Beware A Downward GDP Revision is Coming

Real GDP growth for the fourth quarter was revised higher Thursday, into positive territory from the initially reported contraction. However, I expect forecasts for the full year of 2013 to be revised downward near-term given what looks like sure spending cuts that will cost growth.

Whether it be via the sequester plan or a more politically plausible set of cuts devised in a midnight hour negotiation, cuts are coming. The Budget Office and the Federal Reserve Chairman see those cuts as costly to economic growth by six-tenths of a percentage point. In his testimony to House and Senate financial committees this past week, the Fed Chief said the 0.6% impact would be part of a 1.5 percentage point drag to economic growth this year on recent changes to fiscal policy. Chairman Bernanke suggested policy makers would do better to limit near-term cuts while the economy remains vulnerable, and plan out more aggressive reductions for the long-term.

The market celebrated Thursday’s revision to fourth quarter GDP, which took it to +0.1%, up from the initially reported contraction of 0.1%. Through the close of trading on Thursday, each of the major ETFs measuring the market was higher. In fact, the stock market defiantly stood against the probable austerity measures for most of the week, as investors received a slew of reassuring positive economic data. The strange contrast of economic impact and stock market strength led to some question as to the real significance of the sequester cuts.

Index Security	Thursday to 1:20 PM	Week-to-Date
SPDR S&P 500 (NYSE: SPY)	+0.6%	+0.5%
SPDR Dow Jones (NYSE: DIA)	+0.2%	+0.8%
PowerShares QQQ (Nasdaq: QQQ)	+0.5%	+0.7%

However, one very important positive economic data point will very likely be revised shortly. Revisions to economic growth forecasts must follow the latest cost cutting measures. In its December 2012 publishing, the Federal Reserve saw improving economic growth this year and next. As you can see in the table below, revisions to those projections should not reflect recession, but my simple 0.6% adjustment may prove to be understated. That’s because when the estimates were last produced, the economic prognostication had not foreseen or incorporated the depth of slippage that actually resulted in Q4 2012.

A relief recovery for Q1 2013 GDP might be expected post the passage of the fiscal cliff and debt ceiling circumstances. Those issues likely stymied economic activity at the end of 2012, due to the uncertainty they created about the economic environment. However, the expiration of the payroll tax break may not have been included in those forecasts either, and supports the case for a slower set of growth forecasts nonetheless.

Year	December Forecast	Likely Revised Pace
2013	2.3% to 3.0%	1.7% to 2.4%
2014	3.0% to 3.5%	N/A

Reductions to economic expectations will quell some of the latest enthusiasm generated by recent economic reports. They should also serve to settle stocks a bit, especially cyclical leaders within the financial and industrial sectors. Names like Bank of America (NYSE: BAC), J.P. Morgan Chase (NYSE: JPM), BHP Billiton (NYSE: BHP) and Caterpillar (NYSE: CAT) should soften short-term. Also, high beta stocks that may have been accelerating in an environment more accepting of risk might ease off a bit temporarily. For instance, biotech names lacking FDA news catalysts and ETFs like the iShares Nasdaq Biotechnology (NYSE: IBB) should see short-term softness as a result of the economic recalculation. The same should go for Tech and Telecom ideas like Oracle (Nasdaq: ORCL) and Cisco Systems (Nasdaq: CSCO).

However, I expect just a short-term slip here, as the economy does seem to have traction on the back of a finally recovering real estate sector and special opportunity therein. Low mortgage rates and dissipating distressed inventory are finally allowing for a favorable imbalance between supply and demand in housing. The sector has such broad reach that it affects the economy significantly. Though, the high flying (and high beta) housing stocks are vulnerable to profit taking if economic worries become excessive. Ancillary ideas like Home Depot (NYSE: HD) and Lowe’s (NYSE: LOW) are still attractive, though they are getting harder to find.

Capital wants to flow into equities, and it has been, given the start of a more positive outlook for the U.S. economy. Such capital flows and the relative strength of the U.S. versus some of the world’s other markets offer important supports that will only allow for slight slippage. However, partisan politics in the U.S. have been an obstacle to efficient recovery, and must be resolved in these times of perilous economic and financial consequences. This sequester issue has only served to shine a spotlight on the problem.

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