Weak GDP Points to Stronger Q2
A report on first-quarter U.S. gross domestic product released May 31 came in weaker than expected, raising eyebrows among those worried about the pace of U.S. growth. But the GDP report, along with other reports unveiled the same day on manufacturing sentiment and construction spending, actually shows that the economy has passed through a more aggressive downturn in business inventories than was previously assumed, leaving a weaker first quarter but a stronger outlook for the second.
The GDP data revealed a shift in the first-quarter mix from inventories to sales, while the sizable bounce in the Chicago purchasing managers' index, a drop in weekly first-time jobless claims, and a construction spending report that showed underlying strength in that sector's data, all suggest a sharp reversal of the inventory cycle in the second quarter.
Here is Action Economics' rundown of the May 31 releases:
GDP: The preliminary reading of first-quarter GDP was revised to a 0.6% growth rate (below economists' median forecast of 0.7%) from the advance report of 1.3%. The first-quarter gain marks the weakest quarter of growth since the fourth quarter of 2002.
The downside headline surprise was almost entirely in business inventories, which were knocked down sharply to a big $26.9 billion subtraction from the $7.6 billion subtraction reported earlier. The downward net export adjustment was also larger than expected, at a $29.2 billion subtraction from –$15.2 billion, due to a sharp bump in import growth to 5.7% from 2.3%, alongside the expected bump in exports to a 0.6% rate of decline from –1.2%.
These downside surprises were accompanied by an unexpectedly large upward bump to consumption growth, to 4.4% from 3.8%, while business fixed investment was revised up to –3.5% from –4.7%, and government consumption was revised up to 1.0% from 0.9%. The GDP chain price index was left unchanged at 4.0%, with the core rate (excluding food and energy) steady at 2.2%.
Though the surprisingly low headline print will attract market attention, the robust sales data and lean inventory trajectory sharply boost prospects for the second quarter, and cap downside risk to the economy despite the lean headline. Service-sector spending is now entering the second quarter with a much stronger growth path, and it will be difficult for inventories to subtract further in the current quarter.
We have tentatively raised our second-quarter GDP estimate to 3.2%, and a "3-handle" for that report would send a clear signal to the markets that the prospects for quarterly U.S. GDP figures have reversed course. The down draft in inventories has likely ended, and the downward pull from single-family home construction is on track to diminish as expected through 2007.
Chicago purchasing managers' index: The Chicago PMI surged to 61.7 in May from 52.9 in April, which sharply exceeded the May bounces in the Empire State and Philly Fed indexes, and suggests that the inventory cycle has turned a corner. We will boost our May forecast for the Institute for Supply Management's manufacturing survey to 54.0, but leave our ISM nonmanufacturing estimate at 56.
Construction spending: The U.S. April construction spending report revealed a surprisingly strong set of both nonresidential construction data and new construction figures in the residential sector, and the mix has further boosted prospects for second-quarter GDP growth.
To be sure, the April headline gain for construction was still restrained at 0.1%, as signaled by the 0.8% drop in the construction-hours-worked index in the April employment report, and residential construction fell 1% in April despite the 2.5% rise in housing starts in April and the 16.2% April new-home sales surge. The residential figures tracked the small 0.5% decline in starts under construction for the month, and the bigger 2.6% drop in April existing home sales.
Yet new single-family home construction has been nearly flat over the last two months, which is a notable shift in trend from the steady declines of the 11 months ending in February. And the robust gains in nonresidential construction have capped the risk that the slowing in capital spending in January and February reflected a broad slowing in fixed investment, and not just a concentrated and temporary adjustment in the construction and heavy truck sectors.
We now assume that residential construction in the second-quarter GDP report will show "only" a 5% to 10% rate of decline, following the 15.4% rate of decline reported for the first quarter in the May 31 release, and the 18% to 20% rates of decline in the third and fourth quarters of last year. Nonresidential construction could post growth of as much as 17% in the second quarter, given the hefty 1.5% to 2.6% gains for this sector in each of the last three months.
Weekly initial jobless claims: The initial claims drop of 4,000 for the final week of May leaves a still-lean 310,000, with the month now averaging a surprisingly low 305,000, and with a similarly low 296,000 reading for the Bureau of Labor Statistics survey week, which is used to determine the nonfarm payrolls component of the month's employment report.
All the available May data suggest that we will see a continuation of oscillating payroll increases in the month's employment report, scheduled for release June 1; we peg the headline job-growth figure at 135,000. The initial claims data suggest a stronger number, as do the Empire State, Philly Fed, consumer confidence, and Michigan sentiment data, though the ADP figure released May 30 has capped the upside risk for the month. Our payroll forecast does incorporate an expected payroll slowdown in 2007 from the remarkably strong average monthly gain of 189,000 in 2006.