Tim Phillips, CEO – Phillips and Company
On Friday the BEA released US GDP numbers for the first quarter of this year. Unfortunately, GDP grew by only 2.2%, slower than last quarter’s growth of 3%. So the economy is slowing, but before we dig into the numbers it’s important to remember that GDP growth is not correlated to equity market returns.
When you compare the GDP numbers from this quarter to last quarter, the difference was the fact that the massive inventory rebuild we highlighted in the 4th quarter numbers did not continue into the 1st quarter of this year. It's also clear that the Government will continue to be a drag on GDP numbers. As you can see, the government sector continued to shrink for the sixth consecutive quarter.
With that said, there are still several positives:
- Consumer spending contributed 2 percentage points to first quarter growth, the most since 4th quarter of 2010
- Residential construction increased at 19.1%, the fastest in almost two years
- Cars sold last quarter at the fastest pace in four years
Going forward, the real challenge is to assess the likely outcomes in the next few quarters. We know that approximately 70% of our GDP is made up of consumption, and if we assume the consumer remains on track, that will provide a strong foundation for some moderate GDP growth. Working off that foundation, it’s also possible for companies to go through another inventory rebuild cycle this year. After all, companies are sitting on a tremendous amount of cash and can accelerate spending at any time.
Unfortunately, in the most likely scenario, we believe that companies will continue to be cautious in light of continued uncertain tax policy driven by the Affordable Care Act (ACA). Beginning in 2013, the ACA will increase the Hospital Insurance portion of the payroll tax from 2.9% to 3.8% for high income individuals.
To add further uncertainty around tax policy, you have the extension of the Bush Tax Cuts coming to an end this year, meaning personal taxes on income, interest and capital gains could go up for nearly all US taxpayers. If market participants start discounting both of these policy issues, we could see much more chop associated with this election. As you can see, there is a lot at stake when it comes to tax policy and this election. A recent study at the University of Iowa highlights how economic volatility increases during political campaigns. According to the study, “In general, more mature democracies saw increased market volatility in the six months prior to an election.”
All that being said, it's also likely that as we move into the 2nd half of earnings season, we will continue to see some more adjustments to earnings beating expectations, and corporate officers guiding revenue and earnings lower in the coming quarters. Although there will be growth, it likely won’t look as good as it did a few weeks ago when we started this earnings season. The earnings beat rate have come down to 65.6% from last week’s 72%.
So at the end of the day, the confirmation of a slowdown appears to be upon us, and it's clearly being reflected in the amount of volatility we are now experiencing in our equity markets.
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Tim Phillips, CEO – Phillips & Company