Will the Real Economy Please Stand Up?
Investing is never free of uncertainty, and that has felt especially true in the current macro environment. With the release of the first-quarter GDP report, however, clarity is dipping its toes back into the market ever so slightly. Let’s dive in. Economic growth in Q1 2025 showed a much anticipated deceleration, with real GDP contracting an annualized 0.3%. This marks the first contraction since Q1 2022 and a significant slowdown from the 2.4% growth figure last quarter. While typically alarming, this headline figure warrants a closer look, as it was heavily influenced by volatile components rather than a fundamental collapse in economic activity.Real Gross Domestic Product
The negative Q1 reading was primarily driven by a massive surge in imports and significant changes in business inventories. Imports spiked a dramatic 41.3%, causing the Net Exports component to drag down growth by 4.8 percentage points. Simultaneously, businesses increased their inventories, adding back about 2.3 percentage points to growth, but not enough to offset the import drag.
This unusual activity was a direct consequence of businesses responding to trade policy upheaval. Evidence suggests that companies — particularly those reliant on foreign goods like transportation equipment, pharmaceuticals, and computers — rushed orders to bring them into the country before potential tariffs made them more expensive. This led to both the recorded import surge and the related build-up in inventories as companies stockpiled goods.
To gauge underlying economic momentum, economists often look at "real final sales to private domestic purchasers," more casually known as private domestic demand. This measure excludes government spending and volatile trade and inventory effects, which can be helpful when the broader data is being possibly distorted. In stark contrast to the headline GDP figure, this measure grew a solid 3.0% in Q1. Consumer spending did slow a bit, but private fixed investment picked up the slack.
Real Private Domestic Demand
Bond Market Puzzle
Historically, Treasury yields tend to rise when the economy is expected to grow strongly and fall when it's expected to slow or contract. This relationship exists because strong growth can fuel higher inflation expectations and potential interest rate hikes by the Federal Reserve. That dynamic held in recent years, but the latest GDP print brings it into question. Despite the weak -0.3% headline GDP in Q1 and recession fears, the 10-year Treasury yield is still around where it began the month at 4.15%-4.20%.Treasury Yields and Growth Diverging
There are lots of possible reasons for this disconnect. For instance, some investors posit that inflation fears associated with tariffs could be boosting yields. After all, core PCE inflation accelerated from 2.6% to 3.5% in Q1, but this theory doesn’t seem exactly right. Looking at the difference in yields between nominal Treasurys versus Treasury Inflation-Protected Securities (TIPS), we can see that 10-year inflation expectations have actually fallen from 2.37% to 2.23% since the start of April.
Instead, an “all of the above” explanation is probably needed to explain the stickiness of higher yields. Investors could be looking past the distorted GDP figure in part, and focusing on some of the recent worrisome inflation data and the relatively resilient underlying domestic demand data. Additionally, heightened uncertainty around trade policy and the Fed’s future actions, as well as waning foreign investor appetite for investments in the U.S. may be pushing up the "term premium" – extra compensation investors demand for holding longer-term bonds amid increased risk.
Staring Into the Unknown
The combination of slowing headline growth (-0.3% Q1 GDP) and persistent inflation (+3.5% Q1 Core PCE) has revived concerns about stagflation – a period of stagnant economic activity coupled with high inflation. How this will all impact corporate earnings is unknown. S&P 500 companies have beat consensus expectations by more than 9% so far this earnings season, yet the rapidly shifting landscape means that in many ways, the results are already stale. Companies exposed to imports have been hesitant to give much guidance on future quarters, while analysts on the whole have not revised earnings much in the grand scheme of things. Indeed, consensus currently expects solid earnings growth this year and next.S&P 500 Consensus EPS Growth
Sectors more sensitive to trade policy uncertainty are expected to have weaker earnings than other parts of the market, but given resilient current expectations, there’s room for these numbers to change in the coming months. A recession would almost certainly weigh on earnings, but an inflation acceleration complicates the picture since price increases could boost nominal earnings even if real growth is challenged. That’s similar to what happened from 1980-1982: From the start of the 1980 recession through the end of the 1981-82 recession, trailing 12-month earnings fell just 3%. The same can’t be said for stock prices, however, as those periods saw drawdowns of 17% and 27% despite the resilient earnings.
Much will depend on how trade policy plays out and how businesses and consumers respond, but for now the market remains on a razor’s edge.
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