ECONOMIC UPDATE

  • High economic optimism and accommodative monetary and fiscal policy continue to boost risk appetite in U.S. financial markets
  • The first estimate of Q1 GDP showed 6.4% growth, leaving the U.S. economy less than 1% below Q4 2019 levels in real GDP terms
  • The inflation debate persisted in April as several companies announced price increases due to higher input costs, while the Fed remains firm in its belief that any near-term price increases will be transitory

Risk appetite continues to grow in U.S. financial markets, fueled by frothy economic optimism and a Fed with its foot still firmly pressed down on the accelerator. The S&P 500 generated a 5.33% return in April, bringing the year-to-date figure up to 11.8%, and credit spreads for corporate, municipal, and consumer credit finished the month tighter. The trajectory of the economic recovery has been impressive, and last week, we received the first estimate of Q1 GDP. The U.S. economy is now less than 1% from Q4 2019 levels in real dollar terms following a 6.4% growth rate (q/q annualized).  Exhibit 1 illustrates the dramatic rebound over the last year as well as projected growth over the next four quarters, which shows GDP blowing through pre-COVID levels in the current quarter.

Consumer spending was a major driver of first quarter growth, rising 10.7% q/q and powered in large part by two rounds of fiscal stimulus. A decline in inventories, largely attributed to supply chain troubles, subtracted 2.6 percentage points from the headline growth rate. If those issues are resolved in current quarter or Q3, it could present upside risk to already lofty expectations (+9.4% and +7.2%, respectively, per survey data provided in Exhibit 1).

Within the Q1 increase in consumer spending, goods consumption surged 23.6% versus -1.4% the prior quarter. Growth in services spending was little changed at 4.6% versus 4.3% in Q4. The large skew toward goods consumption reinforced the perception that stimulus checks were quickly spent, but as the economy continues to open in the coming weeks/months, service sector consumption could experience a strong bounce, assuming, of course, that consumers are ready to resume pre-Covid behaviors, including business travel. That said, the base is relatively low for q/q or y/y comparisons.

Price Increases Sticking?

There remains a healthy debate in economic and financial market circles related to inflation, and tying back to the discussion above, the GDP Price Index was hotter than expected in Q1 at 4.1% (2.6% expected).  The sharp rise in commodity prices on everything from metals to cheese has been well publicized in recent weeks. For example, lumber prices are at the highest level on record and up 80% on the year. With that in mind, a big topic of discussion over the last couple of weeks has been growing reports of companies passing price increases on to consumers. An April 26 Financial Times article highlighted discussions from several corporate earnings calls related to this topic. Executives from Coca-Cola, Chipotle, Whirlpool, Procter & Gamble, and Kimberly-Clark, all of which covers a wide range of products, said they are preparing to raise prices to consumers to offset higher input costs, including commodity prices. The decision to pass through price increases also reflects a confidence in the economy and the ability of consumers to absorb these higher prices without affecting a material drop in demand.

This puts the Fed right back in the center of the discussion. At the April FOMC meeting, Fed Chair Jay Powell didn’t stray from recent script, stating an opinion that near-term inflation will be transitory and reflective of base effects and supply chain bottlenecks as the economy reopens. A popular definition of inflation is a sustained increase in the overall level of prices. The Fed’s “transitory” argument is effectively a belief that any near-term price pressures will fail to meet the “sustained” component of this definition.   Covid-related supply chain disruptions would presumably be temporary from the Fed’s perspective, as would price rebounds in hard-hit sectors like travel and leisure.  Wage inflation is another important metric to monitor as it relates to the overall price inflation outlook. We discussed in last month’s commentary the rebound in aggregate wages from the monthly jobs reports, and the Q1 Employment Cost Index released last week showed labor costs rising 0.9% q/q, the highest since June 2007 despite a 6% unemployment rate (see Exhibit 2). The ECI is a preferred gauge of labor costs for Fed leaders because it also tracks bonuses and benefits. If wage pressures persist across sectors, Fed leaders may have a more difficult time selling the transitory argument.

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