A lot can change in 3 months? How much? Read on…
The First Advance estimate for 2Q released last week showed GDP fell at an annualized rate of 0.9%. Put this together with the 1Q GDP decline of 1.6% and we have a technical recession, by popular definition. You might also know that the National Bureau of Economic Research is the final authority on “naming / calling” a recession and whether the last 6 months will be labelled an official recession will be known only months from now. In any case, that is irrelevant. What matters most is – what is the complete economic data picture?
I have provided the link to the previous 1Q GDP article here to drive home the title of this article. A lot can change in 3 months! The first read of 1Q GDP, while negative on headline GDP growth, really seemed to suggest that real consumption was still robustly strong and the negative read was mostly attributable to the large negative net exports. But revisions, subsequent economic data and the 2Q GDP advance release have shined some more light on the picture.
Takeaway 1: The first release of 1Q GDP was misleading to some extent and the subsequent revisions peeled the onion a bit more.
The US consumer is the foundation of the US and probably the world economy as well. 1Q US real consumer spending growth was revised down from 2.7% in the first release to 1.8% in the final release. In other words, real consumption in 1Q turned out to be weaker than original anticipated / calculated.
Gross domestic private investment which includes the all-important business investment, on the other hand, was revised up from 2.3% in the advance estimate to 5.0% in the third release. But this raises cause for concern when viewed together with Q2 GDP data. Read on to understand why.
Takeaway 2: The robust growth in the 4Q 2021 was indeed significantly attributable to an inventory build-up. In fact, 1Q 2022 was not dissimilar on this aspect. i.e. Inventory build-up continued in Q1 2022 as well. Recall Q1 GDP was negative 1.6%. Change in private inventories contributed minus 0.35% out of this negative 1.6% headline number. In other words, if the change of inventories would have been even lower in Q1, we would have seen an even worse Q1 GDP print. For the record, change in private inventories (real / inflation adjusted), seasonally adjusted at annual rates, was US$193bn and US$188 bn in Q42021 and Q1 2022.
In Q2, the pace of inventory change declined much faster. That explains a negative GDP print of 0.9% despite real consumption holding up at 1% and despite the absence of the net exports drag that had negatively affected the 1Q GDP number. For context – change in private inventories contributed minus 2.01% out of the headline negative 0.9% compared to it having contributed minus 0.35% out of the minus 1.6% in Q1. The graph below explains the point.
Change in Private Inventories – Contributions to Percent Change in Real Gross Domestic Product (Table Below)
(The color coding in the graph and table is to help explain the effect of changes in inventory on GDP growth. Orange = Positive / Blue = Negative)
Make no mistake, there is still a significantly large inventory build that will contribute to deflationary pressures, once consumption slows further. But for now, consumers continue to consume. With the money from the stimulus cheques likely gone, the expenses have moved to the credit card tab.
Takeaway 3: The first advance release of 2Q GDP is all about Fixed Investment. And it doesn’t look good. Gross private domestic investment fell in Q2 2022 at a seasonally annualized of 13.5% ! Just for clarity – this includes things like machinery purchases, residential investment, etc. You look at this in the context of the first quarter (the revised gross private domestic investment number of 5%) and you can see why this is a big deal.
Retail sales and monthly income and outlays releases are generally showing that consumption is still relatively strong. PMI releases are showing a downward trend with some sub-indices already in contraction territory. CEO confidence, measured by surveys is cautious at best and outright down at worst. In this context, a significantly lower business investment number in the GDP release holds even more significance.
Summary: So what’s the bottom line? Its all about the Fed “pivot”. And whether a “pivot” is a u-turn on rates or just a mild indication of slowdown of rate increases does not matter at all. This is probably evident in the equity market price action since the Fed meeting. High duration stocks are up significantly. One might argue that with such strong headwinds to the economy these companies would suffer even more from an earnings perspective. But again, remember that valuation is a 2 factor formula. The denominator (discount rate) had so massively impacted valuations that markets are already treating bad news as good news from a rates perspective. The final point to mention is the latest data point – fresh from the oven hours ago! ISM Services PMI has surprised on the upside. No wonder the Nasdaq is up 2% at the time of this writing ! (12 noon EST / 12 midnight SG time). Good night and Happy Investing!