1Q GDP Plunges Nearly 3% – What Will The Fed Do Now? by Gary D. Halbert

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert

July 1, 2014

IN THIS ISSUE:

1.  The US Economy Tanked in the 1Q, But Why?

2.  2Q Growth to Quicken but Still Another Slow Year

3.  Will Fed Alter “Taper” Due to Weak GDP Report?

4.  Lots of New Faces on Fed Open Market Committee

5.  The Beginning of the End of the Stock Bull Market

Overview

Today we take a closer look at last week’s very ugly 1Q GDP report and see if we can discern why it was so much worse than anyone expected (hint: it was more than the severe winter weather). Fortunately, it continues to look like 2Q growth will come in at +3.0% or better. But even if GDP for the rest of the year comes in strong, the devastating 1Q will ensure yet another slow growth year.

The stunning 1Q GDP report immediately raised the question of what the Fed will do in response. Will the Fed slow down its methodical reduction of QE bond purchases? Will it put the so-called “taper” on hold? Or will it continue to taper as planned and end the program in the fall? I’ll share my thoughts as we go along today.

Finally, one well-known financial writer – Mark Hulbert – believes that the recent decline in corporate profits spells the beginning of the end of the bull market in stocks. I have reprinted his latest article below, and I suggest you read it and give it some serious thought.

The US Economy Tanked in the 1Q, But Why?

By now the whole world knows that the US economy plunged much worse than expected in the first three months of this year. Last Wednesday, the Commerce Department reported that 1Q GDP shrank at an annual rate of -2.9% in its third and final estimate. That was much worse than the pre-report consensus of -1.8% and was the worst reading in five years.

In the second estimate in May, the government reported that 1Q GDP was -1.0%. The difference between the second and third estimates was the largest on record going back to 1976, the Commerce Department said. Growth has now been revised down by a total of 3.0 percentage points since the government’s initial estimate was published in April, which had the economy expanding by a modest 0.1%.

GDP

The economy’s woes in the 1Q have been largely blamed on the unusually cold winter. However, most economists agree that the cold weather only slashed 1.0-1.5 percentage points from GDP growth in the 1Q. (The government does not report statistics on the economic impact of the weather.)

The magnitude of the latest downward revisions confirms that other factors were at play beyond the weather, as I have suggested for several months. So what were those other negative factors?

Recent data have confirmed that healthcare spending was much weaker than expected in the 1Q, which I discussed in some detail last week. Actual health spending came in substantially lower than expected based on Obamacare enrollments and Medicaid data, declining at a 1.4% annualized pace in the 1Q, compared with the May estimate of a 9.1% increase. That’s a huge revision! Yet with all of the uncertainty surrounding Obamacare, this should not have been such a big surprise.

Consumer spending, which accounts for more than two-thirds of US economic activity, was reported to have increased by 3.1% (annual rate) in the May estimate; however, in the latest report, this key reading was revised down to only 1.0%. That was very disappointing.

Trade was also a bigger drag on the economy than previously thought. Exports declined by 8.9%, instead of 6.0% estimated in May, resulting in a trade deficit that further reduced GDP growth.

Businesses accumulated fewer inventories than estimated in May. A measure of domestic demand that strips out exports and inventories expanded at a 0.3% rate, rather than a 1.6% rate estimated in May. Both residential and non-residential fixed investment were revised lower as well.

For all the reasons cited above, the final 1Q GDP number was the worst since the 1Q of 2009.

2Q Growth to Quicken but Still Another Slow Year

As I discussed last week, most forecasters believe that 2Q GDP will come in much stronger. Several are revising their estimates higher, despite the terrible 1Q report. Last week, consulting firm Macroeconomic Advisers increased its forecast for 2Q growth to 3.5% from 3.3%.

Consumer confidence is at the highest level today since January 2008 (for more on that, see my blog last Thursday). Since consumer spending makes up over two-thirds of GDP, that explains why some forecasters now believe that GDP could be up as much as 4% for the April–June quarter that ended yesterday.

GDP

As the chart above illustrates, consumer confidence is still well below pre-recession levels, and we should keep in mind that consumer confidence can change quickly. Let’s hope not this time.

Let’s be generous and say that the economy grew by 4% in the 2Q and continues to do so for the rest of the year – a level only attained twice in the last five years – the overall growth rate for 2014 would still work out to only a tepid 2.2%.

The first estimate of 2Q GDP will be released on Wednesday, July 30 at 8:30 AM Eastern.

Will Fed Alter “Taper” Due to Weak GDP Report?

Not long after the GDP report came out last Thursday, analysts quickly turned to the question of how the bad news might affect the Fed. Might it influence the Fed to put its bond-buying taper on hold for a while? Since late last year, the Fed has been reducing its purchases of Treasury and mortgage bonds by $10 billion at each FOMC policy meeting.

The last policy meeting was on June 17-18 at which time the FOMC reduced bond purchases by another $10 billion, to $35 billion per month, down from the high of $85 billion late last year. The next policy meeting will be on July 29-30 when the Fed is expected to reduce purchases to $25 billion a month.

After that, the next FOMC meeting will be on September 16-17 when purchases would likely be cut to $15 billion, followed by the next meeting on October 28-29 when some analysts believe the Fed will vote to stop all QE purchases.

But does last week’s dreadful GDP report suggest that the Fed will alter its taper course? While the Fed is intent on reducing bond purchases as described above, it has always left its taper options open with the following qualifier:

If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation…

Former Fed Chairman Ben Bernanke often reassured markets and the media that if the economy faltered, the Fed would not hesitate to

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