Economic Activity was Punk, Wages Creep Higher

The US economy in Q1 grew by .7% q/o/q annualized which was below the estimate of 1%. Higher inflation took some wind out of the real print as the price deflator rose 2.3%, 3 tenths more than expected and matches the quickest pace of gain since September 2012. The core inflation rate was up 2% as expected. Looking at GDP on a y/o/y basis saw it higher by 1.9%. Within GDP, the biggest component was up just .3%, 6 tenths less than expected as spending on durable goods fell 2.5% driven by a decline in auto sales while spending on services was higher by just .4% with healthcare spending mostly driving that. Investment spending added 7 tenths to growth led by equipment spending and residential real estate. Spending on structures (commercial real estate, fixed assets such as oil rigs etc…) also added 6 tenths. Capital spending on intellectual property was little changed. Net trade added nothing as exports grew at a similar pace as imports while government spending was a headwind of 3 tenths with a drag from defense spending and state and local government spending. Inventories were a big drag on growth as it subtracted almost 100 bps from the headline print. Taking out this effect and looking at Real Final Sales saw growth up by 1.6% bringing the 4 quarter run rate to 2%. Final sales to private domestic purchases was higher by 2.2% which was the slowest in a year.

Bottom line, Q1 economic activity was punk as expected and there is a possibility it may get revised even lower because the retail sales component was using old news. On Wednesday there were downward revisions to retail sales for the quarter but didn’t show up in today’s calculation. It will though in the next revision. The 4 quarter run rate in GDP is averaging 1.9% with nominal GDP at 3.9%. Let’s be honest, we are in the 9^th year of an economic expansion that has pulled forward a lot of activity, particularly on the consumer spending side and especially in auto’s. On the investment side, capacity utilization is still well below its long term average and we know productivity growth is lame. It is also tougher to find qualified employees at this stage of the cycle and that itself makes it tougher to grow. The US economy certainly needs a kick in the ass and regulatory and tax relief will certainly give it but still has to deal with the economic reality just stated. Also, it runs up against a tightening of monetary policy and a rise in the cost of capital for many, especially LIBOR based borrowers.

The employment cost index for Q1 rose .8% q/o/q, two tenths more than forecasted. This brings the y/o/y gain to 2.4% which is the best in two years. Specifically, private sector wages and salaries were up by 2.6% y/o/y which matches a two year high. Bottom line, the ever elusive evidence of rising wages might finally be peaking its head above water. Anecdotally, in last week’s Fed Beige Book we saw every single one of the 12 regional districts reported areas where good employees couldn’t be found and we are already seeing labor getting a greater share of the profit pie that we believe will continue. It will be great for wage earners and a headwind to corporate profit margins if companies can’t offset it with price increases. We can debate all day whether we are at full employment or not but the reality is the supply of qualified labor is thin and even unskilled workers are in short supply. Again, this puts the Fed well behind the eight ball and raising rates at the exact wrong time in the economic cycle.