The final Q4 GDP revision ended up showing 2.9% growth which was up 0.4% from the prior revision. The consumer was at the heart of the growth as consumer spending grew 4% which was up from the prior report which showed 3.8% growth. The non-durable spending growth was increased from 4.3% to 4.8%. The durable spending was revised down from 13.8% to 13.7%. This huge growth came from the rebuilding efforts after the hurricanes. There was a big boost in spending on autos which needed to be replaced after they were destroyed from the flooding.
Total vehicle sales went from 16.4 million in August to 18.9 million in September. You can see the sales were pushed forward after the hurricanes because the sales were 17.4 million in February. It appeared the auto sales were peaking before the hurricane. At best, sales are at a plateau. The overall GDP growth was stronger than the 2.9% headline implies because the results were hindered by the trade balance and weakness in inventory growth. Without those factors, GDP growth would have been 4.5%. There was certainly a post-hurricane bounce, but no, destruction doesn’t help the economy.
Q1 Estimates Are Falling
On the bright side, Q1 will be helped by the tax cuts, but on the other hand it will deal with the hang over effect that comes from the demand pulled from it into Q4. The tax cuts and the expectation that temporary growth in Q4 would continue might have caused the quarter’s estimates to be overzealous to start the year. The worst change on Wall Street is when estimates are revised down. That’s why firms try to under promise and over deliver. The blue chip estimate for Q1 growth has fallen from 2.7% in early February to 2.2% as of mid-March. It appears January was a decent month for the economy, but February saw some weakness.
Explanation Of The Atlanta Fed Model
The Atlanta Fed’s GDP Now estimate is often misinterpreted, so we’ll give a brief explanation before we get into the details of what it means for the economy. The GDP Now is a model which is more accurate as more data comes in. The model is virtually useless at the beginning of the quarter because there’s sparse economic data which is mostly surveys. The survey data always comes out before the hard reports.
The Atlanta Fed model has started off strong for many quarters in the past couple years because the soft data has been so strong, while the actual economy has been decent. The ISM reports specifically have caused the GDP Now model to have a ridiculous growth rate forecast. In Q1’s case it was 5.4%. Bearish investors are making a phony argument by stating hopes have been dashed because anyone who understands the model realizes it only makes sense to review it near the end of the quarter.
Weak Hard Data Reports Coming In February
With that caveat in place, the estimates have certainly been coming down in the past few weeks because of the recent poor data. The Atlanta Fed’s estimate was at 1.8% before it increased to 2.4% based on improved expectations for inventories. If inventories boost Q1 GDP, that will be a temporary help which will quickly wane because demand isn’t there to take care of the excess products. More recently, it increased to 2.8% on a strong construction report and a great ISM manufacturing report. The ISM reports have been pushing GDP estimates up for the past year while actual results pull them down. To be clear, the Atlanta Fed’s estimate is one of 3 regional Fed models. The NY Fed’s model is at 2.71% and the St. Louis Fed’s model is at an extremely optimistic 3.61%. Both have fallen recently. The advanced report for Q1 GDP comes April 27th.
As we mentioned, there has been periods in the past couple years where the soft data was extremely strong. After Trump’s election, businesses were euphoric because they were expecting regulation cuts and tax cuts. Any estimate for economic growth in 2017 which was based on surveys was too high. It’s great for businesses to be optimistic, but growth was probably limited by structural issues such as an aging population. We recently discussed whether record business optimism should be used as a contrarian indicator?
Also, a true transformation of the economy to become freer would include net regulation cuts and spending cuts. Instead we saw slowing regulation growth and increased spending. The debt to GDP ratio fell slightly, but that’s not good enough for a late cycle economy with near full employment. The chart below shows the recent hard data has been weakening. Keep in mind, the declining index in March implies a weak February as the March data isn’t out yet.
Earnings Revisions Done Moving Up
The goal of this discussion on the economy is to determine where markets will move. Equity bulls acknowledge the headline risk and some of the weak data, but they believe Q1 earnings in the spring will turn the stock market around. However, investors shouldn’t rely on the expectations for double digit year over year earnings growth. That’s already priced in; earnings need to beat estimates by more than usual to push equities higher. An alternative viewpoint to saying the expected earnings growth will push stocks up is to say they have prevented the correction from getting worse. In that case, the earnings won’t push stocks up, but they are acting as a counterbalance to the negativity. There has been a sentiment shift in the market as it has gone from euphoria to balanced.
The chart below shows the earning revision ratio is falling because the tax cuts are already in the estimates. The one month earnings revision ratio fell from 2.52 to 1.36. It’s not surprising to see the positivity not being sustained. The key question is how much the S&P 500 bottom up earnings estimates fall in the next 12 months. Economic growth is one driver of this change, so weak growth does matter for stocks.
To be clear, we aren’t saying stocks won’t move up. They can move up if the economic growth improves, if the Fed becomes more dovish, or if there is positive news in the negotiations for trade deals. It’s foolhardy to say stocks will rally on what is already known. That’s not an edge. An edge would be a thesis on why you think earnings will beat expectations by more than average. The earnings season will be important as we will find out if the analysts’ estimates, which were revised much higher earlier this year, are correct.
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