Many analysts assert that weak first-quarter gross domestic product growth, estimated by the Atlanta Federal Reserve Bank’s GDPNow model at just 0.3 percent, will prove to be an aberration. The trend for all of 2016 will be stronger, they contend, mirroring the pattern of recent years that has seen U.S. growth rebound after a sluggish start to the year. Indeed, steady employment growth and some rebounds in purchasing managers’ indexes — both purported harbingers of improvement ahead — helped fuel the sharp February–March rally in U.S. stocks as well as surges in risk assets around the world. In reality, though, the first quarter was an aberration to the upside caused by an enormous but largely ignored distortion — the weather. The economy’s underlying trend is recessionary.
Freakishly mild meteorological conditions this winter gave a major boost to the economy, which otherwise would likely have contracted in the first quarter. Moreover, the weather has set investors up for a shock because, as data for the second quarter become available, they will exhibit exaggerated drops from the weather-boosted first-quarter figures. Worse still, they will be dropping back to a much weaker and, in all probability, recessionary trend. Thanks to the weather, the economy has given a big head fake to the markets, and markets have fallen for it.
Can weather really make that much difference? Usually not, but in extreme cases outlier winter weather can markedly change the economy. Output fell at an annual rate of 1 percent during the frigid, stormy first quarter of 2014, then rebounded at a rate of 4.5 percent in the second quarter. For the calendar year, real GDP expanded by 2.5 percent. Last year a severe February combined with labor actions at West Coast ports caused a similar if less dramatic pattern, with the economy growing at a tepid rate of just 0.6 percent in the first quarter, followed by a second-quarter surge of almost 4 percent.
This year we are seeing an opposite effect: A lack of cold and storms boosted first-quarter activity, so the second-quarter payback should be sharply downward. The winter of 2015–’16 was arguably the mildest ever recorded in the 48 contiguous states in terms of temperatures, frozen precipitation and stormy winds. It was also among the mildest winters ever in the entire northern hemisphere, so in the world economy, not just in America’s, economic activity got a boost.
Yet even with the weather boost, the first-quarter expansion appears to have been paltry, implying serious underlying weakness. The fading weather effect should mean a major drop in the GDP growth rate in the second quarter, giving a substantially negative reading.
Although the impact of unseasonable weather is amplified by winter’s big seasonal adjustments, the weather effect is not merely a statistical aberration. Firms actually experience stronger sales because of mild weather. A delicatessen that serves factory or construction workers and usually experiences sharp sales drop-offs on bad-weather days enjoys better winter sales, and when it orders extra supplies, its suppliers experience better sales as well.
Investors are deluding themselves if they view employment growth as a harbinger of the future, which it is not. Employment growth slowed only a little in the first three months of the year from the 2015 average and still averaged more than 200,000 per month, yet that number would have been smaller without the weather boost. Look out for an abrupt slowdown in job growth this spring.
A true leading indicator, and one that has been signaling economic deterioration for more than a year, is corporate profits. They have fallen for five straight quarters on a year-over-year basis through the fourth quarter of 2015. Falling profits not only reflect deteriorating business conditions but also foreshadow weaker capital spending and other business retrenchment, ranging from reduced production and employment to dividend cuts. Although the mild weather helped boost profits as well as GDP, first-quarter profits are likely to register another decline. Without the mild winter, profits would have been dismal.
Many analysts have pointed cheerfully to the improvements in recent readings of a number of purchasing managers’ indexes around the world, including a spurt in the ISM Manufacturing index in March. These highly sensitive measures can pop up in response to relatively moderate variations in conditions, and the mild weather undoubtedly helped create temporary momentum and reduced inventories in some industries.
However, the long slide in profits is weighing heavily on executives, adding downward pressure on capital spending. Nonresidential fixed investment fell in the fourth quarter, and a plethora of diverse data series points to continuing declines in 2016 in both domestic nonresidential investment and in global capital spending. These data include falling capital goods orders, exports and executive confidence. Since fixed investment is the biggest single source of profits in a market economy, the investment outlook is one of the reasons why we expect a continued profits decline and the spreading global recession to engulf the U.S. economy in coming months.
The strong price increases for risk assets since mid-February was a bear market rally, amplified by better-than-expected winter data. The spring payback is one of the reasons we expect this rally to end soon. Investors, be careful here.
David A. Levy is chairman of the Jerome Levy Forecasting Center, a macroeconomic consulting firm in Mount Kisco, New York, that provides research and investment strategy services for clients.