What Happened to Business Investment in 2Q?

As the U.S. consumer gained confidence in the second quarter of 2016, data from the Commerce Department released Friday showed businesses investment didn’t quite keep up.

The first read on second-quarter GDP showed the U.S. economy grew at a 1.2% annualized pace, up from a 0.8% growth rate in the first quarter, but far below consensus expectations for a 2.6% pace.

Perhaps the biggest shock to Wall Street was the sharp drop in inventory building from American businesses. Digging into the data, non-residential fixed investment dropped at a 2.2% annualized rate in the quarter, shaving 0.28 percentage point off of GDP, while the total change in private inventories erased 1.16 percentage point from 2Q GDP.

As businesses slowed down during the quarter, consumers continued to spend at a robust pace of 4.2% from the first quarter, the most since late 2014. The 3% jump in services spending was the most in six quarters, likely aided by improved household finances, continued job growth and firmer wages.

“The staggering subtraction from inventory building was the biggest surprise to us and the market with the story likely being that businesses were caught off guard from the surge in consumer demand and were playing it safe in terms of restocking shelves,” BNP Paribas economists Paul Mortimer-Lee and Bricklin Dwyer said.

They estimated non-residential investment would likely see a bounce back in the third quarter as businesses begin to believe the uptick in consumer confidence and spending will be longer lasting than originally expected. Additionally, the BNP economists pointed out a period in 1986 was the only time in which the change in private inventories remained negative for two-consecutive quarters outside a recession.

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Additionally, residential investment, which saw a 6.1% annualized drop in 2Q, after several solid quarters of double-digit expansion, could also see a reversal in the third quarter. IHS chief economist Nariman Behravesh noted the strong demand for housing, as evidenced by the 3.5% pick up in June new home sales and 1.1% rise in existing home sales data, could serve as a catalyst for an upward trend in 3Q.

To that point, Larry Shover, chief investment strategist at Solutions Funds Group, said without an unexpected economic event, the factors that have boosted consumers in the first half of the year should continue to serve as a buoy through the remainder of 2016.

For the Federal Reserve, which said Wednesday in its latest policy statement that the economy continues to improve as near-term risks abate, Friday’s GDP report likely comes as somewhat of a disappointment.

“While the inventory hit will be temporary, the downward trend in business investment must be concerning,” Shover said. “Unlike households, business leaders are just not showing much confidence in the economic outlook. This could foreshadow slower job growth ahead.”

Next Friday helps usher in a new month and along with it, a fresh look at the labor market with the release of the Labor Department’s July non-farm payrolls report. June saw a snapback in job creation, with 287,00 net new jobs added to the economy with an unemployment rate of 4.9% after a big miss in May. Economists expected to see 180,000 net new jobs in July alongside a tick down in the jobless rate to 4.8%.

PNC’s economists said the U.S. central bank is likely to put more weight on changes in labor-market conditions than “wild swings” in inventories.

“Although the doves will cite these [GDP] numbers as a reason for more ‘wait and see’…labor market data and U.S. equity valuations will likely be the key tell for when the Fed moves. In our view, July payrolls are likely to be a robust 175,000 and will support a Fed rate hike in September. [Friday’s] numbers don’t undermine that.”