are high, then be warned that the U.S. economy is vulnerable. Under this scenario, indexes and index ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA) and (NASDAQ:QQQ) will be in for a rough ride.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.