Earlier this week the Commerce Department issued their second revision to fourth quarter GDP growth up to 3.0 percent from the initial estimate of 2.8 percent. This compares to 3rd quarter GDP of 1.8%. The upward revision to the percent change in real GDP primarily reflected an upward revision to nonresidential fixed investment, a downward revision to imports (which is a plus to GDP), and a slight upward revision to personal consumption expenditures (PCEs). This appears to be all good on the surface until you start looking underneath the headlines.
As we discussed in our original post on 4th quarter GDP “There was an incredibly large surge in Q4 in the business investment category. Railroads and trucking companies have recently reported upticks in tonnage hauled. Likely, we will begin to see a reversal in the coming months as the surge in activity was primarily attributable to a rush to purchase capital goods ahead of the expiration of the100% bonus depreciation allowance. That surge, which has now pulled forward future capital expenditures into 2011, will likely leave a void in coming quarters. Companies have been boosting 2012 views based on the past couple of months of activity – this could be a very dangerous trap for investors.”
As we have stated many times recently, the pickup in the 3rd and 4th quarters in the economy was not from a resurgence of real economic growth. The pickup came from the interruption in manufacturing that occurred post the Japan earthquake/tsunami/nuclear disaster trifecta. With inventory rebuilding now potentially becoming inventory destocking it is likely that inventories will become a net drag in the 1st quarter. We have been seeing evidence of this with either stagnation or declines in many of the transportation related indexes. This has also shown up in comments in the manufacturing indices as well such as from the recent Chicago ISM report: “We are hoping the slow down in new orders in December and January is temporary.” It is very likely that the big driver of GDP in the last quarter will impact the upcoming one as capital spending weakness will provide either no contribution or a slight drag to the first quarter.
In the 4th quarter consumer spending rose a tepid 1.52% as savings accounts ran dry and credit cards hit their reduced limits by year end. The Service Sector, which comprises 66% of PCE, fell completely flat which is going to be an impact to those industries’ profit margins in coming quarters.
What is more disturbing is that personal income and expenditures were both weaker than anticipated in January. In real terms consumer spending was flat which does not bode well upcoming reports for 1st quarter GDP. However, as we showed in our report on consumer credit: “The rise [in consumer credit] is NOT about increasing consumption by buying more ‘stuff’ it is about just about being able to purchase the same amount of ‘stuff’ to maintain the current standard of living.”
The issue here is that when the Conference Board took their survey gasoline prices were about $3.40 a gallon versus $3.70 today. That 30 cent swing is about a $40 billion tax (at an annual rate) on consumers’ wallets. Unfortunately, given that incomes declined by 0.1% in the latest period, it will likely immediately crimp consumption going forward.
Construction spending also declined by 0.1% (month-over-month) in January, in contrast to consensus expectations for a moderate gain. However, the report also included a large upward revision to construction spending growth in November (to +1.9% from +0.4%) due to the unseasonably warm weather in the later part of the year. Seasonal adjustments will start becoming a net drag on reports in the coming months ahead and since construction spending directly affects GDP we will be watching this closely.
For all of these reasons it is very likely that when we begin seeing reports for the Q1 GDP for this year they will be much weaker than currently anticipated. Therefore, we are pinning our estimates for GDP in the 1st quarter to be at or below 1.25% and that is being very optimistic. If we really crunch numbers it is entirely possible that we could see Q1 GDP at or below 1%. This would not be at all surprising given that Q1 in 2011 was .36%.
I have clearly made the case in past missives about the potential for a recession in 2012. When real GDP has declined below 2% growth on a year over year basis the economy has normally been, or was about to be, in a recession. With the 2nd revision to Q4 GDP, which will likely be revised downward in the next month, we will have now had three consecutive quarters of sub-2% GDP growth. There are NO instances in history, post WWII, where there were three consecutive quarters of sub-2% GDP annual growth and the economy wasn’t already in a recession.
Given the impact from higher oil and gas prices on the economy, which is a real and pervasive tax on the consumer as discussed yesterday, it is highly likely that the low end of our estimates may even still be optimistic. That would mean four consecutive quarters of negative GDP growth without a recession. The rise in pricing pressures combined with continued weakness in incomes and a decline in real purchasing power does not bode well for a sustained economic improvement ahead that has a 70% dependency rate on personal consumption.
These pressures lead to a potential for further deterioration in corporate earnings due to rising input costs and weaker demand. A weaker economic environment overall poses a real threat to an already elevated and overbought market. During an average recessionary drag financial markets historically lose about 30% of their value average. For investors with a finite time horizon this is an important concept to learn because as opposed to media which hypes every return to a previous level as victory – when it comes to retirement planning “breaking even” is not an investment strategy.