Ignore first-quarter GDP miss

Bottom line 

The Department of Commerce reported this week that U.S. GDP declined in the first quarter—the first time the economy has contracted in nearly two years. It fell 1.4%, a surprising miss and a far cry from the strong gain of 6.9% in last year’s fourth quarter. However, both numbers are unsustainable aberrations, in our view. The fourth-quarter 2021 surge was boosted by 5.32 percentage points from inventory restocking, while Q1’s slip largely is attributable to a soaring net trade deficit that deducted 3.2 percentage points. The Bloomberg consensus estimate was for 1% growth, while the Blue Chip consensus estimate was at 0.9%, the Atlanta Fed’s “GDPNow” model was at 1.1% and our estimate here at Federated Hermes was at 1.6%.

Private domestic final sales solid This metric is a much better indication of the economy’s underlying fundamental strength, because it excludes volatile net trade, inventory liquidation or restocking, and government spending, all of which detracted from Q1 growth. Sales actually rose 3.7%, a larger gain than the last two quarters of 2021—an 1.4% increase in Q3 and 2.6% in Q4—as the important personal consumption, corporate spending and housing categories all contributed.

Fed on track to hike aggressively We believe the Federal Reserve will ignore yesterday’s unexpected miss and raise the fed funds target range by a half point at its policy-setting meeting next week. That would be the first time in 22 years it moved rates by such a magnitude. The Fed likely also will formally announce the plans they discussed in the last FOMC meeting to shrink its bloated $9 trillion balance sheet by a third over the next three years. 

Equities on edge The S&P 500 plunged by more than 3% today, extending its decline from the beginning of the year to nearly 14%. Investors believe the Fed may follow next week’s half-point hike with a 75 basis-point hike at its next FOMC meeting on June 15 to combat the worst inflation in 40 years. The last time it jumped that high was in 1994. Further proof came just this morning as the employment cost index leapt 1.4% for the first quarter, the largest such increase in the 26-year history of this metric. 

No recession in sight Despite the first-quarter’s negative GDP growth print, we do not believe  the economy is on the verge of a recession, typically defined as two consecutive quarters of negative growth. There is simply too much monetary and fiscal stimulus in the pipeline to allow it. In keeping with the practice of the National Bureau of Economic Research, Federated Hermes’ macroeconomic policy committee measures the following four metrics to judge if the U.S. economy is in a sustained economic downturn:

• Employment
• Industrial production
• Real personal income less government transfer payments
• Manufacturing, wholesale and retail sales

Each of these indicators is in good shape at present, which suggests that the risk of recession in 2022 or 2023 is low.

Here are the details on the first-quarter GDP report:

Personal consumption (70% of GDP) rose a weaker-than-expected 2.7% in the first quarter (accounting for 1.83 percentage points of the gain in overall GDP), versus consensus expectations for a 3.5% increase. This compares with a 2.5% fourth-quarter gain. After a powerful 16% year-over-year gain in Christmas spending, which included a strong January due to record gift-card redemptions, consumers began to right-size their budgets during February and March, ahead of Easter spending. But the personal savings rate has plummeted from 26.6% in March 2021 to 6.2% in March 2022. People have less dry power to spend, especially with prices rising sharply. 

Corporate nonresidential capital spending leapt 9.2% in the first quarter versus a 2.9% gain in the fourth quarter (adding 1.17 percentage points). Structures declined for the fourth consecutive quarter and for the ninth time in the last 10, falling 0.9%. But equipment spending surged 15.3% in the first quarter versus a 2.8% fourth-quarter gain and intellectual property spending rose 8.1% in the first quarter versus an 8.9% fourth-quarter gain. 

Housing rose for the second consecutive quarter (reversing two consecutive negative quarters), rising 2.1% in the first quarter (adding 0.10 percentage points) versus a 2.2% fourth-quarter gain. After leaping to a 15-year high last year, the housing market has generally slowed as the inventory of both new and existing houses available for sale has plunged, prices and mortgage rates have risen sharply, and commodity and labor costs have soared. 

Net trade was by far the biggest loser this quarter, subtracting an outsized 3.2 percentage points. Exports fell 5.9% in the first quarter (subtracting 0.68 percentage points) versus a 22.4% fourth-quarter gain, as the relative strength in the dollar against the yen, pound and euro made our exports relatively more expensive. But imports rose for the seventh consecutive quarter, soaring 17.7% in the first quarter (subtracting 2.53 percentage points), compared with a 17.9% fourth-quarter increase, as the domestic demand for foreign goods accelerated with the strong dollar. 

Inventories rose for the second consecutive quarter, after three consecutive declines, increasing $158.7 billion in the first quarter on a chained-dollar basis, down from $193.2 billion in the fourth quarter. But this quarter-over-quarter decline in the pace of inventory restocking subtracted 0.84 percentage points from growth.

Government spending declined for the second consecutive quarter and for fifth time in the past seven quarters, falling 2.7% in the first quarter (subtracting 0.48 percentage points) compared with a like-sized 2.6% fourth-quarter decline. Federal defense spending declined for the fifth consecutive quarter by 8.5% (subtracting 0.33 percentage points). Given the uncertainty surrounding the Russia-Ukraine war, however, we expect more spending on defense.