Q4 GDP - Real GDP vs. Final Sales

I'm seeing plenty of headlines this morning highlighting how GDP supposedly came in much better than expected at down 3.8% (annualized) versus an expectation of down in the 5-5.5% range. As always, the devil is in the details.

Not too surprisingly, personal consumption and private investment both fell significantly, -3.5% and -12.3% respectively. The key figure in understanding the headline number, however, is the change in inventories. Real inventory growth in the quarter had the effect of adding 1.32 percentage points to real GDP. When we ignore this inventory build, we get a figure known as final sales. Final sales fell 5.1% in the quarter.

Inventory was reduced by $50.6 billion in the second quarter and $29.6 billion in the third quarter. Why did inventory grow in the fourth quarter? It can most likely be attributed to a weak holiday selling season combined with a little too much optimism. Retailers didn't sell as much as they hoped, so they ended the quarter sitting on extra inventory which left excess inventory at the wholesaler/manufacturer level.

Why is this important? If an inventory build occurs to prepare for future growth then there shouldn't be a problem. However, to the degree that any increase in inventory can not be met by demand, we are effectively borrowing production from a later period.

The bottom line is that an inventory build that isn't met by current demand will result in lower future GDP since production will need to be scaled back to reduce the excess inventory. It's kind of like getting an advance on your paycheck. Your income may have technically gone up today, but that "loan" has to be paid back. With the global economy clearly slowing further over the past month, this "better than expected" GDP report will likely lead to a weaker report next quarter -- at least weaker than it would have otherwise been.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

The Output Gap

I don't want to single out any specific 2008 Nobel Prize-winning economist for criticism, so let's just call this anonymous person Paul Kr_gm_n. Paul, as we'll refer to him, has been busy of late blasting any economist who dares offer a critique of his recommendations or dares to provide an alternative solution to our economic ills. He hasn't been bashful. He's been critical of some of the most respected names in the profession. It seems that shaking hands with the King of Sweden (yes, Sweden has a King) instantly confers a sense of infallibility upon the shakee.

Paul belongs to an overwhelmingly large group of blathering wisenheimers known as Keynesians. Keynesians can be easily recognized due to the fact that they answer every question the same way. How do we get the economy moving again? "The government should spend more money." What do we do about insolvent banks? "The government should spend more money." What's the capital of Latvia? "The government should spend more money."

Keynesians are arguing that massive fiscal stimulus is needed to fight the current economic downturn. That's hardly surprising. That's what Keynesians do. That's what they've always done. They're the best shoppers in the world with the biggest credit card.

Let's focus on just one of the concepts that the Keynesians rely upon to justify their shopoholism-- the output gap. The output gap is a measure of the potential GDP of the country less actual GDP. In other words, it's a measure of the difference between actual economic output and potential economic output. Not to get too academic, but actual GDP consists of consumption, investment, government spending and net exports. During a recession, consumption and investment typically fall. Government spending, of course, never falls. The fall in consumption and investment lead to a drop in actual GDP to levels below potential GDP. Keynesians have a solution for this shortfall. "The government should spend more money."

Keynesian posterboy, Paul, recently summed up the current situation:

Bear in mind just how big the U.S. economy is. Given sufficient demand for its output, America would produce more than $30 trillion worth of goods and services over the next two years. But with both consumer spending and business investment plunging, a huge gap is opening up between what the U.S. economy can produce and what it's able to sell. And the Obama plan is nowhere near big enough to fill this "output gap."

Even the CBO says, however, that "economic output over the next two years will average 6.8 percent below its potential." This translates into $2.1 trillion of lost production. "Our economy could fall $1 trillion short of its full capacity," declared Obama on Thursday. Well, he was actually understating things.

To close a gap of more than $2 trillion - possibly a lot more, if the budget office projections turn out to be too optimistic - Obama offers a $775 billion plan. And that's not enough.

Paul is arguing that government spending should be increased by over $2 trillion over the next couple of years to make up for lost output, but shouldn't we be questioning whether recent levels of GDP are even defensible? Didn't we just experience a massive credit bubble? In recent years, both residential and nonresidential construction experienced a tremendous and unsustainable debt-driven boom. Consumption was pushed up to unsustainable levels in recent years with people racking up revolving debt and pulling equity out of their homes to buy plasma TVs, take vacations, and pay for a lifestyle they couldn't afford. This historic credit bubble most certainly goosed GDP in recent years. Is this really a level of GDP that we should be trying to support?

There is an analogy here between GDP and the financial system. We now all realize that the profits reported by the financial system between 2002-2007 were grossly overstated due to the fact that asset values were being overstated and loss reserves understated. Similarly, sustainable and productive GDP has been overstated in recent years as consumption and investment have been driven unsustainably higher through the use of massive amounts of nonproductive debt. It's madness to try and sustain this level of economic activity.

So, now GDP is likely to fall a couple of trillion dollars over the next couple of years. Great! It shouldn't have grown to this level in the first place. Yes. More plants and businesses will close, and more people will lose their jobs. That is unfortunate, but a sustainable level of demand doesn't currently exist to support these plants or jobs, and it would be fiscal madness to plug this gap indefinitely. The government should let the market clear away the excess. Trying to sustain economic activity at an unsustainable level and growth rate will just lead to larger levels of government debt, higher inflation (and/or higher levels of future taxation), lower future growth, and a less productive economy as government spending displaces the private sector. There is no free lunch.

If our economists and politicians want to focus on an output gap, I recommend they spend some time looking at the difference between the GDP forecasts of economists and actual GDP. Now that's a huge output gap.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Government Revenue Creep

I concluded my November 25th post ("Who Doesn't Enjoy A Good Spending Spree?") with the following comment: "This has been the enduring failure of Keynesian economics. Everyone loves a good spending spree. No one ever wants to take away the punch bowl."

The following graph (courtesy of Greg Mankiw) does a wonderful job of illustrating this. The rapid increase in government revenue relative to GDP in the early 1940's was due to World War II. The more interesting observation, though, is that this temporary increase in the size and scope of government was never reined in following the war. Instead, the government's share of economic activity has continued to grow over the past 60 years.



It would be naive to think that our government will ever proactively address the growing deficit and debt (on and off balance sheet) problem that we face. As has typically been the case, our leaders won't act until forced to, at which time we may be faced with a serious decline in the value of the dollar and/or the arrival of hyperinflation. Some combination of less government expenditure, higher taxes, lower entitlement spending, higher inflation, reduced entitlement benefits, and a weaker dollar are what ultimately await us. What we don't know are the exact contents of this poisonous cocktail or the timing of its arrival.

As for the investment ramifications of this, I would expect dollar weakness and gold strength. Assuming reasonable global growth, I would expect many commodities to perform well, and select international equity markets with better growth prospects and better fiscal restraint should handily outperform the U.S. (assuming reasonable valuation). Much of the U.S. fixed income market would be destroyed, although TIPS would certainly benefit.

Not coincidentally, many of our core long-term positions would benefit from such a scenario. Also consistent with this thesis, I recently added a long Canadian dollar and short U.S. Treasury (20+years) position. I'll spend a little more time on each of these later this week.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

GDP-U

First quarter GDP came out today and showed the economy grew at a whopping .60% rate, the same as last quarter and the slowest pace since the fourth quarter of 2002. It's difficult to know what to do with these releases since they come from the biased government and are often significantly revised well after the fact. However, the market pays attention to it, so we have to pay attention to it. It's a silly game. We all know the figures are manipulated and heavily revised, but since we think others are trading on the data, we'd better too! Game theory run amok.

The bulls will take some solace in the "fact" that we haven't seen the two consecutive quarters of negative GDP growth that some still look for to define a recession. Either way, it's clear that the economy has at least stalled out over the past 6 months.

Keep in mind that real GDP takes out the effect of inflation, so the lower the government's estimate of inflation, the better the real GDP looks. For the first quarter, inflation was estimated to be running at a 3.5% pace. Had that estimate come in a little higher, real GDP would have been negative. Given the government's use of hedonic pricing and rent-equivalency for estimating housing inflation/deflation, they can pretty much manufacture whatever number they want.

More striking is the fact that all of the GDP growth last quarter can be attributed to an increase in inventory. GDP measures the value of that inventory even though an increase in inventory means more product is sitting on shelves and may prove to be a drag in future quarters. If you take out the change in inventory, you're left with what's called final sales. This is a purer measure of what actually happened in the quarter. This figure fell .20% last quarter. This is only the fourth time this decade that this figure fell below zero.

As for other contributors, it's no surprise that net exports helped boost GDP for the fourth straight quarter as the dollar has been declining. Personal consumption registered its slowest growth rate since the second quarter of 2001. Residential investment once again took a good chunk (-1.23%) out of GDP.

All in all, this isn't a particularly cheery report. For the balance of the year, consumption and investment are likely to remain weak while net exports and government spending add some support. I imagine the bulls and the press will make a fuss over the fact that GDP came in positive, but I doubt this report will have much of an impact on the Fed's interest rate decision this afternoon.

An Economic Bright Spot, But...........

I'm fairly pessimistic about this year's economic prospects given our economy's dependence on the overstretched, debt-laden, house-poor, inflation-wracked consumer and a corporate sector beginning to curtail investment. However, there is one segment of GDP which should lend some support - net exports. The weakening of the U.S. dollar has helped make our goods more cost competitive globally, and that has recently begun to spur exports. For many of the multinational companies that have reported earnings so far this quarter, international growth has been one of, if not the only, bright spots in their reports.

I expect to hear more and more economists praising the weakening dollar and encouraging further devaluation in order to help spur the economy. This would be a disastrous policy to pursue given the number of dollars held abroad and our dependence on other countries (largely China and Japan) to fund our chronic deficits. No country has ever devalued itself to prosperity. We risk a run on the dollar if we're not careful.

Currently, the dollar still offers perceived safety in a volatile financial world, but foreign holders of our debt these days aren't earning much interest. What little interest they are earning is being wiped out by currency losses (the falling dollar). This state isn't likely to persist long-term. At some point, rational foreigners may begin demanding a higher interest rate on our debt to compensate for the purchasing power loss of a falling dollar. Hopefully, this can be forestalled until the economy is strong enough to withstand higher interest rates. If not, this recession could be much more severe and/or prolonged than widely expected.

The following article from yesterday's Wall Street Journal discusses the "high-class" problem of insufficient container supply:

In what may be the only obvious downside to the current U.S. export boom, domestic producers like Reed’s Inc. are finding it harder than ever to get their products onto outbound ships.

Surging foreign trade, fueled largely by the weaker dollar, is filling up ships faster than at any time in recent memory and created a backlog for companies like Reed’s, a Los Angeles-based maker of premium soft drinks, including cream soda and a spicy line of ginger beers.

“I’m working with a couple of companies that are saying May 21st is the earliest date they can get me a container, ANY container,” says Mark Reed, the company’s executive vice president of international sales. “But I need it now.”

The bottleneck is threatening to take the fizz out of Reed’s upcoming product launch in Europe. The company, which sells its premium drinks in natural food stores in the U.S., recently began to push overseas and was gearing up to begin selling in France. “So here I am, I’ve got product specifically labeled for Europe, but I can’t get it over there,” says Mr. Reed, who says this is likely to delay the product launch.

The problem first emerged last year and has been spreading, hindering exports of everything from manufactured goods to farm commodities and scrap metal. –Timothy Aeppel