The Commerce Department reported this morning that first quarter GDP declined at a 6.1% annual clip–a far bleaker number than the 4.9% drop expected by most economists. This unrevised number is almost as bad as the decline turned in by the U.S. economy in the fourth quarter of 2008 (-6.3% annualized). Under most circumstances, one might expect worse than expected economic news to negatively impact stocks–particularly in light of the strong rally equities have turned in off their early March lows. Aside from the negative surprise, this marks the first time that the domestic economy has contracted for three consecutive quarters since 1974-1975, a time heretofore regarded as the worst recession since the Great Depression.
The market seems to have taken solace in parsing the data contained in the grim 1Q09 report. A record drop in inventories accounted for 2.79% of the negative 6.1% quarterly number. Excluding inventories, the GDP drop would have been only 3.4%. The $103.7 billion plunge in inventories is actually good news as manufacturers and retailers are reducing their inventory of unsold goods to more manageable levels, which is a necessary prelude to any economic recovery.
Exports were a particularly ugly component of the GDP number. Exports turned in their biggest decline since 1969, dropping 30% which is on top of an already bad drop of 23.6% in last year’s fourth quarter. The first quarter also saw big declines in business and residential investment. However, a 2.2% up-tick in consumer spending (which comprises over two-thirds of economic activity) was welcome good news as consumer spending had fallen off a cliff in the prior quarter. Durable goods in particular showed strength, advancing 9.4%, breaking a streak of four consecutive quarterly declines.
Stock investors seem to be assuming that first quarter GDP numbers will be the low point for this recession. Inventory levels are now much more favorable and the effects of the government’s stimulus package–undetectable in this quarter’s GDP–will become much more pronounced. Going forward, the numbers should get much less bleak, although likely not positive for a few more quarters.
Thus, at midday, stocks continue in rally mode. Ockham would however urge caution, particularly in the financials. Coming quarters will see continued huge challenges for financial firms as they labor to rebuild devastated balance sheets. The pain in residential real estate seems fairly well priced-in to financial stock valuations, but continuing foreclosures and a massive overhang of inventory will inflict pain for some time to come. Furthermore, this year’s focus for ailing financials will likely be in commercial real estate and consumer loans. Troubles in commercial real estate could threaten the existence of some banks not deemed to big to fail.
Stocks have rallied dramatically from their nadir. There are small signs of economic improvement (such as the above-mentioned jump in consumer spending and pick up in last month’s consumer confidence number). Government continues to pump liquidity into the system. These factors all point to a stock rally based on expectations of a return to economic expansion and rising corporate profits. However, do not underestimate the damage that has been done and how much time and effort it will require to rebuild our economy. Also, the Administration’s aggressive push in so many various policy areas which impact future economic growth and looming tax increases in 2010 could impact the strength and sustainability of any recovery. Proceed with caution in buying stocks right now. Stick with dominant companies which pay attractive and safe dividends and avoid stocks who have appreciated enormously of late, largely based on favorable accounting changes and lots of hope.