The Mirror Image of the Weak Q1 GDP Reading

The first quarter economic headline is quite negative, and to be sure, concerning underlying data points are present. But it's not uniformly negative, with other data points suggesting higher growth ahead.

It's the Rorschach economy. After much weaker-than-expected U.S. first-quarter gross domestic product (GDP) data, it seems economists' views range from "the economy is stronger than it appears" to the recent spate of anemic "hard data" have painted the real picture. And it's not just disagreement among professional economists citing the discouraging hard versus buoyant "soft data." It's also rising equity prices versus falling bond yields, and a generally strong earnings season versus a poor GDP print, the weakest, in fact, in three years.

Most agree that the first read on the U.S. economy in 2017 may be following a familiar pattern in recent times of a slow expansion early in the year that not only gets upwardly revised but picks up steam in subsequent quarters. Still, the January-through-March 0.7% annual rate of growth over the preceding three months was well short of the 1.2% expected, and its 1.9% expansion from the first three months of 2016 suggests that the anemic 2% pace of annual growth since the Great Recession officially ended in 2009 will continue.

It's hard to say because there's plenty in the GDP report that's both positive and negative. Despite all the strong consumer and business confidence surveys—the soft data—consumer spending was the lowest in eight years. Inventories, meanwhile, also declined, a bearish signal. Broad personal consumption rose 2.8% in the first quarter from the year before, down from 3.1% in the fourth quarter of 2016. But purchases of durable goods, at 7.4%, was hardly weak, and residential investment picked up to 2.4%, more than double the previous quarter's pace. And if inventories declined, non-residential fixed investment rose strongly, to 3.1%, after four straight quarters of negative reads.

"People say they feel great, but spending just isn't occurring," says Thornburg's Lon Erickson. Retail spending in aggregate declined in February and March, while growth in lending has been ebbing. "It's unclear what the disconnect is between what people are saying and what they're doing," he adds.

The Federal Reserve's favored inflation metric, the personal consumption expenditures index, advanced 2.4% in January through March, the most in six years. But excluding energy and food, it rose 2%, hitting the Fed's target. The employment cost index, a leading inflation indicator, came in at 0.8%, higher than the expected 0.6%. The three-month moving average of medium wage growth was an eyebrow-raising 3.4% in March. "That's the fear," Erickson says. How will wage pressures feed through to the broader inflation dynamic? Fed fund futures suggest there's little doubt the Fed will raise its key rate two more times this year, though the second of those two is only about half priced in, he cautions. The hikes are pushing up the front end of the yield curve. At the same time, the back end of the yield curve has been drifting lower, suggesting market fears that the Fed will tighten policy to head off inflation, potentially stifling economic growth in the process. Its balance sheet "normalization"—slowly letting the assets it has purchased run off—will also introduce some volatility into the already complicated mix.

But small rate increases spread out over a longer timeframe shouldn't hurt the economy and will help hard-pressed savers and income investors, Erickson points out. Treasuries are also still supported by international investors, many of whom can get far better yields in the U.S. in contrast to the rock-bottom sovereign yields abroad.

The wild card in the U.S. is tax reform and what it would do to the U.S. fiscal deficit. While details are lacking in President Donald Trump's proposal, it does appear that the deficit would deepen significantly, and pressure U.S. Treasury yields. Furthermore, if Europe's economy keeps improving and rates there start to rise as European Central Bank asset purchases taper off, that could put additional pressure on U.S. yields, as more European fixed income investors stay home.

For now, the mostly good earnings season, with the S&P 500 Index on track for its best earnings growth rate in six years, and an apparent slowing in deteriorating credit metrics, suggest a decent operating environment in the U.S. Yet on a security-level basis, both U.S. stocks and bonds remain richly priced. Companies will have to keep growing their earnings into those valuations, and a pick-up in consumer spending to match the sentiment surveys would certainly help justify those multiples, not to mention boost the broader economy.

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