GDP Expands 1.5% in Q2

Bloomberg details:

The U.S. economy expanded at a slower pace in the second quarter as a softening job market prompted Americans to curb spending.

Gross domestic product, the value of all goods and services produced, rose at a 1.5 percent annual rate after a revised 2 percent gain in the prior quarter, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 1.4 percent increase. Household purchases, which account for about 70 percent of the world’s largest economy, grew at the slowest pace in a year.

Consumers are cutting back just as Europe’s debt crisis and looming U.S. tax-policy changes dent confidence, hurting sales at companies from United Parcel Service Inc. (UPS) to Procter & Gamble Co. (PG) Cooling growth makes it harder to reduce unemployment, helping explain why Federal Reserve Chairman Ben S. Bernanke has said policy makers stand ready with more stimulus if needed.

Looking at the data, we see the declining contribution by consumption, offset in part by a quarter over quarter (small) rise in investment and a less negative impact from government cuts (i.e. addition by the elimination of subtraction). Overall, considering what was going on during Q2 this report isn't awful, but certainly isn't encouraging considering we are now three years out of the recession.

Source: BEA

More on Corporate Profits

Back in September of last year, I showed this chart outlining that corporate profits as a percent of GDP were approaching a three-standard deviation event. Since that time, the relationships has gotten even more extended hitting an all-time high.

Which brings me to this morning's tweet from PIMCO's Bill Gross:

Simple formula: US profit growth rate = (real GDP x 5) – 10. No “ka-ching” at 2% or less GDP growth.

I appreciate the insight that profits can be thought of as being leveraged to economic growth (hence the wide fluctuations), but struggling to see why nominal profit growth would have a relationship with a real (after inflation) economic growth or why those specific numbers (why 2% real and not 2.5% real?) were used.

Anyhow... I was interested enough to see what this equation looked like using actual data, so I put together the below chart going back 60 years against corporate profits, as well as against my old simple standby of using nominal economic growth (my preferred long-term measure for corporate profits as simple math tells you that corporate profits can't grow faster than the economy over the long term or else they'd be bigger than the economy itself - hence profit growth tends to mean revert relative to nominal growth).

The chart...

What do we see?

Well corporate profits are basically right on trend (a surprise to me), but nominal growth is well below trend and the PIMCO formula (the formula based on 2% real growth) is WAY below trend, indicating corporate profits are significantly above trend (by that record 30% level relative to nominal growth and an off the charts 200% relative to the PIMCO formula).

Seems like the old nominal GDP standby has historically been more reliable, but I will be thinking more about the insight that corporate profits are leveraged to (and in need of) specific levels of economic growth. If anything, this may indicate earnings are potentially more stretched than I previously thought.

For those interested, there was a great piece by GMO on the topic of extended profits a few months back.

Source: BEA

First Quarter GDP Revised Down to 1.9%

Marketwatch details:

The U.S. economy ran into a deeper soft patch in the first quarter than initially estimated, a government report showed on Thursday.

The Commerce Department estimated that the economy grew at a 1.9% pace in the first quarter, slower than the 2.2% rate initially reported.

This is down from a 3.0% growth rate of real gross domestic product, the output of goods and services produced in the U.S., in the fourth quarter.

Source: BEA

GDP Breakdown

Bloomberg details:

The U.S. economy expanded less than forecast in the first quarter as a smaller contribution from inventories overshadowed the biggest gain in consumer spending in more than a year.

Gross domestic product, the value of all goods and services produced in the U.S., rose at a 2.2 percent annual rate after a 3 percent pace, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 2.5 percent rise. Household purchases increased 2.9 percent, exceeding the most optimistic projection. Homebuilding grew the fastest in almost two years

So there you have it... a VERY strong (perhaps unsustainable?) contribution from consumption, reduced impact from inventories, the beginning of contribution from residential investment for years to come (after years of decline), mixed trade, and what is likely to be negative impact from the government sector for years.

Source: BEA

Final Q4 GDP Unchanged at 3%

Source: BEA

GDP Revised Up Slightly on Services Spend

CNN Money details:

Economic growth was stronger than originally thought at the end of 2011 as consumers increased their spending and businesses stocked up their inventories. Gross domestic product, the broadest measure of the nation's economy, grew at a 3% annual rate in the fourth quarter of 2011, the Commerce Department said Wednesday. The government had initially said the economy grew at a 2.8% rate. The Commerce Department estimates the GDP figures three times, and Wednesday's report was its second estimate.

Source: BEA

Equity Valuation Based on GDP Growth 2.0

This is based on my post Equity Valuation Based on GDP Growth with a slight twist.

As I've outlined previously, over the long run equity valuation and earnings both grow at roughly the pace as nominal GDP. If earnings (for example) grew faster, then earnings would eventually become larger than the entire economy, which is not possible.

With that in mind, here goes...

The below chart shows:

• Blue: the S&P index (pulled via Irrational Exuberance)
• Yellow: the value ending in 2011 equal to that of the S&P 500 index, then brought back in time by the nominal GDP growth rate (GDP data is available at the Bureau of Economic Analysis)

This is an attempt to compare historical S&P 500 valuation (relative to the size of the US economy), relative to the current valuation level. For example... if the S&P 500 (blue) is below the nominal GDP line (yellow), then the S&P 500 was cheaper then (on this relative measure) than it is now. It also means when the lines cross, valuation levels were equal to today.

The relevance: The chart below shows the relative valuation for each year from 1929 through 2001 (in December 2011 terms), then shows the subsequent 10 year forward change in the S&P 500 (note this does not include dividends).

This chart shows that if this valuation metric can forecast the future (I am not saying it will, but it seems useful), then equity markets may be a decent buy here. At relative value zero (i.e. today's measure) the trend-line goes through 0% on the x-axis at roughly 7.5% annualized (before dividends).

Source: Irrational Exuberance / Bureau of Economic Analysis

GDP Print Okay, Composition Disappointing

Peter Boockvar (via The Big Picture) details this quarter's GDP print (slightly edited / reformatted):

After three quarters (in a row) that averaged just 1.2%, fourth quarter GDP grew 2.8%, a touch below expectations of 3.0%, but Nominal GDP grew well below forecasts. Because the price deflator was up just 0.4% vs the estimate of 1.9%, Nominal GDP was up 3.2% vs the estimate of 4.9%.

• Personal Consumption rose 2.0% vs the forecast of 2.4%.
• Fixed Investment rose 3.3% (helped by a 5.2% increase in equipment and software spending and residential construction rose by 10.9%).
• Trade was a slight drag on GDP growth and government spending was as well, led by a 12.5% decline on national defense spending.
• State and local government spending fell by 2.6%.
• Inventories added almost 2% to growth and, taking out this influence, Real Final Sales rise just 0.8% vs 3.2% in Q3.

Thus, inventories were a large swing factor in the Q4 rebound. Bottom line, Real GDP was near estimates, but nominal GDP was the weakest since Q3 ’09 and Real Final Sales were the 2nd softest since Q1 ’10.

Details below... we can see the HUGE impact of inventory rebuild (potential is there for this to be a HUGE drag in Q1 '12) and the continued drag of local government (i.e. austerity measures).



The below chart shows the longer term breakdown of GDP, showing the importance of consumption on growth. We can see the huge shift in consumption from goods (i.e. things) to services (i.e. outsourcing of "actions" to make out lives easier). Of note, for all the chatter about how large government has become, the Federal government (excluding defense) has not really become a larger as a component of GDP.

Source: BEA

How Do We Grow From Here?

Paul Krugman's latest article Nobody Understands Debt outlines why government debt is different than private debt:

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

How do you grow the tax base? Two ways, increase the tax rate and/or (with fixed rate debt) grow nominal national income. My view is that an increase in taxes is inevitable, so let's move on to some components of national income to determine areas of "opportunity".

The chart below breaks out nominal GDP by real GDP per hour worked and hours worked (which combined make up real GDP per capita), population growth (which added to real GDP per capita equals real GDP growth), and inflation (which added to real GDP growth equals nominal GDP growth) over rolling ten year periods. As can be seen, the "lost decade" has resulted in GDP growth levels at generational lows.

So.. what are the opportunities?

Inflation: it seems easiest to simply inflate our way out of our debt issues, raising nominal GDP without concern over the impact on real GDP. Our monetary policy (i.e. zero rates through at least 2013, quantitative easing, etc....) is aiming at just that. The problem is it really isn't all that easy to add "good" inflation (all price move higher), rather than just commodity inflation which actually adds deflationary pressure to non-commodity goods (less disposable income remains). In addition, as long as debt deflation concerns remains in the U.S., European issues continue to work their way through the financial system, and a lack of global aggregate demand continues, downward pressure remains on price levels.

Population: to me this is the easiest way to grow nominal GDP in theory (i.e. just open immigration for the wealthy and educated), but probably the most difficult to enact new policy to deal with considering we have an entire party against this. In a perfect world, this brings in wealth (i.e. aggregate demand), population (a component in the above chart), and technical skills (i.e. increases the GDP per hour). Oh well...

Hours worked: we face a continued lack of aggregate demand, so corporations aren't hiring / the public sector continues to shed jobs in the face of required austerity. In a perfect world we put people able to work... to work. This could include any project that has positive return on capital and with our dilapidated national infrastructure, there are in my view plenty of projects that can do just that. In addition, as I've mentioned before on the blog, any policy dealing with outsourcing of jobs abroad would have (in my opinion) a positive impact.

Productivity (GDP per hour): we need investment, which requires an increase in savings. Looking at the chart, it looks like GDP per hour jumped in the early part of last decade. The issue is that a lot of this was simply due to outsourcing labor abroad (hence the decline in hours worked). This is coming to roost as outsourcing and lower savings has caused productivity growth to slip to generational lows despite the number of people working on the decline.

Source: BEA

Something Positive for the New Year

An ugly (yet improving) chart shows the number of hours worked per person...

Which, when combined with real GDP leads to a new high in GDP per "man hour".

We have never been more productive with our labor in our history than now (because this is meant to be a positive for the New Year, I won't get into detail why this is also a result of outsourcing labor to emerging countries which has been a horrible policy move IMO).

Source: BLS / BEA

GDP Revised Down to 1.8% on Weaker Consumption

The WSJ details:

The U.S. economy expanded less than thought during the third quarter as consumer spending fell short of an earlier estimate, though signs point to stronger growth in the final months of the year. Gross domestic product, the broadest measure of all the goods and services produced in an economy, grew at an inflation-adjusted annual rate of 1.8% in the July to September period.

The revisions cause?

The latest estimate showed personal consumption expenditure, which accounts for about two-thirds of spending in the economy, rose by 1.7% in the third quarter. That compares to a previous estimate of a 2.3% increase.

Source: BEA

GDP Growth Revised Down Due to (Lack of) Inventory Rebuild

Bloomberg details:

The economy in the U.S. expanded less than previously estimated in the third quarter, reflecting a drop in inventories that points to a pickup in growth as 2011 comes to a close.

Gross domestic product climbed at a 2 percent annual rate from July through September, less than projected and down from a 2.5 percent prior estimate, revised Commerce Department figures showed today in Washington. The median forecast of 81 economists surveyed by Bloomberg News called for no revision. Excluding stockpiles, so-called final sales climbed 3.6 percent, the most since last year’s fourth quarter.

As can be seen below, the decline was almost entirely due to the negative impact from inventories (i.e. we consumed what we had previously stored and businesses didn't restock), offset in part by an increase in net exports.

As I mentioned following the most recent trade release:

Trade (imports) is down not because we are consuming goods made in the U.S., but rather because businesses paused on rebuilding inventories.

In other words, it seems we are simply consuming past imports, thus when inventories are rebuilt, the above "should" revert to negative territory unless aggregate demand collapses. Something else to keep an eye.

Source: BEA

Economy Grows at 2.5%, Led by Spending and Investment

BusinessWeek details:

The U.S. economy grew in the third quarter at the fastest pace in a year as Americans reduced savings to boost purchases and companies stepped up investment in equipment and software.

Gross domestic product, the value of all goods and services produced, rose at a 2.5 percent annual rate, up from 1.3 percent in the prior three months, Commerce Department figures showed today in Washington. Household purchases, the biggest part of the economy, increased at a 2.4 percent pace, more than forecast by economists.

Looking at the chart below, another potential bright sign is the pickup in non-residential investment in the quarter showing that corporations may finally be using all that cash to reinvest in their businesses (though they also appear to have "paid" for this investment by delaying inventory purchases).

If the next step in this cycle is an inventory rebuild and (don't want to jinx it) hiring, we may be in business.

Source: BEA

Below Trend Growth

The WSJ details:

It looks as if, despite everything, gross domestic product picked up in the third quarter, easing fears that the U.S. was on the cusp of another recession. But that doesn’t mean the economy is anywhere near where it needs to be.

Economists expect Thursday’s GDP report from the Commerce Department will show the economy grew at a 2.7% annual rate in the third quarter. That would still leave economic output 6.7% below what the Congressional Budget Office estimates its potential is. In other words, in a world where employment and economic activity were as high as they could be without the economy running into inflationary trouble, the U.S. would be producing about $900 billion more in goods and services a year than it is now.

Experts quibble about exactly where potential GDP is these days, and that’s especially true in light of all the damage the economy has suffered.

As the last portion of the article outlines, experts quibble where potential GDP is these days. I (a non-expert) will outline an alternative way to project potential GDP... past performance. While past performance does not guarantee future performance for investments, it also does not guarantee where the economy should be today. That said, it does represent a growth rate that Americans and American systems (tax levels, spending, debt accumulation) were used to dealing with / expected.

Below is a chart outlining just that... real GDP going back to mid-1971, along with what real GDP would look like today if it grew at the 3.1% pace of growth it saw on average between June 1971 and June 2007. In addition, the yellow line is the difference between the two.



In this case, the differences implies current GDP is 11% below potential.



Source: BEA

More on Chinese Investment

Yesterday, I posted about China's Investment Conundrum (specifically, that China can't keep growing their investments at the torrid pace we've seen due to simple math). Below is a comparison of the composition of China's economy vs. that of the U.S., as well as growth in each component from 2001-2010.

To show this in a different way, below is just U.S. and Chinese investment. Combined, they have grown at a ~4.5% annualized clip, which not coincidentally is just about the pace of global GDP growth over that time frame. In other words, China has been taking production market share (a lot of it) from the U.S. (and developed world). At some point in time there isn't any more market share to take (or in theory the outsource trend could reverse), thus the entire consumption pie (including Chinese consumption) needs to grow at a faster pace in order for China to maintain the outpaced growth seen.

Source: BEA / Chinability

Where's the Investment?

Calculated Risk posted some great recession measure "drawdown" charts:

• Real GDP / GDI
• Real income less transfer payments
• Industrial Production
• Employment

One additional area not outlined in the post was investment, which is the only component of GDP (of the C + I + G + NX) to still be in negative territory relative to pre-crisis levels.

The bulk of the decline is concentrated in residential investment, but non-residential investment has declined over that time as well.

Source: BEA

Corporate Profits, Economic Growth, and Equity Valuation

Scott Grannis asks:

Corporate profits are fantastic—what's wrong with equity prices?

As I've discussed numerous times (an example is Equity Valuation Matters), over the long run, earnings matter for equities and those earnings are very closely tied to underlying economic activity. However, over the short-run, earnings (and equity prices) may dislocate from the underlying economy due to a number of factors. In the current market where earnings have dislocated in a positive direction, some reasons may include cost cutting, accounting that allows banks to smooth write downs, low taxes, cheap financing, and a lack of competition for corporations (i.e. the struggles we've seen within the small business sector).

This is another way of saying that all earnings are not created equal. If earnings could in fact consistently grow faster than the underlying economy, then earnings would eventually be larger than the economy itself (a mathematical impossibility). A warning sign is that in the most recent data, as shown in Scott's chart, corporate earnings as a percent of GDP are above 10%, 4% above its 50+ year average.

While this 10% level is unprecedented over the past 50+ years, dispersion between earnings and/or equity performance and nominal economic growth is not. However, in the long-run (sometimes a very long-run), the relationship tends to be very tight. The chart below shows this connection in a chart normalizing data going back to 1951 (the BEA has data going back three more years to 1948, but the relationship is the same).

As for equities being cheap, I actually happen to believe there is in fact a lot of value out there, but I personally wouldn't call the broader market cheap with all the tough issues that need to be addressed. In addition (ignoring whether earnings are / are not sustainable), it matters when you start looking. As Scott outlined, over the last 10 or 20 years, earnings have grown faster than equity valuations. However, over the last 60 years (i.e. the chart above), equities are actually outperforming (i.e. P/E's have expanded).

Source: BEA, Yahoo Finance

Core European Growth Stalls

In case you missed this yesterday.

Source: Eurostat

Turning Japanese

I've recommended Steve Keen's piece The Roving Cavaliers of Credit before, but I highly recommend it for those that think inflation remains a concern.

Source: BEA

U.S. Economy Firing on No Cyclinders

As Calculated Risk points out:

Not only has growth slowed, but the recession was significantly worse than earlier estimates suggested. Real GDP is still not back to the pre-recession peak.

The chart below shows the rolling three year average contributions by consumption, investment, government, and net exports... all of which combine for a real GDP lower than the level seen three years ago.

Source: BEA