Tuesday, January 31, 2012

GDP: Softer Than It Looks and Struggling to Muddle Through

The Q4 2011 GDP reading of +2.8% produced what may appear to be a respectable headline number, a full percentage point above Q3 GDP growth of 1.8%. On the surface, the Q4 report also compared favorably to an increase in real GDP of 1.7% for all of 2011. But 2.8%, even at first look, is still softer than the 3.0% gain in real GDP logged for 2010, repeating a pattern that we’ve seen over the past few years: GDP rises, only to drop off again.

Although it may be tempting to look at the economy as a glass that’s half full, I’m afraid it’s far emptier than it looks. Diving into the Q4 GDP report, we see that two-thirds of the amount of growth reported (1.9%) was due to private inventory build-up. (According to standard accounting practice, growth in inventory increases GDP, while sales of inventory reduces it.) Drilling further, the stat that is most meaningful is the real final sales of domestic product -- GDP minus the change in private inventories. This data point eked out only a 0.8% increase in Q4 2011, compared with an increase of 3.2% in Q3 2011. That is very telling.

Although one could conceivably spin the inventory growth number as businesses being optimistic about future sales and building inventories, that scenario is doubtful given weaker retail sales of late. Thus, it seems likely that inventories will be drawn down over the next few quarters, which will be a drag on future GDP numbers.

Retail sales growth has not been strong, and a slow pace is anticipated for 2012. The National Retail Federation (NRF) is projecting 3.4% sales growth for the year, down from 4.7% in 2011. The NRF told Bloomberg News that expansion in 2012 will be “incremental, modest,” citing the housing slump as the “biggest drag” on the U.S.

Indeed, the S&P/Case-Shiller Home Price Index continues to show decreases in the housing market. The 20-city composite for November, just released, showed a 1.3% decline for the month. Year over year, prices are down 3.7%. Nationally, home prices remain below year-ago levels, once again sparking questions about when and where the housing market will finally bottom.

Another weakness in consumer spending was reported by the Commerce Department: Personal income grew by 0.5% in December, up from a 0.1% rise in November. Spending was flat, however. The personal saving rate, meanwhile, was 4.0% in December, compared to 3.5% in November. Saving instead of spending may be good for consumers’ personal balances sheets, but it doesn’t do much good for an economy that needs to gain traction. Additionally, sales increases still appear to be driven by increases in debt which is not sustainable.

No wonder the Fed has been making such somber projections. Last week, its “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents” pegged real GDP growth at 2.2% to 2.7% for 2012 (based on the “central tendency,” which excludes the three highest and three lowest projections). This range of projections for 2012 was softer than those given in November of 2.5% to 2.9%, and was considerably lower than the projections made in June of 3.3% to 3.7%.

GDP readings of late have been helped by inventory and inflation numbers that are not likely to be repeated. Plus, continued fiscal problems in the Euro zone will probably hamper U.S. exports, while decreases in U.S. government spending will also hit demand at home. For a long time I have maintained that the U.S. economy is in a “muddle through” target of around +2.0%. Last year when estimates were for 2011 to show economic growth of 4% to 5% I looked so bearish. Now, not so much. Even the muddle through target of +2.0% would have been better than what we got.

For 2012, I believe we will be lucky to hit the muddle through number again this year. As for stocks, expect the market to take its cue from the lukewarm GDP forecast.

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