Today’s commentary
I am not a raging bull, largely because I have concerns about the long-term sustainability of today’s policy mix in Europe and the United States and the rise in equity multiples. But it is undeniable that we are seeing a more bullish outlook for the global economy at present. Below are some thoughts about the outlook in the context of today’s upward revision in US GDP figures.
The salient point on the figures were the upward revision, the inventory builds, consumer spending, business investment and corporate profits. I want to take these each one at a time.
First, the headline number was big. The US economy expanded at a 3.6% annual pace in the third quarter according to estimates. That’s up significantly from the 2.8% figure released in the first estimate. The US is very far from recession as pundits like the ECRI’s Lakshman Achuthan have been calling. Moreover, the jobs data point to strength. Today, the jobless claim number came in sub-300,000, with the four week average claims figure declining to 322,250. That’s incredibly low and it points to strength in the jobs market that will bolster consumer spending going forward. Therefore, the takeaway from the number is that the US economy is moving out of the stall speed zone where any exogenous shock like the next upcoming sequestration cut could throw it into recession. As I wrote yesterday, “the initial phase of the financial crisis is clearly in the rearview mirror”.
I also have to take issue with the bearish bias in one of the posts that will appear in the next links posts. Naked Capitalism had a good piece examining the ISM manufacturing and services sector data and what they saw as a disparity between the what the ISM data were telling us about economic growth and the actual growth. The conclusion the piece seems to have drawn is that the ISM data is flawed and not relevant, meaning that the economy is weak and the ISM data should be discounted. I don’t see this. The conclusion I drew from the analysis is that the ISM data is pointing to sustained recovery and is directionally accurate, though the strength of the signal may be too powerful. One needs to drop bias and see the data for what they are – and they are undeniably positive.
Nevertheless, the GDP report was not as bullish as it seems. As Brown Brothers Harriman noted this morning, inventory data were pointing to the upward revision. BBH also noted the following:
Every year, since the US economy bottomed, there has been at least one quarterly growth number that put the annualized rate about 3%. Many had given up on it this year, but recent inventory data points to that quarter being Q3. That pace of growth, however, does not appear to be extending into this quarter.
So, it is not at all clear that the US economy is about to spring up to a new level, though I believe we are beyond the stall speed phase that got us QE2, operation twist and QE3. Two things: first, every year since the recovery began, we have seen a spring-summer swoon which caused the Fed to increase policy accommodation. This year, the Fed started talking about reducing policy accommodation via tapering. That’s significant because it tells you that we have reached so-called escape velocity where exogenous shocks don’t cause recession.
On the downside, however, it is clear that the pace of growth is going to diminish. Retailers do not want to get stuck with massive inventories after the holiday shopping season is over. They built inventories in anticipation of demand. Meanwhile, retail data for this quarter are somewhat lacklustre. Therefore, I expect inventories to decline as companies attempt to avoid getting caught out with too much stock. That will lower production and act as a drag on this quarter’s GDP. I have already said that I expect the figure to have a 1- handle getting to perhaps as high as 2% or thereabouts.
If we look at the consumer spending subcomponent in the data, we see that consumer spending actually climbed only 1.4% annualized in Q3. That’s the lowest quarterly gain since the recession ended in 2009. So consumer spending was weak in Q3 and looks to be somewhat weak again this quarter. The difference in my view is that companies should not be building inventories this quarter as they did last quarter because of the weak retail picture. The countervailing point however is that ISM data do tell us that new orders are up substantially. Therefore, we might see a surprise on the inventory side again. Let’s wait and see.
And note that I don’t think retail data are nearly as weak as some. It is in the 1-handle range, which is above stall speed but not as robust as one would hope in the middle of a cyclical expansion. A case in point comes from auto sales, where we have seen some strong credit growth figures. Reuters is reporting that, in the US, the average loan-to-value on new cars is now 110.6% and on used cars it’s 133.2%. And while bad loans are declining at this point in the business cycle, the average loss on bad car loans is now $7,770, up substantially in the last year. Repossessions are up sharply, particularly for subprime borrowers. What this tells you is that the robustness we do see is partially attributable to leverage and rising household debt levels. This will be problematic in the next downturn.
In terms of sustaining this upturn, however, the worry here has to be that business investment is just not accelerating. Usually, we would expect business investment to increase at this point in the cycle, especially given all of the risk-on investing we see with the rise in equities and the increase in high yield and convertible bond issuance. That increases job and wage growth to sustain the recovery in a virtuous circle that feeds back into more capital investment. But the (nonresidential) business investment subcomponent of the GDP figures showed slowing. It advanced at a 3.5% pace versus 4.7% in Q2. Those numbers need to be higher.
Perhaps business investment is not as high as it could be because we have overestimated corporate profits. My friend Marshall Auerback wrote me a few days ago about his concerns on accounting. He said that the government deficit at all levels has come down very fast. By accounting identity, we know that connotes a reduction in the combined surplus of the domestic and external sectors. Yet, the national income and product account data show no decline in the profit to GDP ratio. Marshall asked the BEA to discuss the profit data and they basically told him that he was looking at the wrong profit rate. The profit to GNP ratio is 6.5% – much lower than profit to GDP. Moreover, they also said they have properly scrubbed the corporate accounts but that they were worried they weren’t doing it enough for the financial sector.
The conclusion here then is that there is an unexplained profit difference between the GDP and GNP accounts. The BEA weren’t sure what to think. Marshall said that transfer pricing was part of it, as was foreign sourced profits. But clearly something “fraudulent” could be happening in terms of the corporate accounting. I want to flag this issue because we saw it during the tech bubble when there was a disparity between reported earnings and NIPA earnings. Here we are seeing the difference as profits to GDP vs GNP.
The way this ties into business investment is that, if the profits are not as robust as we think, it should follow that business investment will be more muted than anticipated. Now, the GDP numbers show corporate profits after tax, but without inventory and capital consumption adjustments, advancing 5.8% year-on-year. But the S&P 500 was up 16.4% in the year to Sep 30 and is now up 27% in the year to Dec 5th. That tells you we are seeing a massive multiple expansion. And this concerns me.
The bottom line here is that the numbers are good. And the new orders subcomponent on the ISM survey as well as the jobless claim data tell us they should continue to be good and perhaps improve in 2014. But we should be very concerned that multiple expansion and risk-on thinking is going to produce weak returns going forward or create a bubble that ends in a violent correction.
My view here is that the US GDP numbers do point to a relatively bullish global outlook. I have already told you I think good things about Europe, though I believe the recovery there is extremely fragile. Europe is still at stall speed and has not achieved escaper velocity but it is headed in the right direction. My questions are India, China and Japan. Citigroup Chief Economist Willem Buiter has some useful commentary on the global economy. Buiter writes that:
“what is revolutionary about 2014 is that the likelihood of severe downside tail events, which could paralyze the global economy, seems to have diminished significantly (though not disappeared). Granted, the euro-area is still work in progress, China presents meaningful question marks, Congressional gridlock in the US could still throw sand in the federal fiscal wheels and geopolitics can always surprise. But, enough progress has been made that all of these issues seem less threatening today than 12 months ago.”
Buiter sees around 3% growth in the UK and the US in 2014 and 3.1% globally. Like me, he sees China as a question mark. This is especially true given the crackdown on housing. And Japan should see slowing growth due to the consumption tax. Frankly, I think their macro plans are disastrous, especially when one considers that Japan’s government debt to GDP is higher today than it was after World War 2.
Overall though, the picture is good on a cyclical basis, especially in the US and the UK. Where this leads over the longer term is still unknown. But for now, we should expect growth.