WEEKLY ECONOMIC COMMENTARY -- WEEK OF APRIL 28, 2017
The financial markets continue to navigate a litany of contradictions, reflecting mixed readings on the economic, fiscal and geopolitical fronts. With a light calendar of data this week, the economy took a back seat to other developments that stand out for their ambivalent consequences. The French elections, for example, elicited a strong positive response in the markets as the far-right candidate Marine Le Pen came in second to a more centrist candidate, whose likely victory in the May 7 run-off reduces the odds that France would bolt from the EU. But neither Le Pen nor the likely victor, Emmanuel Macron, belongs to mainstream parties, thus keeping alive the anti-establishment sentiment that has roiled investor psychology since the U.S. elections last November. That said, the French election registered on the positive side of the geopolitical ledger, igniting a risk-on trade early in the week that sent stock prices sharply higher.
On the domestic front, the Trump administration unveiled the outlines of an ambitious tax reform proposal that contains few details and leaves many questions about how it will be financed. The centerpiece of the package - reducing the corporate tax rate from 35 percent to 15 percent - is expected to drain between $2 to $7 trillion from Treasury coffers assuming no additional growth in the economy. But the administration disputes this "static" view, claiming that the tax cuts will pay for themselves by jump-starting growth and, hence, a corresponding increase in tax revenues. Most economists are skeptical that even with "dynamic scoring" the economic feedback would be strong enough to render the tax proposal revenue neutral. Many of these skeptics are members of the Republican party's deficit-hawk brigade, so the road to passage will be long and winding with little chance of the proposal seeing the light of day in its present form.
The markets had a mild reaction to the tax proposal, viewing it as the opening gambit to negotiations, which will ultimately yield a package of reforms and cuts that has a much less dramatic impact on the deficit. From our lens, a final bill will not be fully implemented until early 2018 and the eventual cost will come to about $1.2 trillion, including increased infrastructure spending of roundly $200 million. While the main economic impact will not be felt until next year, some anticipatory investment spending could well occur later this year as more details on the likely timing and composition of the tax cuts become available. And while the tax proposal garnered most of the attention this week, the more pressing issue on Capitol Hill was whether Congress would cobble together a stopgap-spending bill to avoid a government shutdown on Saturday. On Friday, a one-week bill was be approved in both the House and Senate, giving lawmakers some breathing room to negotiate a longer-term deal that would fund the government through the end of the fiscal year on September 30.
As noted earlier, the slim batch of economic data this week was overshadowed by the French elections and the administration's tax proposals. That said, the economic reports conveyed just as many contradictory messages as the latter. On one hand, households remain as upbeat as ever, as the two main gauges of consumer confidence compiled by the Conference Board and the University of Michigan remained at lofty levels in April. Both measures were only a tad below their highs for the recovery and compared favorably with the peaks seen in past cyclical upturns. Interestingly, the Michigan pollsters noted that confidence is unequally split between Republican and Democratic households; the former are extremely bullish about economic prospects whereas the latter believe the economy is heading for the proverbial hell in a handbasket. Still, both Democrats and Republicans agreed that the economy is currently in very good shape, an assessment that probably reflects the strong performance of the job market.
But if their perception of the current economy is positive, households are not behaving as they feel. That contradiction was visibly evident in the first quarter, when the discrepancy between the "soft" and "hard" data was particularly compelling. No yardstick better encapsulates that divergence than the Commerce Department's GDP report released on Friday morning. As we repeatedly noted, the monthly data indicated that the economy's growth rate would downshift significantly in the first quarter, repeating a familiar pattern seen over the past several years. And, as the consumer spending figures rolled out, it was also clear that a pullback in personal consumption would be primarily responsible for the growth slowdown. The GDP report confirmed that outcome, as consumer spending in the first quarter increased at the slowest pace since the end of the Great Recession in 2009.
Over all, real GDP increased at a 0.7 percent annual rate in the January-March period, down significantly from the 2.1 percent increase in the fourth quarter of last year. The quarter was the weakest since the first quarter of 2014 when GDP actually contracted by 1.2 percent. But that temporary slump was brought on by a severe inventory correction, which siphoned off 1.9 percentage points from GDP. Consumer spending actually registered a 1.9 percent increase during that period, prompting businesses to quickly restock merchandise that contributed to a 3.1 percent snapback in GDP in the following quarter. This time, consumers were virtually a no-show, increasing spending at a tepid 0.3 percent pace during the first quarter. The last time spending was weaker was in the fourth quarter of 2009, when it registered no change just as the economy was emerging from the Great Recession
To be sure, the setback in consumer spending in the first quarter was partially weather related, as the exceptionally warm winter depressed spending on heating and utility bills. The late distribution of tax refunds may also have caused households to delay some purchases. But consumers sharply curtailed outlays for durable goods, such as autos and big-ticket appliances, discretionary purchases that would seem to benefit from the euphoria expressed in household surveys. Given the positive fundamentals that underpin such purchases - a strong job market and rising incomes - we expect consumer spending to rebound in the second quarter. However, auto sales will probably provide less of a boost than they had in recent years, as most delayed purchases have been satisfied and auto loan financing is tightening up.
Aside from consumers, the economy's performance in the first quarter suffered from a cutback in business inventory and government spending. The drag from weak inventory spending lopped nearly 1 percentage point from the overall growth rate, an outsize impact that is not unusual for any given quarter, as evidenced by the experience in the first quarter of 2014 noted earlier. However, an inventory snapback in the second quarter may not be in the cards this time. One reason: inventories of motor vehicle and parts surged to the highest level in at least 20 years during the first quarter. Unless a swift upsurge in auto sales clears dealer lots of this overhang, it will take a major stock-rebuilding effort in other industries to offset the likely drag from the auto sector. An unfortunate byproduct of this inventory overhang is that auto manufacturers will also curb production until a better supply/demand balance is achieved.
In contrast to the auto sector, the industries related to housing activity - furniture, home furnishings, electronics and appliances - are building up inventories, a trend that should continue and at least partially offset the drag from the auto sector. With strengthening home sales spurring increased homebuilding activity, the housing sector constituted one of the few bright spots in the first quarter. Indeed, residential outlays increased by 13.7 percent during the period, following a sturdy 9.6 percent increase in the previous quarter. The housing sector contributed 0.5 percent to the GDP growth rate in the January-March period, its biggest quarterly thrust in more than four years. By all accounts, it should continue to be a growth driver in coming quarters.
Builder sentiment climbed to the highest level since June 2005 in March, according to the National Association of Homebuilder Housing Index. And for good reason. Last week, we noted that sales of existing homes soared to the highest level in more than ten years during that month and probably would have been stronger if not for the scarcity of homes on the market. Tight inventories are restricting sales - and pushing up prices - of newly built homes as well, but buyers are still flocking to the market. That was clearly evident in this week's report by the Commerce Department revealing that new home sales jumped by 5.8 percent in March to just under the highest level since January 2008. Unlike the existing home market, where inventories have shrunk on a year-over-year basis for 22 consecutive months, new home sales are being supported by a gradual rise in the housing stock, thanks to the ramping up of construction by homebuilders. That said, inventories are still historically low and, with home prices rising, builders have every incentive to maintain a strong pace of construction activity.
Along with firmer residential outlays, business investment spending is picking up the pace. In the first quarter, nonresidential fixed investment increased by a healthy 9.4 percent, the strongest gain since the fourth quarter of 2013. Spending on structures led the way, up a resounding 22 percent, thanks to an astonishing 449 percent increase in outlays on mining exploration, shafts and wells, reflecting the firming of oil and other commodity prices. However, capital spending -the missing link throughout most of the recovery - appears to be turning the corner as well. Spending on equipment rose 9.1 percent following a 1.9 percent gain in the fourth quarter, which was preceded by four consecutive quarterly declines. We expect the recovery in capital spending to gain traction in coming quarters, as the shortage of skilled labor heightens the demand for equipment that boosts productivity.
Simply put, the first-quarter slowdown is in the books; but looking through the windshield shows a better picture than the rear view mirror. We expect a rebound to about a 2.5 percent pace in the second quarter, with consumer spending picking up alongside firmer housing and capital spending. Even with the setback, the 12-month growth rate through the first quarter comes to 1.9 percent, almost spot-on with the average pace since the recession. We expect that the full year will average 2.1 percent growth, better than the 1.6 percent registered in 2016 but consistent with the longer-term trend. The pace should pick up next year if the fiscal stimulus that we expect finally kicks in.