Main menu

A weaker-than-expected Q4 GDP points to a stronger Q1

The government's first guess at the growth of fourth quarter GDP was less than expected (3.2% vs. 3.5%, with some expecting 4-5%), but if that is the reason for today's market selloff, then this is another good buying opportunity. GDP estimates can and do change significantly over the years, of course, but meanwhile, the main reason that Q4 growth was disappointing was that there was a large decline in inventories. As the chart above shows, inventories subtracted a full 3.7 percentage points from Q4 growth. As Brian Wesbury notes, real final sales (real GDP excluding inventories) rose at a very impressive 7.1% annual rate last quarter, with the result that:

... manufacturers and retailers underestimated consumer demand and ran down inventories dramatically in the fourth quarter. Anecdotal reports suggest that low inventory levels are having a cost in the form of lost sales. Moreover, prices are not likely to be slashed to reduce excess inventories after the holidays. What this means is that there is more room for production increases in 2011 and inflation will continue to move higher.

It is quite likely that businesses are already attempting to rebuild their inventories, but even if they manage to hold them steady, that will have the effect of boosting first quarter growth. I recall quite a few times in the past where a weak GDP number caused by inventories was followed by a stronger number in the subsequent period. It's likely to happen again.

I needed a 4% Q4 print to make my Dec. '09 prediction of at least 3% growth in 2010 be correct. If the first estimate stands, then I will have overestimated growth by 0.2%. Not too bad, but it was my optimism on the economy's growth prospects that led me to mistakenly expect the Fed to begin tightening policy last year, and to expect bond yields to be higher than they turned out to be. But just because I overestimated growth last year does not mean I need to cut my growth expectations (at least 4%) for this year. Stronger growth is likely because confidence is up, uncertainty is down (e.g., the tax cut extension passed), global growth remains very strong (e.g., China and India), fiscal policy headwinds are slowing (e.g., no more wasteful stimulus experiments), and monetary policy remains very accommodative.

Another thing I did not expect was the very small rise in the Q4 GDP deflator (0.26% annualized), which contributed to a very small rise in the nominal growth of Q4 GDP: 3.44%. The very small gain in the deflator last quarter could be just a one-time event, since as the chart above shows, on a year over year basis both the deflator and the Employment Cost Index look to have bottomed. Regardless, relatively slow growth in nominal GDP, alongside somewhat faster growth in M2 in the fourth quarter, resulted in a modest decline in M2 velocity (see chart below), whereas I had been expecting a pickup. But again, that is not a reason to get bearish on 2010. It still makes sense for velocity to pick up (confidence is improving, and the dollar is weak, which suggests that money demand is declining on the margin even as the Fed remains very accommodative), and it is also the case that M2 growth appears to be accelerating a bit.

Stocks gain against gold, and that is good news

The above chart plots the daily ratio of the S&P 500 index to the spot gold price. Stocks have been doing pretty well in nominal terms, with the S&P now up 92% from its Mar. '09 low. But against gold, stocks are up only 36% from last year's low. The thing that caught my eye is that since the end of last November, stocks are up 10% while gold is down 5%. Gold is down almost 8% (almost $110/oz) since its early December high. Stocks may be on the verge of a significant upswing against gold, after losing 87% of their value from the highs of 2000 through Mar. '09, as shown in the next chart.

Taking a very long-term perspective and ignoring the impact of dividends, stock prices have only just kept pace with gold prices over the past 83 years. This fact lends credence to those who advocate a gold standard, since it shows that gold indeed holds its value against other real assets over long periods, though of course there have been huge swings from time to time. But if the best that gold can do over time is to match the increase in stock prices, while delivering enormous extra volatility along the way, then gold is not a particularly attractive asset from an investment perspective, especially since it pays not a penny of income and in fact costs money to store. And it's particularly unattractive today, unless you are convinced that the Fed is on the verge of committing a major monetary mistake and/or the U.S. is going to default on its debt obligations.

What are the drivers behind this recent development? That's anybody's guess, of course, but here's mine. Borrowing from observations made by my friend Don Luskin, I think the recent rise in stocks and the decline in gold reflect an emerging sense of optimism regarding the economy. The economy is doing better than expected, and it's not just because the Fed is buying Treasuries by the bushel. As I've noted before, it's hard to find evidence that the Fed's QE2 purchases have resulted in any expansion of the money supply; indeed, it looks like they have only managed to keep the monetary base from shrinking. In any event, with the economy doing better, the need for a QE3 definitely declines, and that in turn means less risk of a possible Fed inflation error, plus less risk of some significant, adverse geopolitical or financial crisis. So the case for buying gold at prices that are quite high on both a nominal and real basis is diminished.

Consider also that the long-term trends in stocks vs. gold prices reflect major shifts in the relative attractiveness of financial vs. real assets. That relationship, in turn, is heavily influenced by monetary, fiscal, and political trends. Stocks collapsed against gold in the 1970s, because the U.S. devalued the dollar, the Fed was way too easy, and presidential leadership (Nixon, Ford, Carter) was weak. Stocks then surged against gold from the early 80s to 2000, because the Fed was tight, inflation collapsed, taxes were reduced by an order of magnitude, and presidential leadership was generally good (Reagan, Clinton). Stocks have been crushed since 2001, as the Fed began pursuing a very accommodative monetary policy, government meddling in the housing and financial markets led to a huge housing boom and bust, and presidential leadership has been at best controversial and less than inspiring.

It may not be obvious yet, and I may be jumping the gun, but I think it's worth suggesting that we may be on the cusp of a new era, characterized by improving fiscal policy (e.g., a reduction in the size of government and reduced tax burdens), a return to more prudent and/or rules-based monetary policy, and better presidential leadership. We've already seen financial assets recover a good deal of what they lost in nominal terms in the past three years, but stocks could still gain significantly relative to gold.

Claims bounce but still reflect improvement

Weekly claims for unemployment last week rose 50K more than expected, but I don't think that is a concern. Before seasonal adjustment, claims actually fell by 68K, so what this means is that claims didn't fall by as much as the seasonal factors expected. That's the flip side of what was happening near the end of last year, when claims weren't rising as much as expected. Now the dust is settling, and the picture that emerges is one in which unemployment claims have definitely moved lower, but not hugely. It's still a sluggish labor market, but the outlook is gradually improving.

Business investment remains very strong

Once again, new orders for Capital Goods—i.e., business investment—exceeded expectations. December orders were up 1.4% (vs. an expected 1.3%), on top of upward revisions to the data for the previous two months. Over the course of last year, business investment has increased by 15.5%, a staggering figure. If any part of this recovery can be termed "V-shaped," this is it.

(I'm using a 3-mo. moving average in this chart because the raw data are plagued by a seasonal adjustment flaw that doesn't fully correct for what appears to be a tendency for orders  to surge at the end of each calendar quarter.)

Strong gains in business investment reflect the return of confidence to the business sector, while at the same time laying the groundwork for future gains in productivity.

Coach Obama still doesn't understand the game

From a taxpayer's perspective, Obama's biggest weakness is his lack of understanding of how the economy really works. That weakness has already cost us $1 trillion, and what he said in his SOTU speech last night shows that this was a lot of money down the drain, because he learned very little from his failures these past two years. He continues to believe that enlightened politicians can boost economic growth much like a good coach can whip a team or a star player into shape. Last night's SOTU peech was Coach Obama's pep talk before the big game. Problem is, he still doesn't understand the game of economic growth, so there is little chance that his coaching will prove effective.

If he learned anything in the past two years, it was that the public doesn't like the concept of stimulus spending, and it doesn't like a lot of new government programs. Solution? Call the stimulus spending something else, and don't say it's government that is taking over healthcare, energy research, high-speed rail and education, just say it's all about investments that will make our economy stronger. That may sound great to other liberals, but to those working in the trenches it's just more spending, more regulations, and more suffocating government presence. Competitiveness comes from the bottom up, not from the top down: from entrepreneurs, inventors, risk-takers, and just about anyone who is willing to work and wants to improve his standard of living. Policymakers' ability to influence things is limited to setting the ground rules that in turn maximize the private sector's growth incentives. The chances are slim that Coach Obama can direct tens and hundreds of billions of dollars to the companies and industries that are going to revolutionize the future; there are millions of people at work all over the world trying to do this already, and there is no shortage of capital ready and willing to finance economically viable projects.

If Obama really understood the economy, he would have showed much more interest in cutting spending. Proposing to freeze discretionary spending while also proposing to spend a whole lot on "investments" is not going to avoid the fiscal train wreck we are headed for, and it's not going to help the economy. Federal spending has increased hugely under his watch, and is scheduled to absorb an unprecedented amount of the economy's resources in the future. This is sapping the economy's strength by allowing inefficient government programs and bureaucrats to waste the economy's scarce resources. Cutting spending now is the best way to strengthen the economy, since it returns money to the private sector where all true growth originates. Cutting spending also reduces expected future tax burdens, which in turn encourages more investment and work effort.

About the only thing Obama proposed that would actually enhance the competitiveness of the economy is a reduction in corporate tax rates, in exchange for the elimination of loopholes and deductions. A lower tax rate applied to a broader tax base is bound to strengthen the economy, since it increases the rewards on the margin to new investment, and it removes distortions which lead to inefficient investment decisions. Higher after-tax returns should result in more investment, and more investment means more productivity and more jobs.

Since our head coach is almost clueless, should we be worried about the ability of the U.S. economy to win? Fortunately, Obama is not going to be calling many of the plays. He's lost the ability to ram things through Congress, and the Republicans are tightly focused on doing the right thing (e.g., cutting spending and reducing tax and regulatory burdens). At the worst we will suffer from gridlock, but that's much better than suffering from an even more burdensome government. At best, the Republicans will convince some Democrats to move in a more sensible direction (e.g., dismantling ObamaCare, cutting farm subsidies, scrapping the ethanol program, cutting corporate taxes) and Obama may find himself forced to go along. Obama has also lost a lot of his authority, because so much of his agenda has proved misguided, and his popularity and power of persuasion consequently have suffered.

Lacking authority, vision, and a coherent plan for the future, Obama's SOTU was a big disappointment. Nevertheless, it has expanded the political vacuum that exists in Washington, and politicians likely will scramble to fill it, and that is not a bad thing at all. There are plenty of politicians of the Tea Party variety that understand what needs to be done, and the public has already voiced its approval via last November's elections.

I think we have a lot of positive fiscal policy developments to look forward to, and that is an important source for my continuing optimism.

Households continue to deleverage

Many argue that too much debt on the part of U.S. households was one of the contributing factors to the 2008-09 recession. Whether that's true or not, households have managed to deleverage impressively since late 2007. Total financial burdens (monthly payments on mortgages, consumer debt, auto leases, homeowner's insurance, and property tax, as a % of disposable income) dropped 11% in the three years ended last September, and mortgage and consumer debt burdens dropped by almost 15%. By these measures, financial burdens are now close to their average of the past 25 years.

Mortgage defaults undoubtedly have contributed to the deleveraging process, but so has a lot of refinancing of existing mortgages—many millions of households now enjoy paying the lowest mortgage interest rates in many generations. According to Merrill Lynch data, the average rate on all existing mortgages dropped by half a percentage point from Sep. '07 to 5.1% in Dec. '10. Regardless of how the deleveraging occurred, household finances on average are in much better shape today than they were three years ago.

I also note that deleveraging has proceeded at a fairly rapid pace even as the economy has been recovering. This underscores the point I've made repeatedly that leverage does not create growth—it merely transfers demand from one person (the lender) to another (the borrower).

Real estate update--no sign of a double-dip

According to the two indices of real estate prices in this chart, both residential and commercial estate prices have been roughly stable for more than one year, after having suffered brutal declines of 30% and 40%, respectively. While many observers are extrapolating the marginal weakness displayed in the Case Shiller-20 index (shown above) in recent months, and calling for a second wave of price declines, I offer the following chart, which is a subset of the index above, and which reflects prices in the 10 largest metropolitan areas. Despite the fact that this chart is also adjusted for inflation, the trend since early last year or so is flat, if not slightly rising. The nominal value of this index is now almost 5% above its April '09 low. The real estate market is always one in which local conditions can predominate, and the fact that one's selection of markets can paint two different pictures suggests that on balance it's likely that not much is going on.

I continue to believe that the correction in the real estate market has run its course. It's been 5 years since the peak, which is plenty of time for the market to adjust to new realities. Residential construction has plunged by 75%, leaving new home construction far below the level necessary to keep pace with new household formation, and thus effectively taking a lot of excess housing inventory off the market. Borrowing costs have also plunged, and real personal incomes have risen, raising housing affordability to levels not seen in decades (chart below). An index of homebuilders' stocks is up 150% from its late-2008 lows, and lumber prices have more than doubled since March '09, both of which point to a nascent recovery in the construction market's fundamentals. Finally, I note that the economy is clearly improving, and household net worth has risen significantly in the past two years.

There may well be a significant increase in the number of foreclosed properties being brought to market this year, but there is a price that will clear any market. Whether it will take significantly lower prices for the market to clear this year is the key question. I doubt it, but those who are skeptical of the economy's ability to grow believe that real estate prices will need to fall by enough to cause new concerns about the health of the banking sector and new concerns about household net worth. Only time will tell, but I think the preponderance of evidence continues to suggest that the worst has passed, and optimism makes more sense than pessimism.

Bank lending is definitely picking up

Late last year I highlighted a variety of charts that painted a picture of "impressive economic strength." In this post I revisit one that has displayed some impressive follow-through: Commercial & Industrial Loans, a good measure of bank lending to small and medium-sized businesses. The top chart shows the past 5 years' worth of data, while the bottom chart zooms in on the past several months (both are seasonally adjusted by the Fed). The message is very clear: bank lending to businesses has bottomed, and is now rising at a fairly impressive rate. This marks a very important change in financial conditions in recent months: after two years of a sharp decline, bank lending is up at a 13.6% annualized rate since Nov. 24th.

Unfortunately, we can't know whether the recent strength in new lending reflects an easing of bank credit standards or a new-found desire on the part of businesses to borrow (or stop deleveraging), or both, but it's likely a combination of the two. In either case, however, it reflects increased confidence on the part of banks and small businesses, and that is something that has been sorely lacking in this recovery.

The rise in new lending may also reflect an emerging decline in the demand for money (borrowing money is equivalent to being "short" money, or wanting less of it), and that could mean the Fed's QE2 program is gaining traction. The Fed's massive expansion of bank reserves has not yet resulted in any meaningful expansion of the money supply, as I noted yesterday, since banks have been content to let their extra reserves sit idle at the Fed, but this may now be changing, if C&I loans are any guide.

Nothing is out of control yet, of course, but if there has indeed been a real decline in the economy's demand for money, then this, coupled with increased business confidence, would point to a meaningful increase in nominal GDP growth in coming months. That nominal increase would likely be comprised of a pickup in inflation as well as a pickup in the pace of real growth.

Global industrial production recovery continues

Eurozone industrial activity increased at a very healthy pace in November, with industrial orders up 2.1%. As this chart shows, Eurozone industrial production was up 1.2%, and it has risen 7.3% for the past year. As EconomPic notes, the relatively strong rebound we have seen in Europe and in the U.S. is still in the nature of a recovery from the catastrophic 2008 slump—production is still well below prior highs. But it is an impressive recovery nonetheless, especially since two years ago hardly anyone expected the global economy to be as strong as it is today.

The evidence of monetary excess is elusive, but it can be found

This first chart shows the level of M2, arguably the best measure of the amount of "money" in the economy (M2 consists of checking accounts, currency in circulation, retail money market funds, small time deposits, and savings deposits). The y-axis uses a semi-log scale, so that a constant slope equates to a constant rate of growth, which in this case appears to be about 6% per year, compounded. There are times when M2 grows faster or slower, but on average it has increased about 6% per year, which not coincidentally is only about 1% per year faster than the average annual growth rate of nominal GDP over the past 25 years. A good portion of that faster-than-nominal-GDP growth can be explained by the huge amount of U.S. dollars that are now held by foreigners. When money grows in concert with growth in the nominal value of transactions in the economy, it's hard to worry that inflation is going to rise because there is "too much money chasing too few goods and services."

What about those periods during which M2 has grown much faster than 6% a year (i.e., 2001-5 and 2008-9)? The second chart explains what has happened. There is a strong correlation between big increases/decreases in refinancing activity and faster/slower growth of M2. That's because the refinancing process temporarily creates a lot of extra "money" as money flows into and sits in escrow accounts. Most recently, M2 growth has slowed sharply (the result of rising interest rates since last summer), just as refinancing activity has dropped rather rapidly. The recent slow growth in M2 (2.5% annualized growth over the past three months) is nothing to worry about, because it is most likely the natural result of a decline in mortgage refi activity.

We see a similar story—not much of note going on with the money supply of late—in this chart of bank reserves. As of early January, there is no evidence that the Fed's QE2 program has resulted in any unusual increase in bank reserves, the raw material for any expansion of the money supply. In fact, bank reserves today are almost exactly the same as they were at this time last year ($1.1 trillion). Apparently, the Fed's additional purchases of Treasuries in recent months have mostly been offset by other actions which have drained reserves.

It may be hard to believe, but to date, there is no evidence to be found in the money supply statistics that the Fed's addition of over $1 trillion of reserves to the banking system since Sep. '08 (an 11-fold increase!) has resulted in any unusual increase in the amount of money sloshing around the economy.

What we do observe, however, is that the value of the dollar has declined relative to other currencies, and the dollar buys a lot less gold and commodities (e.g., since Sep. '08 gold is up over 60%, and spot commodities are up 30%). This suggests that there has been an effective increase in the amount of dollars in the system relative to the demand for dollars. It is an excess of dollars in relative terms that is likely responsible for the lower value of the dollar and the higher prices of commodities.

With the Fed holding the amount of bank reserves relatively constant, but at a level that is orders of magnitude higher than we what we observe during "normal" times, the key thing to watch is the demand for dollars, since that is the thing that can change on the margin. If the world wants fewer dollars, then the existing supply of dollars will be "un-hoarded," and banks will want to reduce their holdings of reserves, by using those reserves to support an increase in lending. The result of weaker money demand and more bank lending likely would be faster nominal GDP growth.

I think this process is underway. It's still difficult to see with clarity, but a careful reading of the monetary tea leaves tells us that the economy is "reflating" as we speak—the size of the economy is growing, and the volume of transactions in on the rise.