KEY DATA: GDP: 1.9%; Exports: -4.3%; Inflation: 2.1%/ Orders: -0.4%; Excluding Aircraft: +1%; Private Capital Spending: +0.8%/ Consumer Sentiment: +0.3 point
IN A NUTSHELL: “It was a tough year for the economy, but growth in the fourth quarter was not as soft as the headline indicates.”
WHAT IT MEANS: If ever there were a day when the headline numbers misrepresented what was going on in the economy, today was that day. Take overall economic growth, which posted a modest gain in the final quarter of the year. For all of 2016, GDP expanded at a disappointing 1.6% pace. The increase was 2.4% in 2014 and 2.6% in 2015. So why am I saying things are not that bad? As always, let’s go to the details. Consumers spent at a solid, though slightly slower pace in the fourth quarter. But I will take 2.5% every quarter. Business spending on equipment and intellectual property was up faster than in the third quarter. Companies are now rebuilding their inventories. Firms did cut back on investing in structures, but that is a notoriously volatile component. Also, the government, at least state and local governments, is now starting to spend more normally, even if spending on defense remains weak. The real problem with this report is that the economy suffered a “tofu attack”. Poor soybean crops in South America led to a huge surge in U.S. exports in the summer, but that rise was temporary. The fall in exports coupled with a jump in imports meant that instead of adding 0.85 percentage point, as it did in the third quarter, trade subtracted 1.7 percentage points of growth at the end of the year, a 2.55 percentage point swing. In addition, the key measure of private sector domestic activity, final sales to private domestic purchasers, grew faster. On the inflation front, consumer costs rose at the Fed’s target rate in the fourth quarter and over the year, the rise is now close to the Fed’s 2% goal.
Adding to the belief that the economy is in good shape was the December durable goods report. Yes, it declined, but let’s go to the details. The biggest drop was in defense aircraft. Not even a solid rise in civilian aircraft sales could overcome that decline. Excluding aircraft, order rose strongly. In addition, the best measure of private sector capital spending rose solidly for the third consecutive month. Even the energy sector is investing again. This report was strong and indicates the economy may have some momentum building.
Finally, The University of Michigan’s Consumer Sentiment index rose modestly in January after jumping in December. That the gain in confidence was sustained is good news for future consumer spending.
MARKETS AND FED POLICY IMPLICATIONS: The economy didn’t do particularly well last year, but we did end the year on a positive note. Consumers are spending, businesses are investing and the government is no longer blocking the way. With the energy sector, which had restrained growth significantly in the first half of the year turning around, even without any significant fiscal stimulus, growth should move back above 2% this year. That should be enough to cause the unemployment rate to drop below full employment by the end of the year and continue the upward trend in both wage and price inflation. That implies the Fed will likely have to raise rates multiple times this year and I expect an increase of 100 basis points. How those longer-term trends play with equity investors is unclear, but if they read today’s data as weak, that would be a misinterpretation of the numbers.