The US economy unexpectedly shrank 1.4% in Q1, a huge miss considering the markets expected ~1% growth. However, looking into the report, we see reasons to be optimistic that this will be a one-off rather than the start of an unexpected recession.
Most segments miss expectations, but strength in consumption and investment (in absolute terms) is encouraging
Most contributors to GDP disappointed versus consensus expectations (Figure 1).
Figure 1: Most segments missed versus expectations (vs +1% GDP consensus), but we expect a recovery1
However, in absolute terms consumption and business investment, the major cyclical economic drivers, were both significantly positive. So long as this remains the case, we believe a recession is highly unlikely.
In absolute terms, consumption rose 2.7%. This was positive but a notable slowdown relative to Q4 as leisure activity slowed, a result of the Omicron wave during the holidays and into January. However, there has clearly been a pick up in leisure activity since and airlines have recently reported strong numbers and guidance.
Business investment rose 9% (the only major segment in line with expectations), driven by the tech sector, particularly as intellectual property (IP) equipment sales rose and IP investment continued to be strong. Elsewhere, housing rose 2%, but this was a bit slower than expected, likely as bottlenecks capped construction activity.
Inventories and trade causes negative GDP print
Although segments outside of consumption and investment were undeniably disappointing, it has been rare for the main culprits this quarter – trade, inventories, and government spending – to cause US expansions or recessions.
Trade and inventories were a -4% drag on GDP, which has been rare. Notably, a similar decline did nonetheless occur in Q1 2021, which caused a headline GDP miss that was later recouped (with 2021 GDP still strong at 5.7%). These categories are very volatile and have tended to mean-revert (Figure 2).
Figure 2: Inventories and trade are volatile, potentially noise rather than signal2
Interestingly, business inventories actually rose by ~$159bn in Q1, but this was still counted as negative for GDP due to accounting policies (which reflect the fact that inventory growth was slower than the $193bn in Q4). In our view, this is not something to worry too much about.
On trade, exports fell 6% whereas imports rose 18%. This was exacerbated by rising food and energy prices (in nominal terms exports rose 11%). Energy prices were also a drag at home. Gasoline consumption contributed -0.3%, as the surge in crude oil prices likely caused consumers to reduce their driving when possible.
Elsewhere, government spending fell 2.7%. Federal spending fell 5.9% and with state spending down 0.8%. Notably, governments tend to operate under 12-month budgets, devaluing real spending as inflation accelerates. States and municipalities still have record cash holdings from the recent fiscal support packages.
If government spending, exports, and inventories, had been in line with expectations, overall GDP would have been in positive territory at 0.5%.
Disappointing, but not a game-changer
We believe investors need to watch consumption and business investment for signs of cyclical strength or weakness. While consumption will come under pressure from inflation, we expect business investment to hold firm. We also expect trade, government, and inventories to normalize.
We believe the Federal Reserve will take a similar view, meaning it is unlikely to impact its hiking trajectory due to growth concerns. Inflation will remain its focus. As a result, we expect a 50bp hike next week with Chair Powell and the Committee furthering their hawkish tone.