More than meets the eye? Unpacking the first-quarter decline in U.S. GDP

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Sophie Antal-Gilbert, Head of AIS Portfolio & Business Consulting, discussed the U.S. GDP (gross domestic product) number from the first quarter. They also chatted about the surge in the U.S. employment-cost index and reviewed preliminary results from first-quarter earnings season.

U.S. Q1 GDP falls amid widening trade deficit

Gilbert noted that on 28 April, the U.S. Commerce Department reported that first-quarter GDP shrank by 1.4% on an annualised basis - a sharp reversal from the 6.9% growth rate charted during the fourth quarter of 2021. Ristuben characterised the number as clearly disappointing, but pointed out that U.S. markets actually rose the day the report was released. Why?

"There's more to GDP than just the headline number - and some of the underlying fundamentals in this report, such as consumer spending and economic demand, were actually quite strong," he stated, noting that consumer expenditures rose by 2.7%. However, Ristuben said that in this instance, heightened demand for goods and services was fulfilled by a surge in imports, rather than by domestic production. This led to an increase in the U.S. trade deficit, which was a negative to the GDP calculation, he explained.

In addition, Ristuben noted that the first quarter saw a run-down in private inventories, which was likely caused by ongoing supply-chain issues in the U.S. "This is one of these good news/bad news situations, as a decline in inventories is usually a hopeful sign for future economic growth prospects. This is because, as long as demand and spending remain high, companies will feel the need to rebuild their inventories - and that contributes to GDP growth," he stated.

All in all, the first-quarter GDP report was an interesting mix of a negative headline number and underlying data that showed strength in consumer spending, Ristuben remarked. "When considering the report as a whole, it's worth stressing that the consumer is king to the American economy, with consumer spending comprising nearly 70% of the nation's economic output," he stated.

U.S. employment-cost index rises at record pace

Turning to the latest news on the inflation front, Ristuben said the U.S. Labour Department reported on 29 April that its employment-cost index rose by 1.4% during the first quarter, making for the largest quarter-on-quarter increase on record.

"The acceleration in wage pressures has the full attention of the U.S. Federal Reserve (Fed) at this point," he said, noting that markets reacted to the number by dialling up expectations for a 75-basis-point (bps) rate hike - rather than a 50-bps-increase - at the central bank's 14-15 June meeting.

Ristuben added that beyond June, there's also a growing expectation that the pace of Fed rate hikes will slow. This isn't too surprising, he said, given that the Fed is probably targeting a cash rate of 2.0% to 2.25%. If the Fed does raise rates by 50 bps in May and 75 bps in June, that would take the federal funds rate to 1.5% - or more than halfway toward a target of 2.25%, he remarked.

How is Q1 earnings season shaping up?

With first-quarter U.S. earnings season well underway, Gilbert asked Ristuben if mounting wage pressures are factoring into the results. "They're not coming through in the headline numbers, but most S&P 500 companies are noting it in their reports," Ristuben answered, describing wage inflation as a force to be reckoned with. "One of the biggest challenges for businesses when it comes to inflation is that often times, companies can't raise prices by as much as they can raise wages - and I think this is being reflected a little bit in the first-quarter numbers," he explained.

Ristuben said that so far, with roughly half of all companies reporting results, year-over-year earnings growth for the first quarter is around 10%. In addition, slightly over 80% of reporting companies are beating earnings expectations, he observed.

However, performance has varied markedly by sector, with the energy sector outperforming by leaps and bounds, Ristuben noted. On the other hand, the utilities sector is struggling compared to expectations, with the consumer discretionary sector also disappointing. "Wage pressures are probably having an impact on profitability here," he remarked.

Ristuben noted that much of the market's attention has been focused on the tech sector, which so far has been the worst-performing sector relative to expectations, with companies like Amazon reporting a slowdown in growth. "I think we're seeing signs that some of the pandemic trade that overwhelmingly benefited tech companies might be coming off the boil," he stated. Ristuben closed by noting that he expects the theme of weaker tech performance to continue through the rest of 2022.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.