The quarterly GDP report from the U.S. Commerce Department showed a 0.1 percent contraction of the U.S. economy in Q4 2012. It was the first such report to show a decline since October 2009, and economists had expected a 1 percent increase in Q4 GDP. That’s the bad news. The good news is that, according to four economists we asked, there are some silver linings.
What, then, does this report mean for financial markets? And in the long term, does GDP affect markets, or do markets drive GDP in some part? Justin Wolfers, an economics professor at the University of Michigan; Cary Leahey, chief U.S. economist at Decision Economics; Ken Goldstein, an economist at The Conference Board; and Vince Malanga, founder of LaSalle Economics weighed in on both questions.
What does the .1 percent GDP contraction in Q4 2012 mean for financial markets?
The reported contraction in Q4 GDP is an interesting headline, but underneath, nothing so dramatic happened. It’s driven largely by factors which are one-off–a sharp decline in defense spending and a decline in inventory investment. By contrast, the underlying pace of demand in the private sector remained robust (though not great!), as it has throughout the recovery.
And now that we know that non-farm payrolls were growing strongly through the month, there’s even less reason to be concerned by this statistical blip, and even more reason to believe it may end up being revised away. So I don’t see a lot here that should lead to big market movements.
Sometimes the story is less interesting than it first appears.
The financial markets were not unnerved by the surprising drop in Q4 GDP. After the initial shock wore off, investors realized that GDP growth had paused as firms cut inventory investment and federal defense spending was especially weak. Underlying private demands rose at a decent 2 3/4% clip, suggesting that GDP growth would rebound to something closer to the higher pace of demand in early 2013 now that inventory investment had been cut.
The US economy wasn’t nearly as strong as the 3% rise in GDP in Q3 suggested or as weak as the -0.1 percent in Q4. In fact, the economy is gaining traction, one reason why bond yields are moving up and bond prices moving lower. That helps explain why stocks are seemingly more popular now than only a few short months ago. And for once markets might be getting it right.
By itself the 0.1 percent contraction in GDP does not mean much for financial markets because it is in some respects old news in that it is a composite of data reports that have already been published. Also this paltry growth is a partial payback for the unrealistically high 3.1 percent growth rate that was estimated for the third calendar quarter. Averaging the two quarters leaves us with about 2% growth which is below the long term trend and below the Federal Reserve’s internal forecast. With the economy facing headwinds from tax increases and spending restraint growth should remain subdued and this will keep the Fed biased toward easy money policies which in turn is a positive for financial markets going forward.
How much do markets affect GDP, or are they more affected by GDP?
Let me state the obvious: Last quarter’s GDP is not affected by current market conditions. But obviously spending decisions going forward will depend on people’s wealth which reflects movements in equities, and interest rates, which reflect bond market conditions.
While this a bit of a chicken and the egg question, financial markets are more affected by GDP than the other way around. GDP growth expectations are built into current market prices. Since the surprise in Q4 GDP did not shake investors’ anticipations regarding future economic growth, markets prices were relatively unaffected.
Market sophisticates try to guess what the number will be and trade before the release. Remember that movie with Dan Aykroyd? Mr. Jones and Ms. Davis don’t do that, which is why markets can be rationale at times.
Markets affect GDP indirectly to the extent movements affect consumer and business confidence and wealth . It is complex relationship but in some sense one could argue that it is a self fulfilling prophecy in that rising markets boost confidence and wealth and thus spending which is what GDP measures.