GDP Q2: Looking Under the Surface

It’s been a while since we looked at some of the numbers within the US GDP report and what they might say about the underlying trends in the American economy.  This morning, the US government released the final revision for Q2, and the numbers overall proved solid.  GDP came in at 4.6% on a Q/Q annualized basis, a vast improvement over the Q1 negative print.  Y/Y, real GDP came in at 2.6%, solid but not spectacular, continuing the pattern observed since 2010.  Average Y/Y real GDP since Q1:2010 has been about 2.2%.  This compares to an average Y/Y real GDP number of 1.6% from Q1:2002 through Q4:2009.  Thus, all in all, growth is mediocre, but it’s been mediocre for more than a decade.  The “New Normal” really isn’t particularly new at all.

Underneath the headline numbers, there are some interesting trends among the GDP aggregates, Consumption, Investment, Net Exports, and Government, as a percentage of GDP.

Consumption spending continues its pattern of growing in-line to slightly below overall GDP on a Y/Y basis.  As such, Consumption, which reached a high point of 69% of GDP in 2011 has retrenched a slight bit to 68.5% of GDP.  Nonetheless, Consumption still remains near the very high end of the historical range.

A bright spot in the report appears to be growth in Investment.  Real investment growth in Q2 was 7.7% Y/Y, the best showing since 2012 and comfortably above the historical median of 4.7%.  With the improvement, investment as a percentage of GDP continues to move closer to the middle of the long-term range and has reached levels not observed as a % of GDP since the pre-crisis days.

Defying conventional wisdom, total government expenditures continue to probe the low end of the historical range as a % of GDP.  Y/Y real growth in government expenditures came in at -0.7%, the 16^th straight negative year over year print, by far the longest negative streak in the history of the GDP series.  The last period with negative real Government expenditures was the 1993 to early ’94 period.  Prior to that, you have to go back to the early 1970s.  Y/Y nominal government expenditures growth was under +1% for the 14^th straight quarter.  Of note, prior to the current run, nominal government expenditures hadn’t fallen below 1% on a Y/Y basis since a brief negative run in the mid-1950s during the Eisenhower Administration.

Finally, net exports, which have been in negative territory as a percentage of GDP since the early 1980s, remain comfortably higher than levels observed in the years preceding the Great Recession, but near the lower end of the historical range.

Taking Investment + Net Exports as a proxy for “national savings,” we see that the picture has improved significantly since the Great Recession, but remains below historical levels.  It’s currently in-line with the levels observed in the mid-2000s, pre-crisis.

All in all, we continue to believe that consumption growth will underperform relative to the other aggregates, perhaps keeping some longer-term pressure on the consumer oriented segments of the US markets.  Conversely, we believe overall investment will continue moving higher as a % of GDP, as will government expenditures, mainly due to the renewed health of state and local government finances.

Market Tidbits

Dollar En Fuego

Several months ago, we pointed out that the US dollar index relative to gold had breached long-term moving averages to the downside.  After some sideways churning, sure enough, the dollar has resumed its march higher while gold moves back towards multi-year lows, keeping the ratio on the downward slope.  Since the end of 2009, Gold is essentially flat while the dollar index is approximately 15% higher.  Conventional wisdom has been completely turned on its head over the past four to five years.  Three rounds of QE, political turmoil in Washington, and a muddle through economy had many investors convinced a significant dollar collapse was on the way and gold would outpace equities.  The opposite happened, a not so atypical situation in markets.  What happens going forward?  Considering the intensity of the recent moves, we wouldn’t be surprised to see a short-term technical reversal.  Longer-term, there’s still plenty of space to the downside on the below chart, especially in light of the massive upward move in the ratio from 2003 to 2011.   

Source: Bloomberg and IronHorse Capital

Inflation Expectations: Tame

Meanwhile, as always, Fed watchers gnashed their teeth over the future Fed Funds rate trajectory and the Fed statement ahead of this week’s meeting.  After the meeting, the “dot chart” showing Fed members’ predictions on the future rate path showed that the median projection for 2015 has moved slightly higher, from 1.125% after the June meeting to 1.375% today, suggesting rate hikes earlier than projected in 2015.  Two Fed Presidents dissented.  Dallas Fed President Fisher remains preoccupied with heading off phantom inflationary pressures before they spiral out of hand.  Next month should represent the final month of QR.

We remain baffled by the rush for accelerated rate hikes in the US.  We pointed out early in the summer that inflation pressures are completely benign at this point and that contributors to inflationary episodes, such as labor costs, remain subdued.  This week, markets received word that year-over-year CPI came in at a paltry 1.7%.  Year-over-year CPI hasn’t exceeded 2.2% since early 2012.  Around the world, there’s a real risk of outright deflation in Europe and Japanese economic momentum has dropped off dramatically in recent months, perhaps putting some of the price stability gains at risk there as well.  

Market participants are voting.  Looking at the yield spreads between Treasury bonds and TIPS, we see that market expectations for future annualized inflation are rolling over again back into sub-2% territory over the next five years.  We remain of the view that it’s much easier to tame inflation after it appears than it is to reverse the insidious deflationary trends associated with sub-trend economic episodes.  The US remains far below potential.  The worries about “overheated” economic growth seem ridiculous.  If anything, the Fed, ECB and others may be too timid when it comes to pushing economic growth back towards long-term potential.

Source: Bloomberg and IronHorse Capital

Europe and Japan: The Feeling’s Gone

With recent updates to the OECD leading economic indicators for Europe and Japan, we see that the economic momentum that kept markets hopeful throughout 2013 and early-2014 has dropped off considerably.  In Japan’s case, Abe may have a big problem on his hands, with the smoothed Japan LEI moving back into negative territory for the first time since the ‘08/’09 global recession, suggesting that the probability for a Japanese recession is significantly elevated.  Japanese citizens may be getting the worst of all worlds: higher prices, and dim economic prospects.  Europe isn’t terribly far behind in terms of entering negative economic territory.  As discussed above, outright EU deflation could be in the cards; the ECB recently felt compelled to enhance monetary stimulus programs within legal bounds, though indicators this week show that some of the measures had disappointing results.

Source: OECD, Bloomberg and IronHorse Capital

Source: OECD, Bloomberg, and IronHorse Capital

US: P/E’s Creeping Higher:

The S&P 500 index has moved comfortably above the 2000 level again.  Long-term valuation ratios have moved in lock step.  As of today, the 10-year CAPE P/E, using adjusted, pro-forma earnings to satisfy those concerned about accounting changes over time, stand at approximately 22.3x, approximately 0.8 standard deviations above the norm.  Valuations in the US are roughly back to levels observed in ‘06/’07 and during the mid-1960s.  As we’ve mentioned in the past, we’re not suggesting that a big market maelstrom is imminent.  Instead, we want to point out that valuations near these levels have regularly produced sub-median real and nominal annualized market returns over the subsequent seven to ten years.  In other words, it might be a bad idea to count on double-digit US returns over the next several years when thinking through the kids’ college funds.  That doesn’t mean there isn’t opportunity elsewhere around the world, however.  Many individual countries/regions’ index multiples are trading in the low teens and single digits.  As such, we remain convinced that longer-term equity returns will come from overseas stock markets and that the US will be a long-term laggard.  In addition to the P/E chart below, we’ve included a handy-dandy rundown of markets from cheapest to most expensive across several valuation metrics produced on Mebane Faber’s World Beta website.  As you can see, the US is among the five most expensive in the world.  Eastern European emerging markets and peripheral European developed markets hold many of the “cheap” spots.  Much of the European malaise mentioned above has already been factored into equity market outlooks.

Source: Bloomberg and IronHorse Capital

Source: Mebane Faber World Beta Blog. mebfaber.com