Saturday, August 18 , 2018, 12:06 pm | Mostly Cloudy 74º


The Daily Capitalist: Q2 GDP ... Are We in Recovery?

Before we get caught up in headline euphoria, there are some things that just aren't adding up

Some good numbers, if you see a decline in GDP as “good,” came out Friday. GDP only contracted at a 1 percent annual rate vs. an anticipated –1.5 percent rate. The interesting thing was that every article I read on it (The Wall Street Journal, Bloomberg, AP, Reuters, The New York Times) all had stories to the effect that “it’s over,” or “the worst is over,” or “we’re pulling out of it.” Not one ran an article that voices a contrary opinion, which, if you dug a little deeper into the media, were abundant.

According to The Journal, U.S. gross domestic product— a broad measure of the value of goods and services produced — contracted at a 1 percent annual rate last quarter, its slowest pace in a year. That was a marked improvement from the first-quarter contraction of 6.4 percent and the fourth quarter’s 5.4 percent pullback.

One of the big causes of the second-quarter drop was a sharp decline in business inventories, the article continued. With their shelves becoming bare, businesses may be in a position to ramp up production to restock, it said.

To be fair and unbiased, as Fox News likes to say, here are two comments found in the WSJ’s Econ Blog, to show you that well informed economists from major institutions can have a completely different view on what’s happening. Take your pick: are you an optimist, pessimist or realist?

Downside surprises in consumer spending and inventories more than offset surprises to the upside, primarily in net exports. The latter showed a smaller drop in exports in the second quarter than we expected while the drop in imports was in line with expectations. Inventories were the biggest surprise, subtracting about 1.5 percent from measured growth. Over the last two quarters, real inventories have declined by more than $250 billion, by far the biggest two-quarter drop on record. However, these deep cuts should set the stage for increased production, beginning in the third quarter in our view. — Nomura Global Economics

We do not look for (expected stronger growth rates in the third quarter) to be sustained. As far as inventory restocking, those advancing this argument would do well to look at inventory-to-sales ratios, which remain quite elevated — while inventories have plunged, they have not kept pace with the decline in final sales, and barring a more robust rebound in domestic spending than we anticipate, the incentive to restock will be limited. Of course, this will be an industry-specific adjustment; for instance, auto production will be ramped up, but other manufacturing industries will see less of an increase in production. Moreover, even to the extent we see this restocking effect, it is a transitory phase and not a sustainable driver of growth. As for consumer spending, ... while disposable personal income rose during the year’s first half, this was chiefly a function of government stimulus efforts and lower income-tax withholding, the effects of which will fade in terms of income growth. With job losses moderating but continuing into 2010, there is little reason to expect meaningful support for consumer spending from the labor market over coming quarters. As long as this remains the case, real GDP growth will remain below trend. — Richard F. Moody, Forward Capital

Let’s get into the numbers.

First, it can’t be claimed that fiscal stimulus caused the better than expected numbers. The GSA notes that only $70,162,592 of the total recovery package of $787 billion ($288 billion in tax cuts and $499 billion in federal agency spending) had been spent as of July 30.

It is true that government spending grew at a 5.6 percent annual rate for the quarter, moderating the contraction in gross domestic product. But most of that increase came from the defense sector, not the nondefense sectors targeted by the American Recovery and Reinvestment Act. Defense spending grew at a 13.3 percent annual rate, in part a rebound from a 4.3 first quarter contraction. Nondefense spending grew at a 6 percent annual rate, contributing 0.15 percentage points to overall growth. The economy can use all of the help it can get, but it’s too soon to declare that federal spending is effectively making its way into the system.

By the way, the new numbers prepared by the Commerce Department make our recession the worst since World War II. It’s the steepest decline in GDP since 1947 (overall, -3.9 percent from the previous peak in Q2 2008). It is now estimated that the economy grew just 0.4 percent in 2008, down from its previous calculation of 1.1 percent.

Where does this leave us?

We can’t deny the fact that the economic recession is bottoming out. All cycles run their course. As individuals and businesses repair their balance sheets and wipe out bad investment, they prepare the way for new growth. That has been happening. While corporate earnings are subdued, they are solidifying as a result of cost cutting, including layoffs. People are restricting spending and are increasing savings. These are positive things, necessary to start growing again.

The big question is: Will consumer spending come back in Q3 and Q4? Consumer spending declined 1.2 percent in Q2, much greater than economists predicted. If the economy is based on consumer spending (formerly 70 percent of GDP), then we are in trouble. As savings rates continue to increase, it means consumers will spend less. Personal savings reached a new high of 6.9 percent in May.

According to David Rosenberg of Gluskin Sheff, it makes you wonder what will happen to inventories:

As expected, inventories were sliced sharply — by $141 billion at an annual rate, which alone subtracted 0.8 percentage point from headline GDP growth. But with consumer outlays slipping 1.2 percent and no signs of a 3Q recovery in sight, based on early back-to-school results looking rather tepid thus far and spending intentions in the confidence surveys rolling over, we wonder aloud just how much re-stocking we are going to see this quarter and even if we do, whether it will be a one-quarter wonder and set the stage for a fourth-quarter relapse. (Hopefully it has not been lost on anybody that the Chicago PMI inventory index in July hit its lowest level since June 1949. So maybe there is less to this inventory story than meets the eye.) Something tells us that an equity market trading north of a 760x multiple on reported earnings is not prepared for such a prospect.

While it is tempting to strip out the inventory withdrawal and look at the fact that outside of that, real GDP contracted at a mere 0.2 percent annual rate, misses the point. While inventories will undoubtedly add to current quarter growth, we doubt we’ll see another quarter of 13.3 percent growth in defense spending either. This added to GDP growth in 2Q by almost the same amount that inventories subtracted. Not only that, but the sharp improvement in the foreign trade sector, which added 1.4 percentage points to GDP growth in 2Q, is unlikely to be repeated either. The overwhelming consensus is that real GDP will be positive in 3Q; but the key for how 4Q will shape up will rest in how real final domestic demand performs, which sagged at a 1.5 percent annual rate in 2Q, and -3.3 percent for private-sector demand. We remain in the deflation camp for the sole reason that the data compel us to. Wages and salaries contracted at a 5.0 percent annual rate in the second quarter and have deflated 4.3 percent on a year-over-year basis. This is the flip side of having the majority of companies beating their earnings estimates by aggressive cost-cutting — a wage contraction of historical proportions that bites into aggregate demand and requires recurring doses of fiscal stimulus and other gimmicks (like “Cash for Clunkers”) to establish a floor under the economy.

What Rosenberg is getting to is that the gimmicks the Obama administration is trying are temporary in nature. Once they cease, the economic activities they sponsor will cease. It appears the economy has fundamentally changed and that we will likely see subdued growth in the future.

What I fear is that massive government spending will only retard growth. By the time the fiscal stimulus really kicks in, sometime next year, growth will occur in those areas the government has selected. I doubt any of the objects of their generosity will have any lasting economic effect. It will be up to the real economy to carry us forward when government stimulus spending ceases and their projects die.

With the financing demands of a huge deficit, with increased taxation, and with the government increasing its role in the economy, I think we’ll have long term problems sustaining growth. For those of you who remember the 1970s and early ‘80s it will all seem familiar.

— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.

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