On Friday the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce will release the first revision of the U.S. 1st quarter Gross Domestic Product (GDP). The first release, in April, indicated a very slow growth rate of 0.2% for the U.S. economy for the three months ended March 31st. Since that initial estimate, economic data subsequently released suggest it is possible that the 1st quarter estimate could be revised lower to a negative level. In this short commentary I would like to discuss the key components of the GDP measure and where we stand as we head toward the halfway point of 2015.
First, it is helpful to remind ourselves why we care about economic growth. While it is possible – and actually somewhat common – for a company to grow even if the overall economy is stagnant, the ability to maintain high levels of revenue and earnings growth are greatly enhanced when the overall economic environment is robust. Likewise, an economy slowing down can present a headwind for companies, creating challenges in meeting investor expectations. As we’ve stated before, we rely on both “top-down” (meaning the global macro picture) and “bottom-up” (meaning security by security) analysis to identify investment opportunities, so we are not fixated on, nor are we attempting to predict, only one underlying trend.
The biggest and probably most important component of GDP is consumer spending. The bulk of this is done by households, but a small percentage comes from small businesses that are organized as proprietorships and partnerships. As 2015 got underway, market participants expected a fairly strong contribution to GDP from consumer spending. This expectation was based on the drop in gasoline prices, improved wage growth, better job prospects, higher housing wealth and an overall improved sentiment. To date – including retail sales through April – the actual level of spending has under-achieved (see chart). It is difficult to pinpoint one precise reason for this outcome, but it almost certainly goes beyond just another “very cold winter.”
The second component of GDP is long-term business investment. In some respects this component is dependent on the first (consumer spending), but it also ties in with technology evolution, equipment replacement and operating efficiencies. For the better part of the economic recovery (which began in June of 2009), business investment has lagged expectations. Although flush with cash reserves, many businesses have opted to raise dividends, buy back shares, pursue acquisitions or retire debt rather than expand capacity. Because of evolving technology and the need to replace worn out equipment, businesses will spend just to stay fit, but it is unlikely we will see much contribution from this GDP component until capital is invested in capacity expansion projects.
The next component is public sector spending. This component includes Federal, state and local expenditures. The Federal spending level has been held in check over the past four years as a result of the Sequestration agreement reached in August 2011. This agreement constrains outlays in national defense and domestic programs to reduce acceleration. Unfortunately, state and local spending, which are constrained by balanced budget requirements and less robust access to capital markets, have not fully picked up the slack created by the lower Federal spending. There is clearly a great amount of need – particularly with respect to infrastructure – but capital budgets remain tight even with higher tax receipts and restructured and improved debt levels.
The final component is net exports (U.S. exports minus U.S. imports). For years the U.S. has run an international trade deficit but the slower economic growth overseas, strength in the U.S. dollar and blotted inventory conditions in many industrial and energy markets has exacerbated the pressure over the past couple of quarters as import growth has outpaced export growth, leading to a wider trade gap. This creates a drag on U.S. GDP.
Considering the level of the four GDP components and recent trends as we head into the final month of the second quarter, stronger domestic economic growth as initially expected by the consensus view when the year began remains in question, and that uncertainty weighs on both stocks and bonds.
Overall, since the beginning of the year, we have seen consensus analysts’ earnings growth expectations for the S&P 500 multi-national corporations lowered from original estimates. This trend can lead to a market environment wherein valuation multiples (such as price-to-earnings, price-to-book value and/or price-to-free cash flow) become historically high and thus vulnerable to correction. The unexpected soft patch in U.S. economic growth is also creating more uncertainty surrounding Federal Reserve monetary policy. Based on recent public commentary offered by Federal Reserve officials, the FOMC remains on track to begin raising benchmark interest rates later this year. However, they are quick to add that policy decisions are dependent on the economic data. Together, these two factors may create more short-term market volatility than we’ve experienced over the past two and a half years.
As a result of the somewhat unsettled economic environment, we’ve tried to remain nimble with tactical portfolio positioning while staying predominately invested. As such, we hope to be in a position to take advantage of higher market volatility in either stocks or bonds depending on the opportunities that present themselves. With many asset classes fully valued, selectivity is likely critical for the balance of 2015.
Jack E. Payne, CFA, CFP
Chief Investment Officer