The fact that the US recovery gained momentum in Q2 despite heavy headwinds suggests the economy could accelerate later this year as the drag from fiscal tightening fades and pent-up demand is released. We are therefore now more certain that the Fed will move one step closer to tapering today by altering the FOMC statement and begin tapering its purchases after the 17-18 September FOMC meeting. There is a lot of new information to digest in today?s Q2 US GDP report, but here are five things you should know. 1. The economy surprisingly gained momentum in Q2 Real GDP rose at a 1.7% annualised rate in Q2 after a sluggish 1.1% gain in Q1, which was revised down from an initially reported 1.8% rate. The consensus forecast and Nordea?s forecast were 1%. The good news is that the 1.7% growth rate in Q2 GDP was the strongest pace in three quarters. The fact that the recovery has gained momentum despite heavy headwinds suggests the economy could accelerate later this year as the drag from fiscal tightening fades. More on this below. Areas that came in relatively firm in Q2 were business investment, which saw a surprisingly strong increase of 4.6% in Q2 after a contraction by the same amount in Q1. GDP also got a boost from residential investment in Q2, increasing 13.4% roughly in line with the pace in Q1. Moreover, inventory building added 0.4% point to Q2 GDP growth after a 0.9% point contribution in Q1 following a sharp 2% point drag in Q4. Going forward, inventories are likely to be only modestly positive for growth in the next few quarters. Consumer spending rose by a modest 1.8% in Q2, a return to a subdued pace after an above-trend 2.3% rise in Q1. However, in addition to the impact of higher taxes, much of the weakness in Q2 may be payback after unusually high spending on heating during the cold period early this year. With a 0.4% decline, government spending was once again a drag thanks in part to the sequester, subtracting 0.1% point from growth in Q2 but significantly less than a 0.8% point drag in Q1 and 1.3% in Q4. Because of a sharp 9.5% rebound in imports, net foreign trade was a big negative, subtracting 0.8% point from Q2 growth after a 0.3% point drag in Q1. Exports rose 5.4% after a 1.3% decline in Q1. 2. Fiscal consolidation, the most important factor weighing on the economy, is temporary In Q2 the economy probably took the brunt of tighter fiscal policy caused by sequester-related government spending cuts, higher taxes for high-income earners and the expiration of the payroll tax holiday in early January. While some consumers dipped into savings in Q1 to maintain spending, the tax rise has probably caught up with others in recent months, triggering a reduction of their spending. Because Fed chairman Bernanke has repeatedly blamed much of the recent weakness on fiscal consolidation, which will exert less drag going forward, we don?t think the Q2 GDP report will change the Fed?s tapering plans. In fact, because the economy has gained more momentum over the past few quarters despite headwinds from fiscal tightening, we are now more certain that the Fed will move one step closer to tapering today by altering the FOMC statement and begin tapering its purchases after the 17-18 September FOMC meeting, see Moving closer towards tapering ? FOMC preview . 3. Weak foreign demand may be short-lived Slowing growth in China and other Emerging Markets along with the recession in the Euro area has obviously been a negative for US businesses for months. However, recent PMI data support Nordea?s forecast that the Euro area should emerge from recession in Q3 this year. Also Japan is starting to show signs of improvement. Growing demand in Europe and Japan could mean more business for firms in China. Despite continued global downside risks to the US outlook, we take some comfort from the fact that US real exports have recently accelerated, supported by the still weak USD. 4. Growth should strengthen in H2 2013 With much improved private-sector fundamentals and less drag from fiscal consolidation, we still believe the stage is set for stronger growth in H2 2013 as pent-up demand is released, especially in the form of business investment but also stronger consumer spending. We are not concerned that the likely upcoming scaling down and subsequent termination of the Fed?s asset purchases will harm the economy excessively. First, the Fed has clearly communicated that it is only going to start tapering its purchases if a stronger economy does not require such further support. Second, even when the Fed ceases to expand its balance sheet, US banks will remain flush with liquidity in the form of excess reserves that already have been added to the banking system. Finally, rising mortgage rates as imminent QE tapering has been priced into the market should not derail the housing recovery. For a mortgage on a median-priced single-family home (around USD 200,000) with a 20% down payment, the recent rise in mortgage rates represents an increase in the monthly mortgage payment of about 3% of disposable income. All else equal, higher mortgage rates will obviously act as a drag on growth. However, in the current environment this negative impact is likely to be at least partly offset by increased incentives for banks to lend because of recently rising home prices and employment and hence a lower risk that mortgages turn delinquent. Moreover, because of earlier postponed housing demand we see a potential for pent-up demand to be released before rates and prices rise even further. We expect this week?s main data releases to indicate that employment stays fairly strong and that GDP growth has picked up in early Q3. Thus, tomorrow?s ISM manufacturing index is expected to increase to 52 in July from 50.9 in June and 49 in May. On Friday we expect to see a 175k increase in payrolls and a decline in the unemployment rate to 7.5% in July. 5. Annual revisions lowered earlier reported growth over the past year The stronger-than-expected GDP growth in Q2 was partly offset by downward revisions to the four preceding quarters. Thus, over the four quarters ending in Q1, GDP rose a sluggish 1.1% against a previously reported 1.6% gain. GDP growth in 2012 as a whole was revised up to 2.8%, from 2.2%, but most of that was due to some very sharp upward revisions to the quarterly growth rate in Q1 2012. The Commerce Department also made substantial alterations in how it defines GDP. Those changes have increased the size of the economy through 2012, by 3.6%, or USD 560bn. These changes, which put the US national accounts in line with new international standards, include adding to GDP things like spending on research and development and intellectual property like recorded music. (Note: Europe hasn?t made these changes yet.)
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