Lunch with Dave
by David A. Rosenberg
U.S. GDP Review — Consumer, Where Art Thou?
While the headline real GDP number came in a tad better than expected, at -1.0% QoQ annualized rate, the back data were revised lower and show the recession to be deeper. First quarter of this year, for example, was revised to -6.4% from -5.5% previously. And, it may not be lost on anyone that the four consecutive quarters of economic contraction was unprecedented in the post-WWII era; ditto for the -3.9% year-on-year trend. In other words, while nobody is willing to go out on the limb and call this a depression (the same academics that brought you “The Great Moderation” during that last great albeit leveraged economic expansion are now labeling what we have endured over the past year-and-a-half as “The Great Recession”). This does go down as the worst economic performance both in terms of duration and intensity since “The Great Depression”. While we are past the most pronounced part of the downturn, it may still be premature to call for the end of the recession merely because of the prospect of a positive third-quarter GDP result. After all, we saw GDP advance at a 1.5% annual rate in last year’s second quarter, and if memory serves us correctly, the NBER did not subsequently declare the end of the recession. And even if the recession is ending, as we saw in 2002, that does not guarantee a durable rally in risk assets. Sustainability is the key, and it remains the wild card.
The details in today’s report left something to be desired. Consumer spending came in at -1.2% annualized, twice the decline expected by the consensus. This occurred in the face of gargantuan fiscal stimulus and leaves wondering how this critical 70% chunk of the economy is going to perform as the cash-flow boost from Uncle Sam’s generosity recedes in the second half of the year. Imagine, government transfers to the household sector exploded at a 33% annual rate, while tax payments imploded at a 33% annual rate and the best we can do is a -1.2% annualized decline in consumer spending in real terms and flat in nominal terms? What do we do for an encore? In the absence of the fiscal largesse, it is quite conceivable that consumer spending would have shrunk at a 10% annual rate last quarter! Nonresidential construction action sagged at an 8.9% annual rate and this was on top of a 44.0% detonation in the first quarter. Ditto for equipment & software ‘capex’ spending, also down at a 9.0% annual rate and this too followed a 36.0% collapse in the first quarter. Residential construction slumped sharply yet again, this time at a 29.0% annual rate. These are the guts of private sector spending and collectively, they contracted at a 3.3% annual rate — the sixth decline in a row. So while there are many calls out there for the recession’s end, it remains a forecast as opposed to a present-day reality.
As expected, inventories were sliced sharply — by $141 billion at an annual rate, which alone subtracted 0.8 percentage point from headline GDP growth. But with consumer outlays slipping 1.2% and no signs of a 3Q recovery in sight, based on early back-to-school results looking rather tepid thus far and spending intentions in the confidence surveys rolling over, we wonder aloud just how much re-stocking we are going to see this quarter and even if we do, whether it will be a one-quarter wonder and set the stage for a fourth-quarter relapse. (Hopefully it has not been lost on anybody that the Chicago PMI inventory index in July hit its lowest level since June 1949. So maybe there is less to this inventory story than meets the eye.) Something tells us that an equity market trading north of a 760x multiple on reported earnings is not prepared for such a prospect.
While it is tempting to strip out the inventory withdrawal and look at the fact that outside of that, real GDP contracted at a mere 0.2% annual rate, misses the point. While inventories will undoubtedly add to current quarter growth, we doubt that we’ll see another quarter of 13.3% growth in defense spending either. This added to GDP growth in 2Q by almost the same amount that inventories subtracted. Not only that, but the sharp improvement in the foreign trade sector, which added 1.4 percentage points to GDP growth in 2Q, is unlikely to be repeated either. The overwhelming consensus is that real GDP will be positive in3Q; but the key for how 4Q will shape up will rest in how real final domestic demand performs, which sagged at a 1.5% annual rate in 2Q, and -3.3% for private sector demand.
We remain in the deflation camp for the sole reason that the data compel us to. Wages and salaries contracted at a 5.0% annual rate in the second quarter and have deflated 4.3% on a year-over-year basis. This is the flip side of having the majority of companies beating their earnings estimates by aggressive cost-cutting — a wage contraction of historical proportions that bites into aggregate demand and requires recurring doses of fiscal stimulus and other gimmicks (like “Cash for Clunkers”) to establish a floor under the economy.
And, it is not just labour income that is still in deflation mode. Practically all forms of income are deflating from a year ago — interest income is down 4.5%, dividend income is down 23.0% and proprietary income is down 8.0%. The only income that is really going up is the income from Uncle Sam, which is up more than 10.0% and we have reached a point where a record of nearly one-fifth of personal income is being accounted for by paychecks out of Washington. But it should be known that Uncle Sam himself does not create income — he borrows cash from current bondholders and future taxpayers. Not the stuff that seems deserving of a 760x multiple.
Inflation was non-existent in the second quarter, with the GDP deflator flat and taking the YoY trend down to 1.5% from 1.9% in the first quarter. (We have seen out of the diffusion indices, such as the Chicago PMI, that pricing trends are in reverse.) This lack of pricing power along with sustained negative volume growth, dragged nominal GDP down at a 0.8% annual rate and -2.4% on a year-over-year basis, which is something we haven’t seen since the fourth quarter of 1949. And, what should matter most for stocks and bonds is nominal GDP — price multiplied by volume. Indeed, Charts 1 and 2 illustrate the case — the rate of change in the S&P 500 (Chart 1) and the rate of change in bond yields (Chart 2) ultimately track the trend-line in nominal GDP growth.
