Blog : It Was Worse Than We Thought

by Ed Zwirn on May 29th, 2014

It turns out that the past winter was even worse than we had thought, at least from an economic standpoint. According to a Bureau of Economic Analysis report released this morning, the U.S. economy actually contracted by a full percentage point in Q1.

Analysts had expected a downward revision, to -0.5%, from the meager 0.1% rise reported in the advance estimate produced by the BEA on April 30. Even the advance estimate was disappointing to investors at the time, with the consensus having expected a 1% rise.

Any way you slice it, this morning's numbers come short. Q4 2013 had seen a 2.6% increase in real GDP, and the second GDP estimate produced this morning marks the first time the U.S. economy lost ground since GDP fell 1.3% in Q1 2011.

The downturn primarily reflected a downturn in exports, a large decrease in private inventory investment and downturns in nonresidential fixed investment and in state and local government spending. These were partly offset by a rise in federal government spending.

On the minus side, investment in the real economy fell sharply, underscoring a volatile and recurring weak spot. Nonresidential fixed investment decreased 1.6% in Q1 after increasing 5.7% in Q4. Investment in nonresidential structures decreased 7.5%, compared with a decrease of 1.8%. Residential fixed investment fell 5%, following a decrease of 7.9%. Investment in equipment decreased 3.1% after rising 10.9%.

In addition, the country's import-export balance took a dive during the quarter. Real exports of goods and services fell 6% after rising 9.5% in Q4. At the same time, imports rose 0.7% in Q1 after having risen 1.5% at the end of last year.

Government spending presented a more complex picture.

On the one hand, state and local government spending decreased 1.8% during the quarter after holding steady in Q4.

The federal government, on the other hand, saw an overall 0.7% increase in spending, not much of an increase but a brake on the precipitous 12.8% Q4 decline. Military spending decreased 2.4% after falling 14.4% in Q4. Non-defense spending rose 5.9%, in sharp contrast to Q4's 10% decrease.

But the largest driver of this downward revision, the change in real private inventories, has left many analysts scratching their heads. This change alone subtracted 1.62 percentage points from the change in Q1 GDP, propelling the economic measure into negative territory. Private businesses increased inventories $49 billion in the first quarter, following increases of $111.7 billion in Q4 and $115.7 billion in Q3.

The fact that U.S. businesses sold off inventories to the tune of $62.7 billion in Q1 rather than manufacture new product is a net negative for the economy. And it was basically unexpected, with analysts reporting that April merchant wholesaler and retail inventory data mostly met the BEA's expectations.

But maybe the inventory decline is not as negative a development as it may appear at first blush. December's revision of Q3 GDP, which upped the gain seen for that period from 3.6% to 4.1%, may in fact have been to good to be true, or too good to be sustainable, anyway, based as it was at least in part on a $59.1 billion increase in inventories.

"It's not entirely bad news," Silvercrest Asset Management's Patrick Chovanec says of the inventory revisions. "A big chunk of the 'strong' GDP growth in 3Q13 was due to a build-up of inventories, so eliminating this overhang actually puts the economy on a sounder footing."

This line of reasoning would tend to bolster predictions of a sharp economic upswing in Q2. The relatively strong jobs numbers seen over the past three months also seem to bolster the view that much of the decline was due to harsh winter conditions and is already in the process of being reversed. The same holds true for recent surges in durable goods orders and in commercial bank lending, all of which bode well for penny stock investments.

The test for this proposition will come as soon as July 30, when the BEA releases its advance estimate for Q2. The market may by then have already shrugged off Q1, and along with it memories of a harsh winter. It would be unthinkable for the U.S. economy to register two consecutive negative quarters at this point, and all indications are that this won't happen. That being said, anything less than a reported pronounced GDP resurgence ought to prove nettlesome to the market.

How much is enough? That will only become known as we get closer to July 30 and consensus expectation forms based on incoming data. We still have part of May and all of June ahead before we can put this quarter to bed. At the same time, as the Fed continues tapering off on its monetary accommodation, investors are becoming less likely to see the silver lining in a downturn. Nobody expects the Fed to alter its course in the slightest over the coming months, so penny stock investors might as well enjoy the coming boom, assuming that's what we get.