The U.S. economy shrank 1% annualized during first-quarter 2014, according to a revised estimate released yesterday. This is the first report of negative growth since 2011. So why were both the U.S. stock and bond markets up immediately following this news? Because this downturn was largely expected. We think the contraction is likely to be temporary.

Recessions are typically viewed as two consecutive quarters of negative economic growth. We don’t believe we’re headed there now. A closer look at the numbers continue to point toward slow expansion.

The first-quarter downturn was caused mainly by lower inventories, a big drop-off in exports (-6%) and business investment (-1.6%), both of which were up substantially at year-end 2013. However, consumer spending, the primary driver of the U.S. economy, held steady in first-quarter 2014.

More importantly, recent monthly data suggest the U.S. economy returned to growth in second-quarter 2014:

• Durable goods orders surpassed expectations in April, up 0.8%, following on March’s 3.6% advance.
• Manufacturing continues to grow: the Purchasing Manager’s Index rose to 56.2 in May; higher than 50 indicates expansion.
• The service side of the economy continues to expand: the Purchasing Manager’s Index for Services was 58.4 in May; higher than 50 indicates expansion.
• Retail sales continue to expand at a solid pace. Sales for the three months ended in April were up 3.3%, compared to the year-earlier period (U.S Census Bureau).

Impact on the markets and our strategies

We believe the weak result for first-quarter 2014 is yet another indication that the U.S. economy is struggling to regain its footing nearly five years after the official end of the recession.

As I mention above, however, we continue to see signs of moderate strength in the more recent data, suggesting that the U.S. economy will continue to expand, albeit at a frustratingly slow pace. As we have said to clients in our previous two Quarterly Outlooks, 2014 is not likely to end up with the U.S. back in recession. However, we expect the rate of expansion this year to remain below the long-term trend of roughly 3% annualized.

Still, U.S. companies should continue to benefit from strong balance sheets and record-high profitability. The investment portfolios we have created for clients are designed to capitalize on even below-average economic growth, while cushioning sharp movements in asset prices.