Butt Ugly GDP Report

Thursday’s advance GDP report for the first quarter sent a shock through the stock market, driving small cap stocks down by almost 2.5% in one day.

It wasn’t just the number; it was lower than last quarter’s 3.8% and 2004’s 4.4%, but 3.1% is still respectable. It was what was underneath the numbers. Once you strip out the $82 billion inventory accumulation that added 1.2% to GDP, both real final sales of domestic product and disposable personal income only grew at 1.9% annual rates during the quarter.

After Wednesday’s lousy March durable goods report (-2.8%) it’s no surprise that Personal Consumption spending (3.5%) slowed from the previous quarter. Durable goods consumption didn’t grow at all this quarter, with a decline in autos offsetting strong furniture and household equipment sales. Nondurables (4.9%) and services (3.6%) turned in decent numbers.

Gross private domestic investment grew at a strong 12.5%, but more than half of it was inventory increases; fixed investment, nonresidential investment, structures and equipment and software all slowed. Equipment and software investment growth, which averaged 18% over the last two quarters, slowed to 6.9%. Residential investment stayed strong, up 5.7%, reflecting the housing boom driven by cheap mortgage rates.

But the headline story is in the trade accounts. Real exports of goods and services grew 7.0%, making a 0.69% contribution to GDP. Imports (16.1%), however, grew more than twice as fast, a 2.19% drag on GDP. Most of the damage was in goods trade, reflecting the higher cost of oil imports, higher commodity prices, market share losses for domestic auto makers here and a strong market for imported electronic goods. This will intensify pressure on China to revalue their currency, running the risk of a slowdown in China’s growth rate.

Prices rose at about a 3% annual rate for both GDP and domestic purchases. Worth noting, prices of durable goods are actually 10% lower this quarter than their average level in 2000, a result of rising productivity and increasing competition from companies in Asia.

This is not the end of the world. GDP this quarter was 3.6% higher than it was in the same quarter last year; investment spending is 11.6% higher. But the weakness of demand under the inventory numbers suggests that policy makers should be more concerned with keeping the economy growing than taking away the punch bowl at this time.

For stock markets it is also important to note that profits look strong. We don’t have corporate profits numbers for the quarter yet, but proprietors’ income (small business profits) was $961.8 billion, up from $934.9 billion in the fourth quarter and $902.9 the quarter before that. Corporate profits this quarter are coming in strong as well. As of today, with 359 out of the 500 companies in the S&P 500 reporting, first quarter profits have increased at an 18.5% annual rate, considerably higher than analysts had expected just two weeks ago. The increases were strong across most sectors, except for Consumer Discretionary (autos), Utilities (energy prices), and telecom services (outdated anti-capital regulations). Of these, it is important that we get the telecom sector back on track to build the high-speed networks we need to compete globaly. Ccongress has announced they will rewrite the telecom law this year. If they get it right we have a lot to gain.

I believe the strong profit growth will continue due to two fundamental drivers. The first, and most impolrtrant, is that there has been a permanent change in the terms of trade in the US between capital owners (stockholders and proprietors) and capital users (workers). Two decades ago it was difficult to move capital across national borders. Today it is cheap and easy to do so, and governments don’t even know when you are doing it. That means capital is inexorably draining out of the US, Western Europe, and Japan, and into China, India, Vietnam, and other high-return emerging economies. Good for our stock market, bad for the guy left behind in Indiana with a wrench in his hand wondering where his factory went.

The second reason is important in the short-term. In the past year, banks and non-bank lenders, such as hedge funds, mutual funds, pension funds, and insurance companies, have turned on a firehose of lending to small private and public companies in the US. That increase in liquidity will show up as stronger performance and increased profits later this year. These profit gains will be increasingly visible in small companies, which rely on private lenders for their working capital. That’s why today, when the prices fell, I bought a good sized chunk of call options on the Russell 2000 small caps.

JR