US Economy - Return to Normal OR New Normal?
Just how far can government assisted growth stretch? Are we returning to normal or finding a new normal?
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The downward revision to third quarter GDP was no surprise to economists who had forecast the change. What might surprise them though is if government assisted growth does not translate into a more natural form. The problem with the third quarter's style of growth, you see, was that it was greatly driven by direct and indirect government stimulus. This specific recession has been quite special though, and so we expect more stimulus is going to be necessary to help bridge the gap to normal economic activity. However, the extensive quantity of stimulus allocated to "bridge the gap," quoting the President, is not coming without a cost, and should bear burden of its own.
US Economy - A Return to Normal OR a New Normal?Third quarter GDP faced its first revision this past week, with quarter-over-quarter growth reduced to 2.8%, from 3.5%. That's not the best news for an economy that has recently seen the return of raised concerns. However, the result was right in line with the economists' consensus view. Therefore, not much market impact resulted from the sour data. Still, much can be gleaned from a closer inspection...
"Stopgap measures drove economic growth in Q3"
Even after revision, growth of any sort is comforting to an economy emerging from The Great Recession; but is it misleading as well? In the year's second quarter, GDP contracted by 0.7%, so anything positive would have worked for Q3... the bar was set low. The drivers of growth, however, may not be the kind we can count on in quarters to come.
- Giving proof that "Cash for Clunkers" paid tangible dividends, Motor Vehicle sales added 1.45 percentage points to Q3 GDP, after only contributing 0.19 to Q2.
- A sign that the "First-Time Homebuyer Tax Credit" made a difference, Real Residential Fixed Investment increased 19.5%, after falling 23.3% in Q2.
- The government also continued to play an influential role outside of the two incentive programs detailed here, as its direct investment in the economy increased 8.3% in Q3. Of course, state and local government consumption expenditures and gross investment decreased 0.1%, due to lower capital inflows, a requirement to balance budgets and an inability to print money like Uncle Sam.
- Higher food and energy prices also played a role, as they drove a 1.4% increase in the price index for gross domestic purchases.
Are you getting the picture? Stop-gap measures and inflationary like price change drove economic growth in Q3. Government representatives would rightly respond to this by noting the necessity of government stimulus in times like these, and the effectiveness of its specific effort. That's not what we are worried about though; rather, we wonder if this particular recession will respond and return to normal as quickly as in past economic cycles. And if it does finally recover to special amounts of stimulus, then what repercussions might result from that excess?
More on GDP Factors
On a positive note, revived global demand led exports 17.0% higher in Q3, but a likewise increase in imports led to a net reduction to GDP for the quarter. Still, we find it reassuring that both foreign demand and domestic demand for goods are on the rise, and certainly Chinese domestic growth plays a special role in current times. Also, a favorable quarterly change in inventories helped GDP by 0.87 of a percentage point, and is likely to contribute more to GDP in the near future. Finally, Corporate Profits also improved, increasing by $130 billion in Q3, versus a $43.8 billion in Q2.
Still, another less explored negative aspect threatens; commercial real estate non-investment continues to portend more trouble for that particular marketplace and lenders too, and weighed against the overall economy in Q3. We should also consider what drag this segment of our economy might bring in 2010.
A New Normal OR a Return to Normal?
So if the drivers of growth are unnatural, and if a new normal is taking hold as it seems, then Q3 economic growth might not mean as much as generally thought. Tightened lending standards, increased regulation, new government spending and likely taxation, excessive unemployment, war spending, and inflationary threats weigh on our future, so how then can we find hope in this nascent report of economic growth? This rhetorical question was attempted to be answered for me actually by an economist, whose name I failed to note, interviewed on Bloomberg Radio this past week. He said his faith in the future was fueled by Leading Economic Indicators.
Let's take a look at the leading indicators then...
Leading Economic Indicators (LEI) were reported for the month of October on November 19, and increased by 0.3%, after rising 1.0% in September and 0.4% in August. In fact, October marked the 7th consecutive month of LEI rise. Conference Board Economist Ken Goldstein said, "The data indicates that economic recovery is finally setting in. We can expect slow growth through the first half of 2010. The pace of growth, however, will depend critically on how much demand picks up, and how soon." Well duh...
Taking a closer look at the numbers, 6 of 10 indicator components increased. With all due respect, I'm sorry, but I would not call that "broad-based" nor "wide-spread," like the Conference Board describes them. Positive drivers of LEI improvement included interest rate spread, average weekly initial claims for unemployment insurance (inverted), stock prices, average weekly manufacturing hours, real money supply and manufacturers new orders for consumer goods and materials.
Jobless Claims - While an improved rate of job shedding might be a positive indicator, it's generally agreed that the degree of panic that spread across the economy led to excessive layoffs versus historical recessions. Jobs are not being added to the economy yet on net, and once those excessively cut jobs are returned to compensate for productivity stretching (overworking the employees kept), we wonder if a lull in hiring might ensue in our services heavy economy. By "wonder," I mean, I think there is a good enough chance of it occurring.
Stock Prices - Stocks are clearly acting in a manner now that is indicative of a re-evaluation of valuation. Like the overcompensation in the labor market, stocks had dropped to a sort of anti-bubblistic point in March and have adjusted for that excess decline since. We suspect as we near January, there exists a decent possibility of a different sort of adjustment for a slow recovery, which could include a return into economic contraction. By "could" I mean I think there's a good enough chance for it.
Manufacturers Hours - Overworking the few employees you have left tends to drive increased manufacturers hours. While that happens due to demand renewal, it also happens due to post recession business inventory restocking. In other words, businesses tend to stock at a lower level and in a targeted manner matching lighter recession environment demand. When expectations adjust for an improving economy, great need arises to restock goods. That's not necessarily a sign of longer term economic virility though.
Money Supply - We know why this is higher, and we understand the stimulative effects of it, but we are also aware a dead zone between significant stimulus funds and those for whom it is finally intended. Banks are still not lending like they use to, which is likely a good thing in some respects, but it makes for a new environment that perhaps will not be as vibrant as past economic norms. By "perhaps"...
Manufacturers Orders - We reiterate our inventory restocking note here, and wonder again if a lull will follow such restocking. Historically speaking, inventory restocking occurs after recession and often is followed by a quarter of economic contraction as inventory flow returns to normal and demand adjusts as well.
The Negative LEI Factors
Consumer Expectations - This was the most important negative weight on LEI in October and thus the economy. We live in a consumption economy (we don't make things), and so if consumers are feeling frugal, well that's not a good sign for future economic activity. Clearly some of the LEI factors are going to weigh more than others, and we would likely assign a significant weight to consumer expectations, if it was under our charge to do so.
Building Permits - Housing has always been a critical driver of the US economy. Despite recent New and Existing Home Sales data, we are concerned about what Housing Starts indicated recently (look for an article on this topic soon). We expect incentive provided by the First-Time Homebuyer Tax Credit is running thin, though expansion of the program should help it retain some of its impact.
Supplier Deliveries - We need sales to keep inventory flowing, and so if there is no near-term return to normal after inventory adjustment, then perhaps the US economy, and thus stocks, will teeter along for a bit longer. This is consistent with most expectations for slow economic growth in 2010, and this may already be greatly priced into stocks as well. By "may" I mean...
Manufacturers Orders for Capital Goods - Businesses are not investing significantly yet, as seen in the results of the tech sector. Corporate cost cuts have run deep, and until margins begin to expand on sales growth rather than cost reduction, businesses will not invest in growth. Public companies have a bottom line to manage for the sake of their shareholder overseers after all.
We opine that the drivers of nascent US economic growth are unnatural, and seem unlikely to be followed by the natural factors necessary to drive substantial near-term growth. While leading economic indicators are somewhat enthusing, they certainly do not indicate economic boom ahead, if even modest growth. We conclude, therefore, that further economic stimulus should be considered, but we also worry about the tangible repercussions of such actions.
Rather than a return to a normal economic environment, a new US economy seems to be emerging. While the "new normal" or "new economy" theory is often posed, we have a more encompassing view of these individual theories. We see each such change as a tweaking toward a better economic machine. Technology has brought with it productivity improvement and margin expansion. Globalization has created a more competitive environment beneficial to consumers and shareholders. Given, in a fair competitive operating environment, the benefits of globalization might better serve long-term American prosperity and the American worker.
This latest tweaking toward "new economy" will be the result of recent excesses, and will likely include excessive and politically inspired changes of its own. The drag of substantial unemployment; and the weight of regulation (whether necessary or not); tightened lending standards; inflationary pressures; and the other factors highlighted here bear a cost and point toward a new normal. The consequences of that "new normal" are many and varied, and so we hope you will join us as we better serve you with those communications as extensions of this theory and article.
Editor's Note: This article should interest all investors, especially those in cyclical shares including Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC), Citigroup (NYSE: C), Morgan Stanley (NYSE: MS), Goldman Sachs (NYSE: GS), J.P. Morgan Chase (NYSE: JPM), U.S. Bancorp (NYSE: USB), Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE), Toronto-Dominion (NYSE: TD), Royal Bank of Canada (NYSE: RY), PNC Financial Services (NYSE: PNC), SunTrust (NYSE: STI), Robert Half Int'l (NYSE: RHI), Korn Ferry (NYSE: KFY), Manpower (NYSE: MAN), Monster World Wide (NYSE: MWW), Wal-Mart (NYSE: WMT), Target (NYSE: TGT), Apple (Nasdaq: AAPL), Microsoft (Nasdaq: MSFT), General Electric (NYSE: GE), Ford (NYSE: F), Berkshire Hathaway (NYSE: BRK-A, BRK-B).
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