Hard Evidence of a Soft Patch?


By Michael Englund The plunge in durable goods orders for March (see BW Online, 4/27/05, "Behind the Durable Goods Bummer") should have been viewed as a warning sign of weaker U.S. economic growth for the first quarter.

Indeed, that notion gained credence from the Apr. 28 release of the advance report on

gross domestic product (GDP) for the quarter. GDP rose 3.1%, well below economists' median forecast of a 3.5% increase. And the release contained another unpleasant surprise: The price index, the component of the report that measures inflation, surged 3.3% (median 2.6%), from 2.3% in the previous quarter.

SOFTWARE SURPRISE. The weak GDP figure, short of the 4% gain generally seen over the past seven quarters, supports the view that higher costs are contributing to what could turn into a widely feared "soft patch" in the U.S. economy. But will the first-quarter lull in GDP growth prove to be the full extent of the softness?

The first-quarter weakness was led by trade, which subtracted 1.5% percentage points from aggregate growth. Fixed-investment growth slowed to 5% in the first quarter, from more than 10% growth over the previous three quarters. The downside surprise for most economists came in fixed investment's equipment and software component, which moderated sharply in the first quarter to a growth rate of only 6.9%.

By comparison, U.S. consumers held up pretty well. Consumption posted only a modest slowdown: a 3.5% growth rate in the first quarter, from 4.2% in the fourth. Inventories added 1.2% percentage points to first-quarter growth. Inventories have recovered the hurricane shortfall of last year's third quarter, and the accumulation rate may now contract to a more sustainable clip in the second quarter of 2005.

JITTERS. Ironically, the mix of consumption figures, with weak durable goods spending but strength in nondurables and services, suggests that auto-sector frailty in the first quarter reflected this change in consumer spending, rather than a softening in the growth figures overall -- even though soft-patch fears actually started from early readings on consumer confidence.

Taking into account the new consumption data for the first quarter -- as well, perhaps, as the March monthly service consumption figures with the personal income report, set for release Apr. 29 -- economists may hesitate to pronounce much of a soft patch in household spending in the second quarter. Gasoline prices may have peaked in late March and early April, concentrating much of the effect on spending in the first quarter. Unless fuel prices resume their surge later in the second quarter, we may have already seen the soft patch from the consumer sector.

Still, soft patches have a way of taking on a life of their own, and this particular one resides in the business sector of the economy rather than in the consumer sector. Businesses may have grown jittery in February and March; wholesale oil prices soared, and executives feared that once the impact showed up at the gas pump, it would hurt their own cost structures as well as overall household spending. This pattern would fit in with durables data for the period, as the March report revealed a sharp moderation in equipment spending for that month and in February. The figures marked a reverse in the December-January period's surge.

BOEING BRIGHT SPOT. The key question is whether the weak business spending seen in February and March will persist into April and May. If shipments and orders of equipment and software bounce in April, it will kill the soft-patch theory. If orders and shipments are weak again, economists will scurry to calibrate the extent of the damage of surging oil prices on business confidence. Much is at stake, so investors should brace themselves for potential volatility around the May 25 durable goods report.

This report can bounce around a fair bit, but we should note aerospace giant Boeing's (BA) sizable backlog of reported orders, which have not materialized in the monthly durables report. That may indicate the brink of a significant bounce in the transportation sector in either April or May. Also, the capital goods figures have followed a zigzag within a robust double-digit growth clip throughout the two-year business investment boom, and the recent four monthly figures look like just another zig and zag to us.

In short, as economists absorb the first-quarter soft patch into their outlooks and review their second-quarter estimates, they may find the consumer unlikely to contribute too much of a slowdown in the current period. The equipment sector and inventories could emerge as the new source of weakness, especially if the next round of durables data is subpar. But that assessment will look quite suspect if we see a typical bounce in the durables data for April. Englund is chief economist for Action Economics


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