Weekly Economic Commentary • Principal Global Investors
Covering the week ended May 2, 2014 — Published on May 9, 2014
The Bureau of Economic Analysis (BEA) Must Have Left Off a Digit
GDP barely moved in the first quarter, rising only 0.1%, far less than the expected 1.1%. Consumer spending was robust, up 3%. But, utilities and Obamacare-driven health care costs explained most of the gains in consumption. Other sectors were weak: lower inventory growth hit the private investment component; and exports fell surprisingly as did state and local government spending. Weather was likely the culprit, pulling down construction and durable goods purchases as well as hours worked. March and April data already show the U.S. economy regaining strong momentum. We expect robust growth of about 3.25% to 3.5% the rest of the year. Still, this weak initial report of first quarter GDP cratered the full year potential from nearly 3% down to only 2.5%.
Obamacare, weather, inventories, and exports were the main drivers, good and bad, of economic activity in the first quarter. Here is a breakdown of GDP components:
- Consumption increased 3% adding 2 percentage points to GDP. Spending on durable goods rose only 0.4% but services jumped 4.4%.
- Health services costs soared 9.9%, the largest gain since the 1980s, explaining over half the gain in consumption and adding 1.1 percentage points to growth.
- Expenditures on housing and utilities, likely associated with the frigid winter, were the other drivers of consumer spending, adding 0.73 of a point to GDP growth.
- Gross private investment subtracted 1.0 point from growth; inventories alone had a 0.57 point drag. The good news is that reduced inventory accumulation last quarter translates into better expectations for this quarter.
- Residential construction deducted 0.18 of a point from GDP, partially associated with the rotten winter.
- Net exports were another big drag, pulling 0.8 of a point from GDP. However, this first estimate of GDP only included hard trade data for January and February. Exports will likely be revised up and imports down, reducing the drag.
- Government spending surprisingly fell 0.5% from the prior quarter. Spending by state and local governments declined 1.3%. Federal spending rose 0.7% after plummeting 12.8% in the fourth quarter from the government shutdown.
- Real final sales increased 0.7% as consumer spending was robust but investment weak.
BEA assumptions for the Patient Protection and Affordable Care Act likely explained the surge in health services spending. That trend started last fall, picked up in earnest the first quarter and may jump again this quarter. Of the eight million enrolled thus far in health care exchanges, almost half waited until the last minute to sign up for benefits. Once enrollment stabilizes, health care spending growth will likely slow.
We still expect growth to pick up robustly the rest of the year. After all, private GDP growth averaged about 3.5% in 2013, so if the drag from shrinking government spending simply stops, our forecasts should be in the ballpark. Most sectors gained momentum in March and April. The April ISM manufacturing index rose to 54.9 compared to 53.7 last month and four of the six regional indices out so far surged higher. Consumer confidence is almost back to pre-recession levels. Payroll growth is decisively above last year's average; the last three months averaged 238,000 versus 194,000 in 2013. Core-capital goods orders jumped 3.5% in March, the most since January 2013.
What about the Federal Reserve (Fed)?
The anemic growth of the first quarter will not derail the taper train that left the station last December. As Stanley Fisher said, the Fed has begun its exit. We expect the Fed's bond purchases to end in October. If our optimistic base case comes to pass, rates will move higher. A reasonable expectation is a range of 3.25% to 3.5% on ten-year Treasurys by year-end. Short rates are likely to go up as well except at the very short end. In 2015, a range of 3.25% to 3.75% might be realistic as the robust economy persists at least early in the year.
Despite pronouncements to the contrary, the Fed may be forced to raise the Fed Funds rate for the first time this summer, June or July. U.S. inflation has surely bottomed. Services prices have been rising at a 2% to 3% pace; it has been the fall in goods prices that has kept inflation near 1%. With rents rising robustly and commodity prices firming as global growth stabilizes and trends higher, inflation should approach the Fed's 2% target perhaps in the fall. Wages are accelerating modestly and the pace should creep higher as job gains improve. Rates should be in a clear uptrend later this year.
Asset Allocation Corner: Modest April Returns
Buffeted by geopolitical problems in Ukraine, credit and growth worries out of China, no validation of faster U.S. growth, yet supported a bit by a wave of mergers and acquisitions, investor returns in April were generally modest. Unless one owned U.S. or global Real Estate Investment Trusts (REITs), a few select commodities or a rebounding emerging market or three, returns were mostly sub-2% for the month. The outperformance of U.S. value stocks over growth continued as high valuation growth stocks stayed under pressure. Sector performance was mixed with little clear trend. The MSCI emerging market index gained 1%, adding to the nice gains of March. The MSCI all country index moved ahead 1.5%.
Bond investors made gains too with the Barclays U.S. and Global Aggregate indices returning 0.8% and 1.2% respectively for the month. Long-dated U.S. Treasury bonds had a nice return of 1.7%, using the Barclays Long Treasury index, as yields fell a few basis points over the month.
Year-to-date performance was more mixed. Japan, Asia, and emerging markets suffered the most with losses for the four months. REITs soared in that time period as rates fell from cycle peaks at the end of 2013: U.S. and global REITs, using MSCI indices, surged 10% and 12.4% respectively. That drop in interest rates helped bond investors for the year too, with the Barclays U.S. and Global Aggregate Indices up 2.7% and 3.6% respectively.
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