Head Fake on GDP

Real GDP surged 3.2% in the first quarter of 2019. Over half of those gains can be attributed to a surge in inventories and a narrowing in the trade deficit. Exports picked up slightly while imports plunged. Consumer spending and business investment slowed to crawl. The pace of consumer spending was half that of the previous quarter. Residential investment was a drag on growth for a fifth consecutive quarter. Investment in new structures, which includes commercial real estate, contracted for the third quarter in a row.

Separately, federal government spending flatlined in response to the prolonged government shutdown. A rise in defense spending was offset by a fall in nondefense spending. State and local government spending rebounded after contracting in the fourth quarter.

The details revealed a few silver linings. Exports picked up modestly but remain well below the pace of last year. Investment in intellectual property (mostly AI and automation) was the only real positive in business investment. Those gains, however, were more reflective of changes in the tax laws and how technology companies book their investment in intellectual property than an actual increase in investment.

Prices decelerated sharply, which helped to boost inflation-adjusted growth. This is not exactly what the Federal Reserve was hoping for at this late phase of the expansion. It bodes poorly for profit margins, which are expected to be squeezed by everything from higher wages and tariffs to a stronger dollar, which makes imports even cheaper.

Prospects for growth in the second quarter now look much worse because bloated inventories must be depleted. The hope is that consumers bounce back to do some heavy lifting. The fly in the ointment is rising prices at the gas pump, which could erode some of the gains we are finally seeing in wages at the low end of the wage scale.

Bottom Line
This is one of the weakest 3% growth quarters I have ever seen. Underlying momentum in the domestic economy was particularly weak. Now we have to deplete inventories that have been built up for the better part of a year. Our forecast holds for a slowdown in 2019.

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