Caution Lights Flashing For Now

The government reported today thatU.S.gross domestic product increased at a 1.3% annual rate in the first quarter, which is the weakest since the first quarter of 2003, following the recession of 2002. The report will be revised in each of the next two months, but it shows some worrisome trends. Home construction continued to decline and the trade deficit grew. Inflation gauges in the report surged to their highest since 1991. 

Business leaders, investors, and economists have consistently said that the slowdown will not lead to recession. They have pointed to the strength of the general economy beyond the weak housing sector and to the strong global economy. But today’s GDP report does not yet provide overwhelming evidence that the broad economy will avoid the contagion of the housing slump. 

Many of the measures in the report showed continued growth, but at slower rates. Real final sales of domestic product, which is GDP less the change in private inventories, increased at a 1.6% annual rate in the first quarter compared to 3.7% in the fourth quarter.U.S.exports fell by 1.2% and imports increased 2.3%. Inventory growth fell for the second quarter in a row. 

Business fixed investment rose at a 2% annual rate, after falling at a 3.1% rate from October through December. It includes spending on commercial construction, equipment, and software. Spending on new equipment and software increased 1.9% although computer hardware manufacturers have been downplaying expectations for the coming quarters. 

The Fed will likely not provide any help to the economy anytime soon. Today’s GDP report showed that a measure of inflation tied to consumer spending that eliminates food and energy costs rose at an annual rate of 2.2%, compared to 1.85% in the fourth quarter. Chairman Bernanke and other Fed governors have said that they prefer to see inflation in the range of 1% to 2%. 

Experts have said that they expect the economy to strengthen in the second half of the year as the housing slump eases and businesses regain confidence to begin re-investing in their growth. Momentum in the global economy is likely sufficient to continue for a few more quarters, but US exports will have to do much better than they did this past quarter to provide any meaningful support to the US economy. 

For now, it looks like the consumer holds the key to the economy’s future just as he has so many times before. Higher gasoline prices and the threat of declining house prices have not had slowed spending, but general inflation beyond food and energy could erode confidence and slow spending. We believe core inflation is not a threat so long as productivity remains healthy and will watch that trend carefully. 

Of greater concern is the threat that gasoline prices may rise considerably higher than anticipated over the next year or two. The World Economic Forum produced its report on Global Risks of 2007 which placed the threat of oil price shocks very high in both their impact on the global economy and in their likelihood. Price spikes in the recent past have demonstrated just how vulnerable prices are to physical and speculative shocks. Events that could trigger a shock are extensive, but a few include threats posed by a potential military strike on Iran’s nuclear facilities, America’s troop withdrawal from Iraq before the government is ready to protect that country’s oil production, Nigeria and other developing oil-rich states that struggle against well-organized insurgencies, and an upcoming hurricane season.

We are optimists at heart and believe that the global economy is resilient and adaptive. But we believe that current trends dictate a more defensive portfolio strategy and are taking steps to implement them. We will share more about the changes in coming Briefs. For now, have a good weekend.