Sure, It Looks Bad, But Don't Kiss Off The Second Quarter Yet

Is it a quadruple dip? More precisely: Is growth in the U.S. economy slipping, yet again, to a pace that feels like a recession because it is too puny to create jobs?

Some of the latest data look disturbing enough. The March readings for consumer spending, factory orders, and the forward-looking index of leading indicators all tumbled. Those losses mainly reflect the month's blizzard that blanketed the East Coast and depressed sales and output. But the size of some of the declines suggests more weakness than the storm alone can explain.

And it's not just the weather-beaten March data. The nation's purchasing managers gave a downbeat assessment of April manufacturing activity (chart), and the broad M2 measure of the money supply, which fell precipitously in the first three months of the year, gives no hint of an April turnaround.

All this comes on the heels of the economy's lackluster performance last quarter, when real gross domestic product rose at a tepid 1.8% annual rate. That followed growth of 3.7% and 4.7%, respectively, in the third and fourth quarters of 1992. The GDP numbers showed a disconcerting mix of falling demand and inventory accumulation that typically presages trouble for future output.

Is trouble brewing? Not yet. It is still too early to kiss off the second quarter. So far in April, reports from retailers and car dealers are encouraging. Also, the Federal Reserve Board's May 5 report on business activity, covering the period from Mar. 1 through Apr. 23, says that the economy is showing "generally modest improvement" across much of the nation.

To be sure, the economy's ability to bounce back this quarter will be pivotal to the outlook, but the real tests of that resilience will be the broader April reports on employment and retail sales, due out in early May.

Those numbers will decide how much of the economy's March weakness was weather-related and how much was real. A gain in April nonfarm payrolls that is significantly below the three-month trend of about 150,000 jobs per month suggests new weakness in the labor markets. Also, the failure of retail sales to rebound by at least 1%, following March's 1% drop, implies that consumers may have more problems than just bad weather.

The March index of leading indicators looks especially foreboding. It fell 1%, a drop rarely seen in an expansion, except in special circumstances. Nine of the 11 indicators that make up the index declined. However, fewer building permits and a shorter factory workweek--two gauges strongly affected by the snowstorm--accounted for half of the overall dip.

The recent collapse in the M2 money supply also would seem to be a red flag signaling recession redux. M2 fell last quarter for the first time on record. Normally, that decline surely would have meant a drop in real GDP.

These are not normal times, though. The data strongly imply that M2 is depressed by outflows of money from bank deposits into stock and bond mutual funds that are not part of M2. This trend reflects the long-standing divergence between short- and long-term interest rates.

One of the newest concerns for the second quarter is last quarter's large accumulation of inventories in concert with weak demand. The GDP report showed that stock levels of nonfarm businesses grew at an annual rate of $32.5 billion, the largest advance in four years, while final sales fell at a 0.3% rate.

However, the inventory rise is not as ominous as it looks. Stock levels in manufacturing did not grow at all last quarter (chart), and the gain in wholesaling was small. The bulk of the buildup occurred in retailing, and more than half of that was autos. All this fits with the March storm: Cars and other goods cannot move when businesses are closed.

Moreover, the inventory backup and the falloff in demand occurred in totally different sectors. The real villain behind last quarter's drop in final sales was a 25.5% annual rate of decline in defense spending. That was the largest plunge since the end of World War II. Excluding defense, final sales slowed from a robust 5.7% rate of growth in the fourth quarter to a not-so-alarming 1.3%.

Clearly, growth in the second quarter cannot escape some impact from the first-quarter inventory buildup. Even if demand growth rebounds, some of the buying will simply reduce inventories without spurring new production. In the GDP numbers, that results in a wash.

That process could explain why manufacturing orders and production looked weak in the April report from the National Association of Purchasing Management. The NAPM's index of industrial activity fell to 49.7% last month. A reading below 50% means that the factory sector is contracting. To the extent that retailers and car dealers sold from their inventories, they didn't order from factories. In that way, March weather may be having a delayed impact on factory activity.

However, a broader survey of manufacturers done by Dun & Bradstreet Corp. shows that optimism held at a record-high level in April. That confidence, combined with the Commerce Dept.'s report that the ratio of factory inventories to shipments dropped to an all-time low of 1.46 in March, suggests further output gains.

To be sure, the future direction for manufacturing lies in the hands of consumers who didn't lend much help to the first quarter. Their 1.2% pace of spending was far below the fourth-quarter pace of 5.1%. Still, aftertax income grew twice as fast as outlays, the savings rate jumped (chart), and April buying looks a little better.

In storm-whipped March, spending fell by 0.4%. That causes an arithmetic problem that could put the economy's growth prospects for this quarter at a disadvantage. Because outlays ended the first quarter below their quarterly average, real spending will have to increase by 0.4% in each of the next three months in order to grow at an annual rate of 2% for the second quarter. Consumers have shown that kind of stamina only three times in the last four years.

However, shoppers may well be up to the challenge. Sales of U.S.-made vehicles rose to an annual rate of 11.8 million in April, the fastest pace in more than three years. Demand for cars and light trucks was one of the major drags on spending last quarter. A bounce-back here during the spring would boost consumer spending--along with factory orders and production.

In addition, the Johnson Redbook Report says that April department-store sales were running 2.1% above their March level. Gains at both car dealers and department stores suggest a healthy increase for total April retail sales, which will be reported on May 13.

Consumers may be opening their wallets a bit wider because there is more green inside. Personal income rose by a solid 0.6% in March, although farm subsidies lifted the total. But after taxes and inflation, income is on an uptrend. Real disposable income grew at a 2.7% annual rate in the first quarter, a pace strong enough to keep consumer spending on the rise.

More muscle in the housing market also argues for a spring pickup in shopping, especially for furniture and appliances. Single-family home sales rose by 4.8% in March, to an annual rate gf 637,000. Plus, sales in each of the three previous months were revised higher.

The burst in buying pared builders' supply of unsold homes to just 5.1 months in March from 5.3 months in February. The supply has been running at this lean pace for six months now (chart). Inventories haven't been this low for that long in 20 years. This means that homebuilding will be a big contributor to growth this quarter.

It also means that it's way too early to write the obituary on this expansion--or even on the second quarter. The key will be the April data that are now starting to trickle in. If they don't show some bounce, then neither will the economy.

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