GDP Revision Concerns Us Still

Investors were not surprised when GDP was revised lower Friday, but as the data is digested, we suspect it will be regurgitated. Stocks closed higher Friday, as press and pundits positioned the message positively. We prefer you not rest comfortably though, because there's a bear lurking. In fact, our analysis turns up an interesting aspect with regard to the trade deficit between the US and China, and a conflict between the trade data and lower private inventory investment in Q2. Meanwhile, some of the factors that propped up GDP in Q2 are clearly falling apart in Q3 and Q4.

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GDP Revision

The Bureau of Economic Analysis published its first revision to second quarter GDP Friday. We were one of the first publishers warning that GDP would be cut in half upon revision, once international trade data were published in early August. Gradually, as economists revised their forecasts lower over the weeks that followed, investor perception was well-prepared for the BEA's news release.

The economists consensus was set for a deep downward adjustment, to +1.3%, from the initially reported 2.4% growth. So, when the data showed a gain of +1.6%, the market was unaffected. Stocks had been moving lower in the days and weeks ahead of the news already. Stocks still dove though once 10:00 AM rolled around, when investors found less than reassuring words in a speech given by Federal Reserve Chief Bernanke in Jackson Hole, Wyoming. However, the Dow moved 1.65% higher by the close.

What investors, or the press at least, liked about the latest take on GDP was that a greater level of imports drove the redesign. However, most of the issues that concerned us about the data detail in the first place were still problematic at its revision.

First of all, there's a misconception about the international trade data that needs to be cleared up. We reported on this upon the early August release. Normally, the deficit is characterized by a higher level of imports-to-exports, but both usually increase. This time around, while imports increased by $5.9 billion, exports dropped $2.0 billion against May levels. The drivers included a seasonal adjustment to petroleum trade, but also a significant deficit expansion between the US and China. Also take note of the fact that the details of the report show that the deficit was mostly driven by decreases in the export of capital goods ($1.4 billion), industrial supplies and materials ($1.0 billion) and increases in the import of consumer goods ($3.1 billion), automotive vehicles and parts ($1.3 billion), other goods ($0.6 billion) and capital goods ($0.5 billion). The decrease in exports helps to create an illusion of stronger imports. And we have a theory on the imports gain as well.

Here's a bit of golden theory you've heard nowhere else, not even from your highly paid economic resources. The increase in import demand from China seems to run counter to signs of decreased consumer spending here at home. I think I know why.

Your Greek Wisdom:

I suspect retailers are demanding more low-priced goods to stock their shelves with and distributors are providing them more Chinese goods as a result. That's not the positive signal the data would seem to offer, and which the popular press and most market strategists promoted Friday. Yes, reporters were painting the drop in GDP with a bright color, saying it was due to higher imports. We're saying that's not the case at all, that there is simply a shift toward lower priced goods that has fogged the view of the novice audience. Our theory makes perfect sense and fits the broader economic puzzle better. Need a market strategists or representative partner for your investment or consulting firm?

Take note also that the BEA said the second most important factor in the GDP revision was a sharp drop in private inventory investment. Might that have had more to do with the lower price of the inventory being added (from China) versus the aggregate inventory investment in terms of quantity? I think this is probably partly to blame, and is the only way I can tie the two conflicting components of GDP together. How else could imports be rising and inventory investment be decreasing? Demand for US goods is slipping too, as seems clear by the manufacturing slow down.

Here's another crack in the foundation you should note. GDP growth was greatly aided by an upturn in residential fixed investment. That's right, so the market's hopes were propped up by second quarter housing strength. Well, we know that temporary strength, if we can even call it that, hinged on the special tax incentive. We also know very well that housing has collapsed since the expiration of that deadline. So, what then does all this information portend about Q3 and Q4, if not serious trouble? Also, federal, state and local government spending helped fuel growth, and we do not see that lasting either.

Thus, the market's high hopes expressed Friday by the Dow reversal seem based on unstable footing. This portends serious economic trouble for Q3 and Q4, so beware the bear. The economy, including both real estate and the stock market remain vulnerable, and so double-dip recession or something similarly sinister threaten. Here's some more good news. With the Iraq draw down about to get going, and with oil prices relatively low, the president's men might soon get the bright idea to begin a war with Iran.

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