Is the economy still growing? We believe that the answer is still “yes” — but that growth is slowing and the details in the first quarter and April of 2019 reveal warning signs.
The GDP received a boost from inventories, exports
Gross domestic product (GDP) grew at an annualized rate of 3.2% in the first quarter, which is above the consensus estimates of 2.5%. The Commerce Department estimated the government shutdown shaved 0.3 percentage points from growth in the first quarter. Rising exports, falling imports, and higher inventory investment drove much of the growth, helping to offset weaker gains in consumer spending and business investment.
Looking closely at the first quarter numbers, however, it becomes clear that the 3.2% increase is largely due to an excessive rise in business inventories and a surging contribution of net exports to GDP. Inventories contributed 0.65%, while net exports added 1.03% to the 3.2% growth GDP, accounting for over half of the increase. The Wall Street Journal reported that, without these temporary contributions (and both could abate in future months), the U.S. GDP in the quarter would have actually been only 1.3%, which is far below even the consensus estimates.
Unemployment drops, but job-seekers drop out
The Labor Department reported in early May that employers added 263,000 jobs in April, well above what analysts had forecast. The unemployment rate sank to 3.6%, the lowest level since December 1969. Employment has grown for over 100 months in a row, dating back to 2010, and the economy has created more than 20 million jobs since the Great Recession ended in 2009.
But despite the bright jobs picture overall, there were pockets of weakness. Retail employment fell for the third month in a row as brick-and-mortar stores closed with consumers increasingly shopping online. Automakers have been closing plants and cutting shifts in the face of declining sales. (Ford recently announced it will lay off 7,000 salaried workers by August 2019, but the Detroit Free Press reported that analysts estimate the company will need to cut another 23,000 to reach stated profit goals.)
There was also a big drop in the number of people who said they were actively looking for work. The labor-force participation rate, which measures the share of those 16 and older who are employed or seeking work, sank to 62.8% from 63% in March 2019. Those dropping out of the labor force helped reduce the unemployment rate to the 3.6% level from 3.8% the prior month.
Index moderates growth outlook
The Conference Board’s Leading Economic Index (LEI) increased 0.2% in April 2019, matching the consensus. Six of its ten components made positive contributions, led by stock prices. But the 12-month average gain of the LEI slid to 0.2%, the least since January 2017. This is down from a high of 0.5% in September 2018 as the outlook for growth has moderated. Similarly, the six-month annualized rate of change of the LEI posted at 0.6% last month, down from as high as 3.7% in early 2018, reflecting a weakening growth outlook.
Retail sales and industrial production
Retail sales declined 0.2% in April, on the back of an upwardly revised 1.7% gain in the prior month, and contrary to the consensus of a 0.2% gain. On a year-over-year trend basis, retail sales were up 3.0%, a near-steady pace compared to the previous month, but less than half the rate of last summer. There were similar trends in discretionary and core discretionary retail sales. This indicates underlying weakening of consumer spending.
Industrial production fell 0.5% in April, down in three of the past four months, and weaker than the consensus of an unchanged reading. Manufacturing, which accounts for three-quarters of industrial production, also fell 0.5%, led by durable goods, with vehicles, machinery, and electrical equipment posting declines of at least 2.0%. Core industrial production, which excludes energy, high-tech, and vehicles, fell 0.4%, led by a 1.9% drop in business equipment, the greatest drop since July 2013. On a year-over-year basis, industrial production continued to cool, posting 0.9%, the slowest pace since February 2017. Core production was even weaker, up just 0.1% year-over-year. Manufacturing output was down 0.2% year-over-year, its first decline since October 2016.
The Philadelphia Federal Reserve General Business Activity Index rose 8.1 points in May to 16.6, a four-month high, and above the consensus of 10.0, indicating a pickup in factory activity in the region. But growth in new orders moderated and inventories shrank. The future unfilled orders index dropped to minus-10.6, its lowest level since November 2008, suggesting that firms expect weaker future demand and no pressure on their operating capacity. Price pressures remained subdued, although there was a modest uptick in expected prices.
Consumer optimism
One positive is the University of Michigan consumer sentiment index, which rose in early May to its highest level since 2004. The headline number has now fully recovered from a drop earlier this year and last year, which was caused primarily by the U.S. government shutdown and financial-market volatility.
There are caveats. Richard Curtin, the survey’s chief economist, pointed out that the index growth was recorded largely before the U.S.-China trade negotiations collapsed. He said negative references to tariffs rose in the past week, and he thinks they “are likely to rise further in late May and June.” Curtin said those who did hold negative views about the impact of tariffs on the economy and pricing had much lower future economic expectations, potentially diminishing the pace of consumer spending ahead of a loss of general confidence spreads.
Effect of Trump tariffs, trade-war winds
Most economists argue that the tariffs backed by President Trump reduce economic activity by raising prices for consumers. That reduction from the China tariffs is apparently small thus far, but it is in those calculations almost certainly a reduction and not a rise. Tariffs have not had a huge effect on prices yet —not because China is bearing them, but because, thus far, the taxes imposed on Chinese imports have not been large enough to budge the inflation rate more than a tenth of a percentage point.
The pain from the tariffs is not the same across all industries. Agriculture appears to be hurt the most. Last year, as retaliation for Trump’s tariffs, China stopped buying soybeans from American farmers, which resulted in a big hit to soybean exports. But as the two countries resumed trade talks, the Chinese restarted some soybean purchases as a good-faith measure. That restart is reflected in the first-quarter data. As reported by the Bureau of Economic Analysis, exports of food, feed, and beverages, which include soybeans, jumped 45% after falling by nearly 50% in the fourth quarter of 2018. That category by itself accounted for nearly two-thirds of the growth in exported goods.
A Department of Agriculture program, which was instituted in 2018 to mitigate the impact of retaliatory Chinese tariffs, has paid out $8.5 billion to farmers so far. A new round of payments to farmers, totaling approximately $16 billion, is planned for this year as the trade war saber-rattling goes on.
Tariffs and taxes
Overall inflation has continued to be tame, with the latest Consumer Price Index showing just 0.3% increase in April. However, this may be masking pockets of price-spikes due to tariffs. And if the trade war heightens, that effect could become more widespread. The tariffs in play currently affect consumers only fractionally. Consumer goods account for only about 25% of the items targeted by the tariff rate increase in early May. However, consumer goods account for about 60% of what’s left of imports from China that could become subject to U.S. tariffs if this goes to a full-blown trade war.
So far, estimates are that the tariffs amount to a tax hike of approximately $500-to-$600 per American family annually. If Trump goes to 25% tariffs on over $500 billion in Chinese imports — hitting nearly every category of consumer goods from clothing and diapers to electronics — it could mean a $2,200 tax hike on the average family of three. By contrast, Trump’s tax cut gave middle-income families a tax cut of about $800, according to the Tax Policy Center.
The trade war boosts GDP temporarily in at least two ways: first, it pushes corporations to build up inventories artificially to get the cost of materials and semi-finished goods before the tariffs begin to hit; second, trade disputes initially result in lower imports while negotiations are underway. In the latest U.S. GDP analysis reported last week, lower imports resulted in what is called higher “net exports” (i.e., the difference between imports and exports). Net exports contribute to GDP. The U.S. economy could be slowing in terms of output and exports, but if imports decline faster it appears that “net exports” are rising, and therefore GDP from trade is rising too.
Business investment, local government and consumer spending
The acceleration in real GDP growth in the first quarter reflected an upturn in state and local government spending, accelerations in private inventory investment and in exports, and a smaller decrease in residential investment. These movements were partly offset by decelerations in personal consumption expenditures (PCE) and nonresidential fixed investment along with a downturn in federal government spending.
Private business investment contributed only a tepid 0.27% of the 3.2% GDP increase, well below its average for GDP share. Business investment is composed of building structures (including housing), private equipment, software, and the nebulously defined “intellectual property,” along with the business inventories previously mentioned. The structures and equipment categories are by far the largest categories of business investment. However, in the first quarter 2019, structures declined by minus-0.8%, housing by minus-2.8%, and equipment investment rose only by a statistically insignificant 0.2%.
An unexpected factor behind the acceleration in GDP growth in the first quarter was a sharp upturn in state and local government spending, which jumped 3.9% after a 1.3% drop in the prior three months. This was the fastest gain in three years. Spending by local governments likely picked up due to the partial federal government shutdown.
Consumer spending, which comprises more than two-thirds of the U.S. economy, slowed to only 1.2% growth last quarter, compared to 2.5% in the fourth quarter of 2018. Thus, it contributed only 0.82% of the 3.2%. That’s only one-fourth of the 3.2%, when consumption is typically two-thirds of the economy. That slowdown was attributed in part to factors like delayed tax refund payouts, which were a result of the government shutdown at the start of the year.
How we see it
Bowen Asset Management is not expecting a recession this year. However, we are seeing slowing growth. Overall favorable economic news is overshadowing some preliminary troublesome economic numbers. Going forward, trade issues will continue to be a primary cause of the volatile market behavior. Until investors see an end to the trade war tariffs, we will continue to run the risk of wild market swings no matter how good the underlying economic news. Those issues are not just true with China but also with the European Union and increased tensions with Iran. A 5% trade tariff on Mexico, which is the United States largest trading partner, would amount to a tax increase of approximately $17 billion.
A mid-May report from the Tax policy Center showed that “tariffs could ultimately increase the price of consumer goods by as much or more than the Tax Cut and Jobs Act cut taxes.” Comparisons with the tax cut-hyped 2018 economy going forward are going to make things more difficult. That points to increased volatility with outperformance driven by a few selective areas. Investor sentiment is likely to swing wildly in 2019.
Disclaimer
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.