The initial first-quarter GDP reported was greeted with a great amount of fanfare, despite a terrible headline number. Though the economy contracted at a 6.1% pace - marking the first time we have booked back to back quarters of down 6% or more since the end of WWII - some of the details in the report showed reasons for optimism.
As an investor, I realize that you are less concerned with the details that economists seemingly over-analyze and more concerned with what the report means to your portfolio. So, today, I'm going to show you where some of the investment opportunities and risks lie in the current environment.
Consumers Opened Their Wallets
The biggest positive surprise in the report was that Personal Consumption Expenditures ("PCE") actually contributed 1.50 points to GDP.
Clearly, in the first quarter, consumers took advantage of discounted prices. The much higher than expected PCE is part of the reason that the retailers and restaurants have been earning so much more than was expected. Almost every retailer and restaurant in the S&P 500 that has reported so far has come in with higher than expected earnings. Given the need to rebuild savings and the mounting levels of unemployment, I am skeptical that the strong PCE levels can be sustained.
Inventory Levels Plunged
On a forward-looking basis, perhaps the best part of the GDP report was that inventory investment subtracted 2.79 points from growth (versus -0.11 in Q4). Large inventory draw downs in one quarter have a tendency to be reversed in the next quarter. When the shelves are bare, people start to order more to restock them, causing output to rebound.
The destocking of inventories has contributed to the cash flow of the retailers, but the restocking will reverse that. On the other hand, restocking the shelves will increase orders for manufacturers, both here and abroad. The report is not detailed enough to say where exactly the biggest inventory draw downs were, so it does not give that much guidance as to which manufacturers might benefit the most from the restocking.
A Bad Trend for Equipment Makers and Software Developers
Essentially all investment in the real economy, both fixed and inventory, residential and non-residential, came to a screeching halt in the quarter. While ugly contributions from inventories are a good thing, the same cannot be said about fixed investments. There bad is bad, and this was real bad.
Fixed investments, particularly non-residential fixed investment is what drives increases in the productive capacity of the economy (along with investments in education which is counted as part of PCE and state & local spending). In other words, it is the engine of future growth, not just a part of the current growth. The stunning declines in all forms of fixed investment mean that businesses are in effect eating their seed corn. However, given the huge amount of idle capacity in the economy right now, it is easy to understand why businesses are cutting back.
Until we see a large rebound in capacity utilization, it is unlikely that businesses will start to spend more for equipment and software. Capacity utilization is at a post WWII low, and is below 70% for the first time since it has been tracked. As a general rule of thumb, 80% is normal, 85% is a boom and 75% is a nasty recession.
