Prior to the release of US second quarter GDP on 31 July, the market had a consensus estimate of 3 per cent annualized growth for the quarter.

 

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Published on: Tuesday, August 05, 2014

by Michael Knox

Prior to the release of US second quarter GDP on 31 July, the market had a consensus estimate of 3 per cent annualized growth for the quarter. This was up from the 2.9 per cent annualized decline in output seen in the first quarter. Our own estimate for second quarter GDP was for a better than anticipated 3.8 per cent annualized. The actual number was better than our estimate and far better than the consensus.

US GDP for the second quarter came in at 4 per cent annualized. The previous quarter was revised upwards to a decline of 2.1 per cent. This is an amazing turnaround of 6.1 per cent annualized in the US growth rate in only one quarter. Pretty much every part of the US economy improved with a possible exception of Federal non-Defence spending.

Personal consumption expenditures improved from 1.2 per cent annualised growth in the first quarter to 2.5 per cent annualized growth in the second quarter. Still, the really big turnaround was in investment. Gross fixed domestic investment, which had fallen by 6.9 per cent annualized in the first quarter, grew by an amazing 17 per cent annualised in the second quarter. This is not just short term good news. If you want an economy to have sustained recovery, what you need is recovery in private investment. Increases in private investment generate increases in employment. Increases in employment then generate increases in demand.

The areas of recovery in investment were pretty much everywhere. Non-residential investment increased from a 1.6 per cent annualized growth in the first quarter to 5.5 per cent annualized growth in the second quarter. Investment in non-residential structures increased form 2.9 per cent annualized in the first quarter to 5.3 per cent annualized in the second quarter. Investment in equipment (including computers) which had declined at a 1 per cent annualized rate in the first quarter rose by a healthy 7 per cent in the second quarter.

The recovery in residential investment was even better. We remember how bad the weather was in the US in the first quarter. Bad weather meant that it was very difficult to build houses. The result was that residential investment fell by 5.3 per cent annualized in the first quarter. Better weather in the second quarter meant a recovery in activity. Residential investment accelerated at 7.5 per cent annualized in the second quarter.

In dollar terms, the economy grew by 6 per cent annualized in Q2. This provides a healthy outlook for US earnings growth.

What strong growth means for markets

In our Economic Strategy of 23 July 2014, we argued that the S&P500 had moved into moderately overvalued territory. We suggested that there was two out of three chance of a bull market correction in the S&P500 in the third quarter. In an interview on the Switzer program on Monday 28 July, we suggested that that correction could be provoked by a higher than anticipated GDP number.

A higher than anticipated GDP number would lead market participants to adjust their expectations of when the Fed would begin to raise interest rates. The market believes that the Fed will not put up interest rates until the third quarter of 2015. Stronger growth could mean that they will start putting up interest rates earlier. The prospect of rising interest rates, together with the end of QE in October this year takes away much of the support which has sustained rises in momentum stocks in the US. It is the rise in these momentum stocks which has taken the S&P500 into overvalued territory.

The release of the GDP number has been immediately followed by a selloff in the S&P500 of some 39.4 points. Our view is that this is just the beginning of a bull market correction which will continue over the period to end September. This could take the S&P500 down towards our model estimate of 1827 points.

Currency

Of course the expectation of rising interest rates in the US is positive for the $US. This is especially true when European interest rates will be “low or lower”. The days immediately before the release of the GDP number saw a strengthening of the $US index and a general weakening in major currencies against the $US such as the Euro and Sterling. Even the $A sold off to its lowest level in two months in the hours immediately following the GDP release. We believe that this is the beginning of the trend to a stronger $US which should continue through to the end of the year.

Conclusion

US second quarter GDP came in at a better than anticipated 4 per cent annualized growth. This higher growth was driven by a higher private investment. This is good news for the US economy and good news for the $US.

However it suggests that the era of easy money may be coming to an end. This realization has generated a pause in the upward path of US equities.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Watch more from Peter on SWITZER TV.

 


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