Thursday, July 31, 2014

Initial 2nd Quarter GDP Report Surpasses Expectations

The Bureau of Economic Analysis (BEA) released its first estimate of 2nd quarter GDP this week, indicating that the US economy grew at a seasonally-adjusted, annualized rate of 4%; well above the median forecast of 3% among 80 economists surveyed by Bloomberg and our own expectations. The bulk of the growth came from personal consumption expenditures, which contributed 1.69 percentage points, and inventory accumulation, which contributed 1.66 percentage points. Personal consumption expenditures grew at an annualized rate of 2.5%, the midpoint of the range over the last 18 quarters. In short, consumption was neither particularly strong nor was it weak. Consumption got a lift from purchases of nondurable goods, which rose 2.5% after a flat 1st quarter. However, after growing at a 1.3% rate in the 1st quarter, spending on services grew just 0.70%.

 Incomes grew at an annualized rate of 3.8% after growing at a 3.5% rate during the previous quarter. However, the BEA noted that “The acceleration in personal income primarily reflected an upturn in personal dividend income and a smaller decrease in farm proprietors’ income that were partly offset by a deceleration in wages and salaries.” In a report that is significantly better than expected, this is one of the few negatives. While the personal savings rate increased from 4.9% to 5.3%, its calculation has been significantly altered over the last year. In its annual revision in 2013, the BEA began including accrued pension benefits in the calculation of savings and as of this year’s revision it has also included defined contribution plans. While this is wholly appropriate from an accounting perspective, it leaves a lot to be desired from a practical standpoint. It raises the savings rate by including pension benefits that carry penalties when accessed prior to retirement. As such, prior to retirement, they are typically only accessed as a last resort and, therefore, are not part of what one would consider traditional savings.

As noted, today’s GDP report included the BEA’s annual revision, which typically covers the three prior calendar years. This one also included supplemental revisions dating to the 1st quarter of 1999. The Bureau revised 1st quarter 2014 GDP higher from a contraction of 2.9% to a contraction of 2.1%. References above reflect the revision. Real GDP growth in 2012 was revised lower from 2.8% to 2.3% while that of 2013 was revised higher from 1.9% to 2.2%. If the 2nd quarter growth rate holds (it’s subject to revisions in both August and September) and long anticipated economic acceleration occurs, growth may indeed surpass 2% this year. However, that in no way alters the conclusion in our previous post that quantitative easing has not had a substantive impact on economic growth. The fact remains that growth has been subpar, and relatively constant, despite quantitative easing.

In its press release, the BEA “emphasized that the second-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency.” That is always the case for the advance report and only time will tell if some of the more volatile components are revised higher or lower. However, even if this figure is revised significantly lower, it’s likely to remain better than we anticipated. Those that have been bullish on the economy will point to this report as evidence that the 1st quarter was indeed a weather-related aberration. Yet, if that is indeed true, it suggests that a significant amount of the strength exhibited in the 2nd quarter resulted from economic activity that was pushed out from the first quarter due to weather. In short, if the weather argument is true, it suggests that the strong 2nd quarter resulted from the timing of economic activity rather than an acceleration of it. On the other hand, those of us that have eschewed the weather argument must answer a different question. If growth truly weakened in the 1st quarter, why did it rebound so strongly in the 2nd quarter? At least part of the answer lies in real final sales of domestic product, which is GDP minus the change in private inventories. Real final sales contracted 1% during the 1st quarter and grew 2.3% in the 2nd. That suggests a far smaller contraction in demand during the first quarter and a much smaller increase during the 2nd that is indicated by GDP. While the difference in the growth rates of GDP over the first two quarters of the year is a rather enormous 6.1%, the difference in final sales is 3.3%; still significant, but not nearly as dramatic. There has long been significant volatility in the rate of inventory accumulation that clearly has little to do with weather. The chart below depicts quarterly GDP growth, at seasonally-adjusted annualized rates, along with the contribution from inventories and all other sources. It is very clear that inventory accumulation has been a highly volatile component.

Yet, for US equity markets, the strength or weakness of the economy over the next several quarters is relatively meaningless. None of the above alters the fact that the market is significantly overvalued based on one of the most reliable valuation metrics, non-financial market cap/GDP. According to John Hussman’s most recent weekly commentary, the ratio of non-financial market capitalization-to-GDP is 1.35 and the pre-bubble norm was 0.55. The ratio peaked during the tech bubble at 1.54. Many have suggested that the market is fairly valued and that stronger economic growth is necessary for stocks to continue to move higher. However, that assertion is refuted by simple mathematics. If the US economy grew 8%, something it last did in 1951, every year for the next five years while the equity market remained unchanged, the ratio would only fall to 0.92. Simply put, regardless of the rate of economic growth, the US equity market is significantly, overvalued and that will only change with a significant decline in equity prices.