Yes, but where’s the GDP?

Friday’s report of 3.2% annualized growth in US GDP during the 1st quarter of 2019 is the strangest on record. The most important components of GDP – personal consumption, business fixed investment and residential investment – were among the weakest in years.

This explains why bond yields fell after the report, and why the money market continues to price in a Federal Reserve rate cut for later this year. The market is forecasting a weak economy, although the Commerce Department statisticians are measuring a strong one. So are the purchasing managers’ surveys, as I reported April 23. Most of the discrepancy lies in the mysteries of measurement of economic growth.

As the chart above shows, growth in personal consumption contributed just 1.2 percentage points to GDP growth, a disappointing result in light of continuing strong employment growth. Residential investment was negative despite very low mortgage rates, and business investment excluding intellectual property was flat. I’ll get back to that issue later.

Four components of GDP accounted for 2.5 percentage points of the 3.2% headline number.

Inventories, net exports, state and local government expenditures and intellectual property were the big contributors. Inventories are a volatile and notoriously inaccurate measure, and a rise in inventories may reflect falling sales.

Net exports may have risen due to weak consumer demand (and the reported number is an estimate based on the first two months of the year).

A rise in state and local government spending is likely temporary. And “intellectual property” is a category that was not counted in GDP until recently. Most of the reported IP investment was in software (0.24 percentage points of GDP versus a total IP investment of 0.39 percentage points).

Not counting inventories, net exports and the state and local component, GDP growth was just 1.3%. Without intellectual property it was only 0.72%.

Of course, it’s possible that the United States is turning into a services economy running on software and little else. That would be an odd result considering the Trump Administration’s determination to revive America’s industrial economy. The Fed’s manufacturing index is barely 1% over its March 2018 level, and orders for nondefense capital goods excluding aircraft are flat year-on-year in real terms.

All the investment components of GDP were negative or around zero growth for the first quarter, except for intellectual property.

I suppose it is possible that Facebook, Google, Microsoft, Amazon and Netflix are investing so much in software that it outweighs the investment bust throughout the industrial economy. It’s also possible that the boom in small business that accounts for most of the hiring has created demand for sales management software and spreadsheets.

But there is no question that the US economy is short of physical investment. Shale producers are trucking their product to port because pipeline capacity is strained. All in all, this can’t be a satisfactory result.

All of this helps explain why the bond market expects weak growth. The yield curve (the difference between 10-year and 2-year Treasury notes) is flat, which means investors are willing to take the risk of buying more rate-sensitive, longer-maturity bonds in order to lock in yields that might go even lower.

The chart above shows the yield curve over the past forty years. The areas shaded in grey are recessions. A flat yield curve doesn’t necessarily imply a recession, but it surely implies a weak growth outlook.

There are too many wild cards in the economic outlook to make a forecast with any degree of precision. The China trade war postponed investment decisions as CEO’s weigh the risks to global supply chains. Consumer spending has failed to keep up with employment gains, possibly because Americans worry about the future employment outlook.

Judging from the details of the first quarter GDP report the underlying growth rate is somewhere below 2%, and that is the likeliest outcome for 2019 as a whole.