GDP Shocker Econoday Simply Economics 7/28/00 By Evelina M. Tainer, Chief Economist

GDP hammers stocks
Stock prices are all about roller coaster rides. The most recent ride hit a peak on July 17. At that point, the NASDAQ composite index stood at its highest level since March 31; the Russell 2000 was at its highest level since March 29; the S&P 500 stood at its highest level since April 7 and the Dow Jones Industrials were at their strongest since May 16.

In the past two weeks stock prices have tumbled dramatically enough that the Russell 2000 index of small capitalization stocks dived below its December 31 average on Thursday, July 27, for the first time since June 1. The other three indices (S&P 500, DJIA, NASDAQ composite) were also below year-end levels, but that's almost normal for these stock index measures in the past several months.

Investors continued to shift between economic fundamentals and earnings reports this past week in determining the direction of the equity market. The NASDAQ composite took the largest hit given that many of the unfavorable earnings reports were from tech firms. While the second quarter GDP figures caused equity investors to once again anticipate a potential rate hike by the Federal Reserve at the August FOMC meeting, the stronger GDP growth also corresponds with high corporate profits,which of course is favorable for stocks.

GDP whacks bond prices; plunging equities lift them back up
In the first half of the week, yields on Treasury securities barely budged. It was a tight range on a daily basis and the markets generally closed unchanged for several of the maturities. Surprisingly, bond markets rallied on Thursday despite the fact that durable goods orders surged 10 percent. Instead, bond investors focused on the 1 percent, as expected, hike in the quarterly employment cost index.

The bullish sentiment changed quite rapidly on the Commerce Department's advance estimate of second quarter GDP - which rose nearly 2 percentage points above expectations. The markets weren't quite sure how to read the news, though. While GDP growth zoomed ahead, the bulk of the activity was concentrated in productivity-enhancing capital expenditures. Consumer spending indeed moderated as Greenspan had hinted earlier in the week. But after all was said and done, bond investors realized that this would once again spark a debate at the FOMC table on the benefits (costs) of raising the federal funds rate target one more time.

The bearish sentiment was somewhat mollified during the course of the day Friday, when equity prices tumbled and flight to safety boosted Treasury prices (and lowered yields). As a result, the Friday close for the Treasury curve was not all that different from a week ago.

Don't be surprised if the volatility continues in the next three weeks as market players go back and forth on the issue of the potential Fed rate hike. Indeed, it really is a question mark with a 50/50 chance.

GDP: the slowdown that never was
The Commerce Department's advance estimate shows that real GDP expanded at a robust 5.2 percent rate in the April to June period, following a downwardly revised gain of 4.8 percent in the first quarter. At the same time, real final sales grew at a 4.2 percent rate, down from the 6.7 percent rate posted in the first three months of the year. Wow! Economists had predicted that real GDP would grow significantly slower than in the first quarter. An acceleration of inventory building did contribute to economic activity in the second quarter, but even the rise in final sales was much stronger than economists and market participants were expecting. What happened? One might consider that it is more difficult to predict GDP for the second quarter because the Commerce Department always revises the historical National Income and Product Accounts at this time. Changes in seasonal adjustment or new data sources lead to the re-writing of history. This time, though, the revisions to the accounts were relatively minor. Quarterly patterns may have been changed modestly, but the annual growth for the past several years remains at a 3.7 percent average rate.

In the second quarter, personal consumption expenditures increased at a relatively modest 3 percent pace. This would normally be considered a pretty good growth rate, but consider that consumption spending surged at a 7.6 percent rate in the first three months of 2000, and averaged a 5.5 percent rate in the second half of 1999. Spending on durable goods actually declined (this reflects mostly a drop in motor vehicle sales); and expenditures on services and durable goods grew more slowly than last quarter.

Housing starts have come down from their peak in the past several months. Yet spending on residential investment still grew at a 3.9 percent rate in the second quarter after gaining at a 3.2 percent pace in the first. The two-quarter growth is an acceleration from the second half of 1999 when this sector declined.

Investment spending on capital equipment and structures surged at a whopping 19.1 percent rate after expanding at a 21 percent rate in the first quarter! Gains were concentrated on equipment and software in both quarters, but spending on structures was pretty strong as well. The healthy growth in capital spending is generally viewed as favorable - even when policymakers might prefer to see slower consumer demand - because increased expenditures in capital goods increase the productive capacity of the nation. In turn, this reduces capacity pressures (and supply shortages) and also can improve worker productivity.

Inventory investment increased in the second quarter. This is an interesting development after a much slower pace of inventory building in the first three months of the year. It is never certain in the near term whether inventory building is planned or not. If it is unplanned, the larger stock of unsold goods may suggest a moderation in production (to work down supplies). However, it is possible that producers desired the increased stockpiling. We will get a better sense of this development in the coming months as we see how retail sales fare going forward.

Net exports were a major drag on economic growth in the second quarter as import growth once again outpaced export demand. Given the torrid economic pace, it may have been comforting to see that foreign goods and services can help satisfy consumer and business demand here.

The GDP deflator increased at a 2.5 percent rate in the second quarter, down from the 3.3 percent gain posted in the January to March period. In both cases, higher energy prices played a major role in boosting the index. Prices for consumer durable goods continued their long-term decline. In the first half of 2000, the price deflator for equipment and software was positive, increasing less than one percent, but still a turnaround from the rapid declines of the past several years. This is bad news that won't go unnoticed by Fed officials.

The bottom-line on economic growth?Economists, stock & bond investors, and government policymakers were all looking for slower economic growth in the second quarter. Surprisingly, economic activity accelerated in the second quarter with healthy growth in investment spending on equipment, structures and inventories. For the most part, this is "good" growth that isn't likely to tax economic resources and might alleviate some of the concerns on the minds of Fed officials. Consumer demand did moderate during the quarter. Nevertheless, Fed officials will have to be worried about the pace of economic activity. Supposedly, they are less worried about growth when inflation is kept in check. The GDP deflator did moderate from the previous quarter, but the trend in the past four quarters is decidedly higher than it was a couple of years ago. The GDP report is likely to put a potential rate hike back on the table for the August meeting.

ECI doesn't disappoint
The employment cost index rose 1 percent in the second quarter, less than the first quarter's 1.4 percent hike. Despite the lower quarterly gain, the index was up 4.4 percent from a year earlier, a tick higher than last quarter's 4.3 percent year-over-year rise. Given that the figures were in line with expectations, market players were reassured by the softer second quarter pace. However, the chart below shows that sharp annual increases in benefit costs are boosting this total compensation measure. The year-over-year rise in the ECI is now at its highest rate since 1991!

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Wages and salaries, the larger portion of this index, have stabilized in the past quarter at 4 percent, a rate last reached in the third quarter of 1998. Benefit costs are mostly hit by rising health care insurance costs.

This quarter was the first time the Labor Department included costs of hiring and referral bonuses. As it turns out, the impact was quite minimal. According to the Bureau of Labor Statistics that compiles the data, about 85 percent of workers do not have access to these bonuses, punching holes in talk that the employment cost index underestimated true compensation. This means that the ECI is probably doing a pretty good job of tracking wage costs.

The employment cost index moderated on a quarterly basis, but the yearly gain still should be disconcerting to Fed officials. To some extent, productivity growth can offset at least a good portion of the rise in the employment cost index. The questions, though, remain: will productivity growth continue unabated and will compensation costs moderate in coming months? The jury is still out whether the Fed will raise rates or not at the August FOMC meeting, at least based on these figures.

Durable goods orders surge
New orders for manufacturers' durable goods jumped 10 percent in June after a pretty healthy 7 percent gain in May, taking market players and economists totally by surprise. The bulk of the new orders could be attributed to defense where new orders nearly tripled in June! But even excluding defense, new orders rose a respectable 3.9 percent on top of a 6.4 percent increase in May. Private aircraft orders also contributed to the rise. But a quick rundown of the major components -- primary metals, industrial machinery & equipment, electronic components and transportation -- reveal increases across the board.

The chart above depicts the annualized quarterly change in total durable goods orders and nondefense capital goods orders. Notice the accelerating trend in both series over the past couple of quarters. Even though some of the nondefense capital goods orders can be attributed to a surge in aircraft orders in the recent period, it nonetheless points to healthy production activity over the next few months.

THE BOTTOM LINE
This week's set of news was a mixed bag of tricks for market players, economists and government policymakers. Second quarter GDP was much stronger than anyone had predicted and although the bulk of the growth came from productivity-enhancing capital spending, it nonetheless reflects healthy aggregate demand. Consumer spending did slow in the second quarter, but existing home sales jumped in May and June in contrast to expectations. This could portend another round of increased spending on furniture and appliances in coming months. It is something Fed officials will certainly monitor. Moreover, durable goods orders surged in June and boosted quarterly figures way above the previous two quarters. This means rising production in coming months.

On the inflation front, the employment cost index was in line with expectations. Market players didn't pay too much attention to the fact that the year-over-year growth in this compensation measure is a full percentage point higher in the first half of 2000 relative to 1999. This may cause some concern among Fed officials. The GDP deflator, though, moderated in the second quarter, after jumping more dramatically in the first three months of the year.

Alan Greenspan testified before the Housing Banking Committee in the most recent week. He didn't really add anything new to remarks he had made in the previous week. Even Congressional leaders commented favorably on the fact that Greenspan didn't make any "market moving comments" during the session. The GDP and durable goods figures have to worry Fed officials and are likely to put back on the table a potential rate hike at the August meeting.

Looking Ahead: Week of July 31 to August
Market News International compiles this market consensus which surveys about 20 economists each week.

Monday
The Chicago purchasing managers' index is expected to decrease modestly to 55.7 in July from June's level of 56.8. This still represents a pretty good level of manufacturing activity in the Chicago area. Investors will also closely follow the prices paid index. It had edged down to 63.6 in June from May's level of 64.4. Some economists are predicting another drop in July. The Chicago purchasing managers' index is considered a leading indicator of the NAPM survey since the distribution of manufacturing in this region mirrors the nation. (Forecast range: 54.1 to 56.0)

Tuesday
Personal income should rise 0.4 percent in June matching the moderate gain posted in May. Increases in the hours worked and average hourly earnings should help to boost wages and salaries, the lion's share of personal income. (Forecast range: 0.3 to 0.6 percent) Personal consumption expenditures are expected to increase 0.4 percent June, twice as fast as the gains of the previous two months. This incorporates the better-than-expected gains for retail sales. (Forecast range: 0.3 to 0.5 percent)

The consensus shows that the NAPM Survey is expected to rise to 52.4 in July from June's level of 51.8 percent. Any level above 50 percent signals continued growth in the manufacturing sector. (Forecast range: 50 to 54) Economists who predict the prices paid component of this index are looking for some downward movement in prices as well, given a slight drop-off in energy prices. In June, the prices paid index stood at 61.2.

Construction spending is predicted to remain unchanged in June after inching up 0.1 percent in May. This reflects the lower level of housing starts in the past several months. This tends to be more of a lagging indicator and is less closely followed by market players. (Forecast range: +0.4 percent to -1.5 percent.)

Wednesday
The Conference Board's index of leading indicators is expected to remain unchanged in June, after a dip in May. While this index is not predicting an economic recession, it could be signaling a slowdown. (Forecast range: -0.1 to +0.2 percent)

The consensus shows a 0.6 percent rise in new home sales in June to an 880,000 unit rate. If this forecast were realized, it would represent a modest gain after two monthly declines. Existing home sales rose 2.8 percent in June, and the two series often move in the same direction during the month. (Forecast range: 860,000 to 900,000)

Economists are predicting auto sales ran at a 6.8 million unit rate in July, on par with June's selling pace. (Forecast range: 6.6 to 7.0 million) At the same time, truck sales are also predicted to come in at a 7.3 million unit rate in July, the same as in June. It does appear that auto sales are dampened by higher borrowing costs as sales have come down relatively sharply from the February peak. (Forecast range: 7.0 to 7.5 million)

Thursday
Market participants are expecting new jobless claims to rise 18,000 in the week ended July 29 from last week's 272,000 level. Claims are likely to be rather volatile in the next several weeks since summer factory shutdown schedules are not exact from year to year. (Forecast range: +5,000 to +25,000)

Market players are looking for factory orders to jump 5.5 percent in June following May's 4.1 percent spurt. Given the sharp jump in May, the June figure represents pretty strong activity for factory orders and incorporates the 10 percent spurt in durable goods. (Forecast range: +4.0 percent to +6.2 percent)

Friday
The consensus forecast is looking for a 75,000 gain in July nonfarm payroll employment. This incorporates a drop in temporary Census workers. Excluding Census workers, the market consensus predicts a 250,000 gain in payrolls. Hourly earnings are expected to rise 0.3 percent and the unemployment rate is expected to remain unchanged at 4 percent in July. Economists are predicting the workweek will remain unchanged at 34.5 hours.