The contraction of economic output continued apace in the first quarter of 2009. The preliminary estimate released by the Bureau of Economic Analysis (BEA) at the end of April shows a first quarter decline in real GDP at an annualized rate of 5.7%. The first quarter decline follows on the heels of a similar 6.3% drop in the previous quarter. Real GDP has now contracted for three straight quarters, and according to the National Bureau of Economic Research, the economy has been in recession since December 2007. Presently, it appears that the downward path will continue for a couple more quarters, though at a decreasing rate of descent.

The collapse of investment activities was the driving force behind the recession during the first quarter. Real consumer spending actually advanced in the first quarter, increasing an annualized 1.5% after two quarters of declines near 4.0%. The increase fell far short of overcoming massive declines in business structures (down 42.3%), equipment and software (down 33.5%), and residential investment (down 38.7%). A drop in government purchases and a large liquidation of business inventories added to the poor showing of the economy, but net exports offset more than two times those declines.

Monetary and fiscal policies are extremely expansionary. The Federal Reserve (Fed) is effectively maintaining a zero interest rate policy and stepping up the use of non-traditional measures to increase the availability of credit to businesses and consumers. Unsurprisingly, in view of the sizeable drop in production, inflation has faded into the background as an immediate issue for policy makers. With near-term inflation concerns completely out of the picture, the Fed will not be taking its foot off of the accelerator any time soon.

We anticipate real GDP will be down roughly 3% in the second quarter and for 2009 as a whole, but fiscal policy will boost real GDP by nearly one percent in 2009, pulling the economy out of recession in the fourth quarter. Consumer spending, new home sales and home inventories now show signs that a bottoming-out phase has begun. Tight credit conditions and irrational fears that consumer spending was falling down a bottomless pit were prime factors in the miserable first quarter figures for business fixed investment. The Fed’s activities have already helped credit markets begin to thaw, as can be seen by narrowing credit spreads and increased new bond issuance. As improvements in these areas become increasingly apparent, the decline in capital spending will abate. The very worst of the bad news is over.

The stock market has likely seen its bottom for this recession cycle, but the near-term outlook remains problematic. Uncertainty in the banking sector will continue to drive investor sentiment. Nevertheless, equities markets are forward looking, and any demonstrable signs of earnings improvement could reinforce an upward trend as cash and other low-yielding investment holdings rotate back into riskier assets. Improvement in financial market conditions will continue, but as all of the bad economic news is not yet out, investors should anticipate a bumpy ride.