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For the Week Ending April 21, 2017

We will find out next week just how much of a speed bump the economy hit in the first quarter. When the Commerce Department releases its first estimate of GDP on April 28, we expect it will show a growth rate of less than 1.0 percent, close to if not the weakest outcome in three years. That's not what post-election optimists were expecting as the calendar page turned to 2017. Buoyed by the prospect of a pro-business incoming administration that trumpeted tax cuts, increased infrastructure spending and a relaxed regulatory environment, confidence that the economy would break out of its stubborn slow-growth trajectory soared both on Wall Street and Main Street. Based on the economy's performance in the opening months of the year, it appears that much of that confidence has been misplaced.

To be sure, a first-quarter setback has become a familiar pattern in recent years. Growth slowed from the fourth quarter in six of the seven years since the economy emerged from the 2007-2009 recession. In every case, activity snapped back in subsequent quarters, suggesting that there may be statistical anomalies associated with the period. We expect a rebound in coming quarters this time as well. That said, unless the expected reversal exceeds expectations, the economy's growth performance for the year will look very much like the 2 percent average seen since the Great Recession ended in mid-2009. When, and if, fiscal stimulus does kick in later in the year, the pace will likely accelerate somewhat in 2018. But demographic trends underpinning a slowing labor force and weak productivity constitute powerful restraints on longer-term prospects; hence, the economy still needs to find the spark that will launch it out of the "new normal" of 2 percent growth and into the 4 percent orbit that the president promised during the campaign.

As we noted last week, investors may be reassessing their ebullient post-election growth prospects. The S&P 500 Index recorded its first decline in March since last October and continued to slip through the third week of this month, despite intermittent rallies. Bond yields have followed an even more dramatic path; the bellwether 10-year Treasury yield is currently hovering at a five-month low, having fallen from a nearby peak of 2.62 percent in mid-March to 2.24 percent on Friday. To be sure, the repricing of financial assets may well be a reflection of heightened geopolitical jitters as much as lowered confidence in the economy's performance. Several important elections overseas are on the calendar, including the looming French elections, with the threat of mainstream governments being upended by populist candidates that could lead to the break-up of the European Union. The administration's hardened stance towards North Korea and Iran, which ramps up tensions with China and Russia, may also be contributing to a risk-off trade that boosts demand for safe assets, particularly Treasury securities.

We suspect, however, that the markets would recapture the post-election mojo if the hard data on the economy starts to validate the optimism shown in household and business surveys. Significantly, manufacturing is one sector where the hard and soft data have been roughly in accord this year. Most surveys of manufacturers have depicted strengthening activity since the election, including the nationwide poll of leading purchasing managers compiled by the Institute for Supply management. In this case, performance has followed suit, as manufacturers increased output for six consecutive months through February, the longest stretch of gains since 2011. However, the string was broken in March, as factories slashed production by 0.4 percent during the month, dragged down by a significant pullback in the auto sector.

While disappointing, the setback in manufacturing activity is not particularly ominous, nor completely unexpected. For one, it was the first decline in factory production since March of last year, and one month does not make a trend. For the first quarter, the sector outperformed the overall economy, as factory output increased by a 2.7 percent annual rate. For another, the March decline was heavily influenced by a pullback in motor vehicle production. The auto industry had been a pillar of strength in the industrial sector for the past several years, as strong sales spurred increased production of cars and trucks. But after hitting a record pace in 2017, sales leveled off early this year and sagged in March, resulting in a substantial overhang of inventories on dealer lots. As a result, automakers truncated assembly lines, reducing motor vehicle assemblies to an 11.623 million pace in March from 11.807 million in February. The March assembly rate was the lowest since February 2015.

Until inventories are brought into a more normal alignment with sales, automakers will keep a lid on assemblies. Odds are, with pent-up demand for motor vehicles now largely satisfied, the industry will not be as much of a growth driver going forward. However, the consumer love affair with cars is far from over and sales should benefit from the continuing strength in the labor market and rising discretionary incomes. One potential roadblock, however, may be a tightening of lending standards for auto loans, which have become extremely lax in recent years, resulting in rising delinquencies. Perhaps more disappointing than the weakness in auto production was the unexpected 0.4 percent downturn in business equipment output last month. That was the first decline since last November, and puts a damper on hopes that business investment spending has turned the corner. Again, it is only one month and equipment output still recorded a solid 2.0 percent gain for the first quarter, following a 1.6 percent increase in the previous quarter.

We still believe that capital spending is on the mend and will make a positive contribution to the economy's overall growth over the balance of the year. The ISM index of manufacturers supports that view, holding firm at an elevated level in March. Indeed, the survey suggests one source of strength that will bolster manufacturing activity this year: exports. In March, the export index surged to the highest level since November 2013, extending a strong upward trend over the past five months. This is an unexpected thrust, given the dollar's strength in recent years and the general weakness in global demand. However, the almighty dollar's rise halted early this year and has wobbled erratically lower since then. The greenback, as measured against a basket of major currencies, is currently about 3 percent below its peak in early January. What's more, global growth is displaying more muscle than expected a few months ago, with both emerging market countries and developed economies picking up activity. The IMF just upgraded its global growth outlook, and a key gauge of Eurozone business activity, released on Friday, surged to a five-year high in March.

The housing sector is another area where the relationship between surveys and performance has held up relatively well. Homebuilders have been exceptionally upbeat about the housing market for some time. The National Association of Home Builders (NAHB) sentiment index roared to the highest level since June 2005 in March before slipping a tad in April. To be sure, their groundbreaking activity hasn't quite lived up to the survey responses, but that's at least partly due to the constraints builders are coping with, most notably a shortage of skilled construction workers as well as available land to build on. Still, the number of new homes being built has increased significantly from the trough of the housing bust, and the gains continued despite the rise in mortgage rates from late last year to March.

To be sure, housing starts slipped in March, according to the Commerce Department's latest report released this week, but the setback follows an exceptionally strong increase in February, which was buoyed by the warmest temperature on record for the month. Even so, the 1.215 million pace of starts in March was 9.2 percent above the level of a year ago and capped a strong gain for the quarter of just under 9.0 percent. The near-term outlook looks bright, paralleling the sentiment of homebuilders. Building permits rose 3.6 percent in March and are up 17.0 percent from a year ago. We expect that residential investment outlays contributed importantly to the economy's growth rate in the first quarter, registering a double-digit increase.

Of course, homebuilding activity will stay firm as long as homebuyer traffic holds up. Here too, the news is promising. Sales of existing homes came in much stronger than expected in March, advancing by 4.4 percent to an annual rate of 5.71 million units. That is the strongest sales pace since February 2007. What makes the strength so impressive is that it comes against the backdrop of a chronically tight supply of homes on the market. Inventories have dwindled on a year-over-year basis for twenty two consecutive months and is currently 6.6 percent, or 1.96 million, lower than a year ago. Not surprisingly, strong demand against a reduced supply translates into higher prices. March was no exception, as the median sales price jumped 6.8 percent over the past year. It remains to be seen how long this can continue before affordability becomes an issue. In this regard, prospective buyers will receive some help from the bond market, where the recent decline in yields has driven down mortgage rates. Indeed, the 30-year fixed rate broke below 4 percent this week for the first time in five months.

That said, homebuilding does not carry enough weight to overcome sluggish consumer spending, which was probably the biggest drag on growth during the first quarter. We will have the details next week in the government's GDP report. But the markets are forward-looking, and it remains to be seen if the hard data in coming months will validate expectations of a growth rebound, following the pattern of recent years. Still, with the French elections and the urgency of Congress to stop a possible government shutdown by April 28, investors will have plenty of distractions during the upcoming week. Stay tuned.