The winter GDP blues
admin | April 5, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
For the fifth time in the last six years, Q1 real GDP growth is running well below trend. In each of the prior five instances, activity bounced back nicely in the spring, usually fully making up for the shortfall. Persistent Q1 underperformance reflects some combination of improper seasonal adjustment, a string of difficult winters, and a series of one-off negative events that just happen to occur in the first three months of the year. A sharp improvement in economic data in the spring should gradually lift the FOMC and financial market players out of their gloom. As wild as it may seem to some at this point, the Fed will likely hike rates again before the end of 2019.
Recent history for GDP
A weak Q1 in 2019 would hardly be a novel way to start the year. From 2014 through 2018, the first quarter recorded the weakest growth of the year four out of the five years, in some instances by a long shot. In each of those four instances, second quarter real GDP growth accelerated noticeably. In fact, in three of the four years, the Q1 shortfall was entirely recovered in Q2, as the first half average was within a tenth of the average advance for the entire year (see Exhibit 1).
Exhibit 1: Q1 and Q2 real GDP growth (Q4/Q4)
In most years, the driving force behind the weak Q1 GDP result was consumer spending. Exhibit 2 shows the Q1 and Q2 figures for real consumer spending.
Exhibit 2: Q1 and Q2 real consumer spending growth (Q4/Q4)
The narratives were somewhat different in each year. In 2014, there was a sharp deceleration in inventory accumulation at the same time that a dip in exports led to a widening in the trade gap. Thus, while overall real GDP fell by an annualized 1.0%, domestic demand advanced at only a slightly sub-par 1.4% pace, mainly due to a soft consumer spending gain. The first quarter of 2014 was a relatively rough winter, depressing consumer spending. Once the winter ended, consumer spending rebounded vigorously in Q2, driving a 5.1% spike in real GDP (also helped along by a run-up in inventories).
2015 is the exception to the rule. Both real consumer spending growth and real GDP growth exceeded 3% in Q1. Interestingly enough, however, the preliminary estimate that came out in April 2016 looked an awful lot like Q1 2014. The first print of real GDP for Q1 2015 was +0.2%, while real consumer spending, held back by somewhat difficult weather, posted a mediocre 1.9% rise. Subsequent revisions over the years have drastically altered the 2015 data.
The beginning of 2016 was especially troubling. In past years when Q1 had been weak, there was almost always a ready excuse of difficult weather. In 2016, the winter was unusually mild, as evidenced by a double-digit jump in housing activity. However, real GDP still only managed a 1.5% annualized rise. Consumer spending was slightly sub-par (2.4%), but the main culprits were, like 2014, a sharp slowdown in inventory accumulation and a dip in exports. Business investment fell as well, due to a large degree to a falloff in oil and gas drilling activity in response to the drop in oil prices. You may also recall that the global financial markets went through a difficult period in early 2016, not unlike what we saw in November and December of 2018. The catalyst was troubles in China, as Chinese authorities were allowing their currency to slide rapidly, triggering steep declines in Chinese stock prices that reverberated globally. The Fed was spooked by these developments (weakness in both markets and GDP early in the year) and ended up holding off on any rate moves for the entire year until December after having finally lifted off of the zero bound in December 2015.
In 2017, for a second straight year, real GDP growth was weak in Q1 despite the absence of weather problems (once again, housing posted a double-digit rise). Once again, the consumer was the primary culprit, as spending increased at less than a 2% pace. At the time, analysts struggled for a good story to explain the softness, with some suggesting disappointment at delays in the progress of tax reform. Clearly, this was not the issue, as consumer spending and real GDP both bounced back in the spring despite continued difficulty pushing a tax package through Congress.
Last year conformed to the classic pattern. The winter was rough (the original Polar Vortex), and consumer spending barely increased in the period (a meager 0.5% annualized rise). Even so, real GDP managed a 2.2% annualized gain in Q1, as business investment exploded on the back of the passage of tax reform in late 2017. The economy accelerated sharply in the spring, as the consumer recovered nicely. Consumer spending jumped at a 3.8% annualized pace, while real GDP registered a 4.2% advance.
Fool me once…
As noted above, the Fed and market participants were largely fooled by the Q1 softness into worrying about a persistent downturn in growth virtually every year through 2016. Finally, in 2017, people seemed to catch on, as economists begin to talk about “residual seasonality” in the data and the BEA even scrubbed the GDP series in search of places where the seasonal adjustment might need to be tweaked. In contrast to the prior several years, the soft start to the year was largely taken in stride in 2017 and 2018, in the former case amidst a euphoric view that the new Administration would usher in pro-growth policies, including tax reform, and in the latter case, basking in the afterglow of the December 2017 passage of said tax reform. It is no coincidence that the FOMC, repeatedly spooked by the early-year data, delivered less than the dot projections had predicted in 2015 and 2016 but was far more aggressive in 2017 and 2018, once the Q1 weakness story had largely been explained away.
2019: Back to the future?
The mood entering 2019 was vastly different than in the prior two years, as the swoon in asset prices globally in November and December 2018 had Fed officials and economists quite worried about the outlook. Indeed, the Fed did a remarkably rapid pivot, going from a rate hike in December 2018 to a full-on pause with no strong predisposition about the direction of the next move by the end of January 2019. Market participants have also worried that a slow start to the year reflects deteriorating fundamentals, driven in part by drag from overseas, i.e. the mood feels more like the mid-2010s than the last two years.
This year’s Q1 has had a myriad of the sort of special factors that have often plagued the winter months in recent history. First and foremost, the 35-day federal government shutdown is likely to represent a drag of 0.3 to 0.4 percentage points directly from the loss of federal government outlays and undoubtedly dampened consumer and business activity early in the year as well. A stretch of very difficult weather in late January and early February also likely held back the consumer.
Current projections for Q1 look an awful lot like the corresponding results for 2018. Consumer spending in real terms appears on pace to register an anemic increase of around 1% vs. 0.5% last year; while real GDP may post a substantially below-trend 1.5% rise compared to last year’s gain of 2.2%. Not coincidentally, Q2 projections also look similar to those for spring 2018, including a 4.0% rise in Q2 GDP, largely driven by a sharp rebound in consumer spending (3.8%), and a bounceback to normal in federal government outlays.
Since most economists and Fed officials at this time expect growth to decelerate substantially in 2019 from the 3.0% Q4/Q4 advance posted last year (my own forecast is more optimistic), the relatively soft Q1 figures have underscored those views and accentuated fears regarding downside risks. Similarly to 2015 and 2016, look for a sharp improvement in economic data in the spring to gradually lift the FOMC and financial market players out of their gloom. As wild as it may seem to some at this point, the Fed will likely hike rates again before the end of 2019.