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GDP Disappoints as Inventory Purge Hits Home

A tough week for U.S. data means the Fed may find it hard to raise rates in September.

It wasn’t a great week for the U.S. economy, with disappointing durable goods and GDP reports. The weakness in these two reports was bad enough to make it very difficult for the U.S. Federal Reserve to raise rates at its September meeting. The world equity markets took the bad economic news in stride as a number of high-profile tech stocks reported good earnings news and interest rates look likely to stay lower for longer. The S&P 500 was down just 0.1% on the week and the Ten-Year U.S. Treasury bond rate drifted lower again to 1.46% from 1.57% a week earlier, as one might expect with slowing economic data.

U.S. GDP grew just 1.2% in the second quarter, about half of what was expected. The consumer continued to do well but could not offset a massive 1.2% subtraction for inventories, a factor that often reverses itself in future quarters. We are nevertheless reducing our full-year growth rate to 1.5%-2.0%, a half-point reduction from our previous forecast. It is nearly impossible, mathematically, to recover from first-half weakness. In fact, we are raising our second-half outlook to over 3%, which was still not enough to keep us from lowering our full-year forecast.

The poor GDP number will dramatically raise the importance of next week’s employment report, to cross-check the GDP data. We expect to see that about 180,000 jobs were added in July, which should help convince investors that the economy is not headed into the ditch. However, an unusually strong June employment number will make the July employment growth figure more challenging than I would like.

Second-quarter GDP growth fell well short of expectations, growing just 1.2 versus most expectations for growth of 2.4% or even more. Just as disappointing, first-quarter growth was revised down from 1.1% growth to 0.8%, which should have made second- quarter growth easier to achieve. Sequential weakness was widespread with consumption being the only category showing significant growth and most categories showing sequential declines. The consumer is standing alone with no aid from a supporting cast. Just net exports (combining imports and exports) provided any real help, which is surprising given all the yammering about a strong dollar and weak world economies.

While the data was disappointing it wasn't all that far off of the mark from what GDP Now was anticipating the night before the release. The biggest negative surprise relative to its 1.8% forecast (which was 2.3% the night before) was inventories, which subtracted an amazing 1.2% off of the GDP calculation. Without the large loss, GDP forecasts would have been a lot closer to predictions. In fact, most forecasters got it generally right. Great consumption growth, better net export data, and soft business investment were three trends that most forecasters got right. Government spending growth fell into decline again, which was a little surprising to us. Because of timing quirks and big bulges in some of the monthly housing data in the first quarter, residential investment made a rare subtraction from the GDP calculation. We suspect that housing will be back in the positive camp in the second half.

Poor Headline GDP Growth Mainly an Inventory Issue

Inventory data is always really tricky to estimate, and the second quarter was no exception. Inventories are subject to so many adjustments that we aren't really sure they tell us much (they are adjusted for prices, aligning company inventory policies with national accounts methodology and the usual seasonal factors). Interestingly, over the course of a full year, inventories usually net out so that they have virtually no impact on GDP, as can be seen in the last column below.

While we expect inventories to be modestly helpful in the second half, we are a bit concerned that they may not fully net to zero in 2016 as declining inventories seem to have turned into a trend, with inventories declining five quarters in a row.

Fluky Housing Data Hurt the Sequential GDP Data, Too

Housing was expected to hurt the GDP calculation and indeed it did. Most of the hurt came from single-family home construction data, which keys off housing starts data with a month or two of delay. (Broker commissions on existing homes and multifamily homes were positive contributors in the quarter.) Recall that despite relatively stable housing permits data, housing starts gapped up in February, likely aiding the first quarter at the expense of the second. That caused housing to subtract about 0.2% from GDP growth, compared with a more typical 0.3%-0.4% contribution. We suspect a return to those levels in the second half is quite possible.

Representing 70% of GDP, consumption is a key driver of GDP growth. Not only is it important from a calculation standpoint, but it also helps drive some of the other GDP categories. Consumption usually leads many other economic factors. Both year-over-year and sequential growth in consumption appear to be growing again, which should also help the rest of the economy in the second half.

GDP Trend Is Worrisome, Though Strong Consumption Data Is Reassuring

We generally focus on same-quarter-this-year to the same-quarter data a year ago to better see economic trends. Unfortunately, the slowing trend looks relatively clear. We think that inventories are likely the real culprit again, but still, the economy is not likely catching fire. The slowing GDP pattern also likely explains the recent softening in hiring. Certainly, this week’s GDP data will put even more focus on next week's employment report to see if the two reports confirm each other.

We are upping our second-half growth forecast to a very healthy 3.2% as we are expecting better housing numbers and a reduction in the inventory hit in the second half. We suspect with defense contractors talking of better results recently we suspect that government spending will move into the black in the second half, too. Though, with potential slower employment growth, consumption may not be the superstar that it was in the second quarter.

Despite upping our second-half forecast, we are still reducing our full-year growth forecast to 1.5%-2.0%. It’s mathematically difficult to get much higher than that given the rough first half and the fact that full-year 2015 growth was revised up to 2.6% from 2.4%, making the growth comparison much more challenging. We do note that our fourth-quarter over fourth-quarter forecast is still about 2.1%, in our normal range of 2.0%-2.5% growth.

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