Investors brushed off Wednesday morning’s announcement from the Commerce Department that its final first-quarter GDP figure showed a decline of 2.9 percent, the steepest contraction since the financial crisis. Stocks were largely mixed, as were other assets that one would think would move sharply on this data (e.g., Treasuries and gold), suggesting that investors really don’t care. After all, this data is backward looking.
But the fact that the economy contracted so much is a big deal. First, while it is easy to dismiss a small contraction as a weather-related incident, we cannot do this with a contraction as large as 2.9 percent. This implies that there were other factors that didn’t immediately disappear on April first. These factors are likely still at large, and they are heightening the probability that the economy weakened during the second quarter, meaning that we could already be in a recession.
Second, we should keep in mind that this contraction coincided with the Federal Reserve’s tapering program, which started in January. This indicates that economic growth has become dependent upon the Fed’s stimulus, and that the economy cannot grow without it. As tapering has continued into the second quarter, it would follow that unless there is some unusual event in which we saw additional pressure impact the economy, which again heightens the possibility that we saw an economic contraction in the second quarter, it means that we are already in a recession.
With stocks trading at or near all-time highs, it is pretty clear that they are vulnerable to the downside. Investor complacency in the face of this lousy news reflects several unsustainable factors. The most glaring is that investors are pricing in earnings growth for many of the stocks in the S&P 500. This is the case because investors have gotten used to the idea that earnings are growing. But it is obvious that if the economy is shrinking that this is unsustainable.