Soft Patch

The US economy will expand by only 0.2% during the first quarter of 2015 according to GDPNow, an economic model published by the Federal Reserve Bank of Atlanta. The GDPNow model is revised after the release of every significant economic data point. At the end of January, it indicated that the economy would grow by 2.4% during the first quarter. Since then, however, the incoming economic data has been so consistently weak that the model now suggests the economy will barely grow at all. In other words, the United States has entered a new economic “soft patch”.

Job creation has been strong. In January 237,000 new jobs were created and, in February, 288,000 more. Almost all other incoming data has been disappointing. Average Hourly Earnings were only 1.5% higher in February 2015 vs. February 2014. Personal Spending fell by 0.2% in January and only managed to expand by 0.1% during February. Retail sales contracted by 0.8% in January and by a further 0.6% in February. Industrial production contracted by 0.3% in January and increased by only 0.1% in February. That sent Capacity Utilization down to 78.9% in February from 79.4% as it was initially reported for January. Durable Goods Orders rose 2% in January, but fell 1.4% in February; and fell during both months when excluding volatile transportation equipment.

Housing starts plunged 17% in February vs. January, leaving starts 3% lower than one year earlier. Exports were down 3.9% and imports were down 1.4% in January (the most recent data available) compared with one year earlier. Moreover, all of this weak first quarter data came on top of data for the fourth quarter that was not much better. US GDP expanded by just 2.2% during the fourth quarter of 2014. The Q4 GDP Deflator was only 0.1%. Had this been at the Fed’s inflation target of 2%, there would have been next to no real growth whatsoever.

There is no shortage of valid reasons that explain why the US economy is weakening again. The strong US dollar makes US produced goods less competitive in the global market. That accounts for the depressed industrial production. The collapse in oil prices has caused a falloff in new investment in the US energy sector. Globalization – and the relocation of factories to ultra low wage countries - continues to put downward pressure on US wages, deterring consumption.

Credit growth in the United States remains too weak to drive economic growth as it did in the past. The most recent data available shows total credit (adjusted for inflation, which was only 1.2%) increased by just 2.4% during the fourth quarter, whereas 5% to 6% credit growth would be required to return to the economic growth rates experienced during the decades leading up to the crisis of 2008. Economic weakness in the United States has put an end to US import growth, resulting in near recession conditions globally. And, as always, when the United States buys less from the rest of the world, the rest of the world buys less from the US. This and the strong dollar explain the slump in US exports.

And, last, but not least, QE 3 ended in October. Consequently, asset prices are no longer rising as quickly as before. During 2013, the Fed created $1 trillion through QE and the S&P 500 Index rose 30%. Last year, the Fed created $500 billion and the S&P rose 11%. This year, the Fed has not created any money through a QE program and the stock market is flat. The QE-induced Wealth Effect has been the main driver of US economic growth since this crisis began. Now that QE 3 has ended, much less “wealth” is being created and the economy is slowing again.

The sharp economic slowdown, in combination with the strong US dollar, is negatively impacting US corporate earnings, which not only fell during the full year in 2014 (for the first time since 2008), but which are also expected to contract further during both the first and second quarters of 2015. Equity valuations are already considerably stretched. Falling profits significantly increase the risk of a sharp stock market selloff.

Against such a weak economic backdrop, the Fed will find it very difficult to justify an interest rate hike this year. The currency markets have already priced in higher US interest rates. If the Fed fails to deliver, the dollar’s sharp appreciation during recent months may suddenly reverse. If economic conditions continue to deteriorate next quarter, speculation will begin to mount that QE 4 cannot be far away. That kind of reversal in expectations would cause violent upheavals across numerous asset classes.

So, keep an eye on the Atlanta Fed’s GDPNow model. If it continues to weaken, we may be in for a considerable amount of volatility – and excitement – during the weeks ahead.

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