* Weaker than expected report. However, the bulk of the downside relative to our own below consensus estimate was in the defense category. Otherwise, the results were reasonably close to our expectations.
* The defense decline of 22% was the sharpest since 1972. It had nothing to do with the fiscal cliff or the looming budget sequester. Instead, the drop reflects the combination of two factors: 1) an underlying moderation in defense outlays that has been evident over the past couple of years reflecting a gradual wind down of the US military presence overseas and 2) payback for an unusual spike in spending that was seen in Q3. Over the four quarters of 2012, defense was down 5%. And, over the four quarters of 2011, defense fell 4%. This downtrend will intensify in 2013 if the budget sequester is imposed as scheduled in March.
* The inventory results in Q4 -- a 1.2 percentage point subtraction -- were very close to what we had been assuming and thus the report had little impact on our assessment of GDP growth in Q1. We will have a firmer grasp on the Q1 outlook after the monthly detail is released tomorrow, but at this point we see Q1 GDP tracking at about +1.5%.
* Consumption was right on expectations at +2.2% -- a bit better than the average pace seen over the past year or so. Residential investment continues to be a bright spot, rising 15.3% in Q4 -- close to expectations and close to the average growth pace seen over the prior four qtrs.
* Relative to our estimates, there were modest upside surprises in business capital spending and net exports. However, these were more than offset by the much larger than anticipated pullback in defense.
* The Q4 inflation results were quite benign with the headline deflator at +0.6% while the core PCE price index rose just +0.9%.
* Because of the statistical noise in the defense and inventory components in recent quarters, it is appropriate to average the Q3 and Q4 results to better gauge the underlying performance of the economy. On that basis, GDP was up 1.5% -- which is right in line with the growth pace seenin recent years. Wealth creation associated with the rally in equities and the ongoing improvement in the housing market could create a virtuous cycle at some point. But, for now, the recovery remains quite sluggish and the US economy still faces some important policy risks ahead.
