Blog : Did A Recession Start on Jan. 1? Probably Not

by Ed Zwirn on June 27th, 2014

Investors were basically correct to shrug off the latest, disastrous revision to Q1's Gross Domestic Product figures. For one thing, GDP numbers, especially third revisions, are backward-looking indicators, and the evidence looking forward seems to look toward a brighter (or at least warmer) Q2. The labor market has firmed up, with the unemployment rate down and job creation numbers up. In addition, industrial production is rising and even the real estate sector, although showing weakness, is still chugging along.

But the latest news from the Bureau of Economic Analysis should nonetheless be parsed by investors looking to get a handle on the direction of the U.S. economy and, by extension, whether the current stock market is on a firm footing.

The U.S. economy fell 2.9% in Q1, the worst showing for real GDP since Q1 2009, a sharp difference from the second estimate of a 1% decline. At the risk of beating a dead horse, the severe winter deserves part of the blame for this poor showing.  But the magnitude of the Q1 debacle begs the question of which other factors were at play, and whether any of these could pose further risks for growth going forward.

If you look at the BEA's third Q1 GDP estimate, the one thing that jumps off the page is the sharp downward revision of personal spending figures. Driven by a decline in services consumption, real final sales were down 1.3% in Q1, according to the revision, down sharply from the second estimate's 0.6% rise. This is the first time that this figure had decreased since Q1 2011. Compounding this, personal consumption spending increased only 1% according to the third estimate, down from the 3.1% Q1 rise reported in the second estimate.

In short, the bulk of the 1.9% downward revision of the GDP estimate was due to a falloff of consumer spending. Some of this may have been due to the weather. Another contributing factor may have been the precipitous purging of the unemployment compensation rolls which occurred in January, when Congress let emergency extended benefits expire. In any case, despite the 554,000 nonfarm payroll slots added during the quarter, spare change was at a premium.

Another frightening factor contributing to the Q1 decline was the 11.7% decline in investment. Nonresidential spending was off 1.2%; residential, down 4.2% and inventory growth fell sharply as companies sold off prior output rather than boost production.

Also crucial to understanding the Q1 debacle is the declining trade balance seen during the period. Real exports of goods and services decreased 8.9% in the first quarter, in contrast to a 9.5% increase seen in Q4. At the same time, real imports of goods and services rose 1.8%, an acceleration from Q4's 1.5% rise.

Wall Street versus Main Street

Critics of capitalism are fond of pointing out the apparent disconnect that often occurs between the progress of the stock market and that of the general economy. The stock market is supposed to be a great predictor of the latter, since investors in effect are betting that things will improve, although maybe not for the masses, over the short haul. But the stock market languished along with the rest of the 99 percent in Q1, with the Dow Jones Industrial Average losing 0.7% and penny stocks, as represented by the small-cap Russell 2000 index, up 0.8%.

Looking ahead to Q2, nobody is predicting negative growth for the three months which will end on June 30 (which would officially mean a recession had started on Jan. 1), but pressures on GDP growth remain all the same. The U.S. trade balance has faced challenges due in part to the falloff seen in external markets, particularly Europe, which is only  just emerging from recession. In addition, as I pointed out previously in this investment blog, the U.S. trade balance will tend to decline, all else being equal, as worldwide central banks like the European Central Bank loosen monetary policy, in effect devaluing their currencies and making their products cheaper to sell in the U.S.

The big question marks that remain are personal spending and overall investment, and so far the news on these is less-than-encouraging. Personal spending rose by a grudging 0.2% in May after holding flat in April. In addition, durable orders fell 1% in May after increasing 0.8% in April. Jobs growth, on the other hand, has picked up so far in Q2, which has seen 505,000 jobs open up in April and May alone.

Whether or not this growth is sufficient to propel a blockbuster reading on the economy for Q2 (and the remainder of the year) remains to be seen. For now, it appears that the train wreck that was Q1 was no anomaly. Recall that last year's Q1 GDP rise was regarded as sickly at 1.1%, and the economy (and the stock market) later rebounded. Recall also that the final Q3 2013 reading of a 4.1% increase was so pleasant that it had analysts raising their upsides.

Of course, that was all before it started snowing...