Last month we posted our analysis of Q3 GDP after the release of the final revision. We stated then: “It is important to remind you that a bounce in economic growth, as we will likely see in the coming Q4 GDP analysis beginning in January, does NOT in any way offset the probability of recession.
As we stated during our initial analysis of Q3 GDP it is not uncommon for GDP to tick up just prior to a recession. In fact, in almost every instance, as shown in the table, the economy has had a positive growth rate, and in some cases a very strong growth rate, just prior to recession.
My point here is that looking at quarter over quarter numbers, particularly when they are presented at an annual rate, is very misleading. As always it is the trend of the numbers which is much more important in determining future outcomes. This is why we look for historical tendencies for future outcomes and in this particular case we note that sub-2% growth rates have always occurred just prior to or in a recession“
There has been a large debate as of late about the economy going into 2012. Will it “muddle through” at a sub-2% rate, rebound sharply to more than 3% as currently estimated, or will we decline into a secondary recession? Cases can clearly be made for all three scenarios and only time will tell who is correct. However, this debate entirely misses the essence of what we are most concerned about – our investment portfolios and the risks to those investments from economic pressures.
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 today’s initial release of Q4 GDP, which will likely be revised downward in coming months, 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.
Digging Into The Quarter
If we dig down behind the headlines we find some interesting issues. For all of the “hoopla”, as we corrected predicted in our analysis “Consumer Spending May Disappoint“, the Black Friday / Cyber Monday shopping extravaganza ran into a brick wall as incomes declined and wallets ran out of cash. For the quarter consumer spending rose a tepid 2% on an annualized basis as savings accounts ran dry and credit cards hit their reduced limits by year end. The Service Sector fell completely flat which is going to be an impact to those industries profit margins in coming quarters.
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. If you look at the chart you can see the rapid decline in Manufactured Goods versus Non-Durable Goods and Services. The rise in GDP in the last two quarters are solely contributable to the resurgence in both manufacturing as production came back online and inventory restocking. Those catalysts have very likely run their course and will become a net drag in the near future.
A Rush To Spend As Exports Drag
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, which 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.
Furthermore, the near neutral growth in exports in Q4 could very easily turn into a net drag as the recession in Europe continues to build momentum. The weakness in demand, as seen by a very tepid 0.2% rise in real final sales, combined with the growth in production has led to a huge $56 Billion increase in private inventories. That increase accounted for 1.94% of the total growth in Q4 of 2.8%. In other words, roughly 69% of the entire increase in Q4 GDP was attributed to the restocking and stockpiling of inventories. Of course, with weak demand already prevalent, the question becomes the disposition of that inventory and a what price? This is another potential drag on earnings in the coming quarters.
While the payroll tax cut will most assuredly be extended in the coming months the decline in gasoline prices that provided a $60 Billion effect tax cut in 2011 is now evaporating. With government spending now on the retreat, and further austerity measures likely coming after the next election, there are real potential headwinds to economic growth. The difference between actual GDP and Real Potential GDP (the output gap) has never been this wide going on 3 years after a recession.
That pressure on the economy, and why a “muddle through” scenario is unlikely to be sustainable, is that gap between aggregate supply and demand that continue to erode economic strength overtime. The recent improvement in the month over month data has been encouraging but it has done little to reverse longer term trends and, if we are correct, will be very ephemeral in nature.
The underlying weakness in the overall economy is pervasive and persistent and it will take a couple of more quarters to tell if the danger has passed. As investors we will have more than enough time to adjust portfolio risk levels to capture improvement when it comes. However, betting against the trend of the data can be dangerous as recessions can come quickly with a devastating impact to portfolios. A missed opportunity in the markets can always be regained – recovery of lost principal is an entirely different matter.
Personally, I sincerely hope that the economy continues to improve – but “hope” is not an investment strategy that we employ.