- After a disappointing first quarter, we think that the US economy will bounce back. A solid labour market will in fact support growth in consumption and in residential investment, but it will take a firmer pace of growth to compensate for the drag of oil-related capital spending and exports. Our forecast was adjusted downward to reflect the acuteness of the slowdown in the first quarter. GDP growth is now 2.7%, down from 3.1% in 2015.
- The Fed considers the first-quarter slowdown as transitory and remains positive about the long-term economic outlook. A rate hike in September remains the most likely scenario, but this will obviously depend on whether the economy recovers convincingly after the weak first quarter.
Why has GDP growth stalled in the first quarter?
There are different sources that explain the slowdown in GDP growth. The “known unknowns” are related to developments that were already ongoing in 2014, but whose magnitude was underestimated. This includes weaker investment in oil-related activities as a result of lower oil prices. The strong dollar, which was boosted by a combination of positive sentiment for the US growth outlook and looser monetary policy abroad, was also a factor. In addition, the disruptions in the west coast seaports that had been building up since fall last year escalated in January and February. This finally resulted in the closing of the major ports, with backlogs clearly moving into April. Not surprisingly, export growth faced major headwinds, but the drag was so acute in Q1 that a moderation in Q2 seems very likely. On top of this, extreme weather took again its toll on the economy, pushing down consumption and construction to similar levels as the year before. The advance estimate of Q1 GDP growth was 0.2%, down from 2.2% the previous quarter. This estimate could be revised downwards in the coming time, but we think that negative drivers are transitory and that a rebound is on the cards.
Could uncertain statistics be pulling down GDP growth?
There is a pattern of recurrent weakness in first-quarter GDP growth reported by the Bureau of Economic Analysis (BEA), which appears to be partly attributable to methodological distortions in the seasonal adjustment process. In fact, first-quarter US GDP growth from 2010 to 2014 averaged 0.6% compared to 2.9% in the other three quarters. Details on first-quarter growth suggest that this pattern of weaker growth can be found in the categories construction, federal and local government expenditures, defence spending and exports. If this residual seasonality were absent, GDP growth would be much higher.
The Federal Reserve Bank of San Francisco has looked into the seasonality issue. Its conclusion was that GDP growth appears to be substantially stronger than the BEA initially reported. They suggest that the very sharp drop in the first quarter of 2009 during the Great Recession potentially leads to several years of residual seasonality. This concern was already voiced by former Chair Ben Bernanke in 2010. The data corrected by the FRB of San Francisco show that published first-quarter GDP growth increases by about 1.5 percentage points. The BEA is currently reviewing their methodology. We, for one, think that this statistical distortion helps to explain the discrepancy between the labour market’s positive performance and the weak economic activity.
Is the labour market losing momentum?
Since 2014 the improvement of the labour market has been clear to see. The unemployment rate is falling at a faster pace than the Fed expected. But that is not all: a broader set of labour market indicators applied by Chair Yellen have been improving as well. It is true that the pace of job creation has slowed over the past few months and that March’s labour market report was disappointing This slowdown in momentum is, however, to some extent a reflection of the weak economic activity in the first quarter of 2014, resulting from the harsh winter and other temporary factors. The labour market conditions index, based on Yellen’s dashboard of indicators, showed that the slowdown in momentum already showed signs of reversing in April.
Looking ahead, we think the labour market will remain firm. Manufacturing and services surveys, as well as the small business survey, are now pointing to solid increases in job creation over the coming period. Employment in the Markit PMI has risen at a robust pace for the 22nd consecutive month. The services PMI showed that job creation was robust in April, while the small business survey shows that plans to increase employment are still increasingly positive. On top of this, unemployment benefits are at their lowest level since 2000.
Will consumers make a strong comeback?
Our consensus forecast relies on consumers doing their share over the next few quarters. In the first four months of this year, consumption was a bit disappointing. It is possible that winter took away some of the spending momentum. We expected consumers to reach for their purses as wage growth improved with the labour market tightening, while lower energy prices increased their disposable income. Consumer spending in the first quarter expanded by 1.9% year-on-year, a little below the 2.3% average, which suggests that there is still room for improvement. The economic health of consumers is steadily recovering. The ratio of household liquid assets to liabilities, as well as consumers’ purchasing power and the rate at which they are saving, indicate that consumers are in excellent shape. In addition, the ratio of household debt to disposable income is down roughly 25 percentage points from its peak (98%). We expect consumers to provide a tailwind for underlying economic activity in the upcoming quarters.
Will the long awaited investment growth lift off?
We see this as the weak link in the recovery. Capital expenditures in oil-producing industries are now a drag to total fixed investment, but business spending in equipment and software slowed as well. The strong dollar has hit manufacturing activity and its investment outlook, and this has put some pressure on business spending. We think that there is still more weakness in non-residential investment in the pipeline. Most projects that were delayed in the oil sector and related activities are not expected to resume this year. Meanwhile, we expect residential investment growth to pick up. This is the result of improving financing conditions and increasing housing demand boosted by a strong labour market. April’s positive housing starts and permits data show that the weather effects are now behind us.
How will this influence the Fed rate hike decision?
FOMC members remain cautiously optimistic about the economy. The changes that have been made to the statements over the past months point to a more nuanced tone about the strength of the economy. That said, they maintain their view that the effects of this slowdown are transitory and remain positive about the long-term outlook. By placing emphasis on these transitory factors, the Fed still seems on track to introduce rate hikes in September this year given the underlying strong fundamentals. The fragility of certain sectors, including investments in structures and business investment, as well as low inflation suggest that rate hikes will be introduced at a gradual pace. As Chair Yellen mentioned in her latest intervention, ‘…it will be several years before the federal funds rate would be back to its normal, longer-run level’.