Assessing the Quality of Q3 GDP Growth

In my last post I outlined how I'd assess the quality of future GDP growth.  I expected to see near term growth coming from a combination of of export growth and government spending near term with business investment eventually taking the baton from government near term.  I also said how I would not want to see growth that comes from consumption of consumer goods (with a high propensity to import) and housing investment.  (I use nominal GDP vs. real GDP, becuase I care about actual cash changing hands, and inflation is relatively low.)

The change in nominal GDP from Q2 to Q3 was $150.3 billion.  Personal consumption expenditures was up $162.6 billion, although $39.4 billion came from increased sales of autos and $48.1 billion came from gasoline and other fuels.  Imports of autos increased $43.2 billion, meaning that the increase in auto sales, partly fuelled by the "cash for clunkers" program, was a net drag on GDP growth.  We also imported $42.1 billion of petroleum products.  In other words, the net effect on GDP from domestinc demand in the auto and petroleum sectors (excluding changes in inventories) was a net gain of $2.2 billion.  Exports of autos and parts increased $20.2 billion thanks to increased demand abroad.

Residential construction increased $15 billion, or about 10% of the net increase in GDP.  Given the excess supply already existing in the housing market, I consider this to be low-quality growth, spurred temporarily by the first-time buyer tax credit.

Business investment added $2.9 billion to GDP growth, more than all of which came from a smaller decline in changes in inventories.  Business investment in structures fell $24.5 billion and investment in software and equipment fell $1.7 billion.  I expect investment in structures (largely commercial real estate) to continue to fall and for investment in inventories, software and equipment to start to rise.

Government spending added $28.6 billion to growth.

Exports increased $69.5 billion and imports excluding autos and oil was up $32.6 billion, a net increase of $36.9.  Imports of autos and oil was $85.3 billion, accounting for 72% of the increase in imports.  Thus the net drag from total net exports was $48.4 billion.

If we strip out the effect of housing investment, domestic auto sales and domestic oil consumption, "quality" GDP growth was $128.5 billion, or 3.7% nominal GDP growth.  Government spending accounted for $28.6 billion of that growth, meaning $99.9 billion of nominal GDP growth came from "quality" private sources.  That would have yielded 2.9% nominal GDP growth.

All-in-all, not bad. 

The Nature of the Economic Recovery

Over the past several weeks I've started several posts with titles like "Time for the Fed to Raise Rates", "Where are the adults?", "Time to cut the Deficit" and "Time to Stand up to the Chinese". Each time, however, I've thought about the facts and stopped. As I've stated many times before, the Dynamist tries to be a neutral observer of how the world actually is, not a prescriber of how the world should be. In a perfect world, I would like to see a more stable set of economic policies that promote balance and equilibrium. In the real world we have something very different: a volatile set of economic policies that try to promote long term equilibrium by shifts in short term disequilibrium. The US government adopts aggressive new policy imbalances to deal with old economic imbalances. The first step in developing an economic outlook is to assess the imbalances in the economy and to prioritize how and when they will get dealt with. As I have done so, I have come to the conclusion that our government is actually doing pretty well under the circumstances.

How we got here

The last 40 years or so have been a period of transition between the "old economy" and the "new economy". The new economy is the R&D-centric, globalized economy driven by technology, biotech and health care, financed by equity, based in the Northeast, parts of the Upper Midwest and the Pacific Coast. The old economy is the consumption-centric economy driven by automobiles, residential investment, petroleum, mass agriculture, mass media and retail, financed by debt, based everywhere but prominent in the Sunbelt and Rust Belt.

Government policy in the time of transition has been a hodge-podge that has favored both economies, allowing the new economy to thrive and supporting globalization, while continuing to heavily subsidize housing, petroleum, mass agriculture and cheap imports (with an overvalued dollar) and encouraging the over-production of automobiles. The US military subsidizes both economies, investing in new technologies and protecting the flow of oil from the Middle East.

So while some of the new economy innovations like derivatives and hedge funds helped us get into the mess we're in, the real problem has come in the collapse of the old economy. Securitized housing and consumer loans are what blew up the balance sheets of US banks. The other, lesser culprits for banking problems are the LBO loans made to buy old economy companies.

The way forward

The way forward is for the Obama administration to complete the transition. Policies meant to prop up the old economy, like "cash for clunkers", the homebuyer tax credit the use of now-nationalized Fannie Mae to effectively dominate the market for housing loans, will only offer short-term salves and cannot lead to sustainable recovery. There is no going back to the old housing, consumer credit and retail bubble.

Other Obama policies have encouraged the transition. The reduction of auto capacity makes sense, as does encouraging the move to hybrid and electric cars. The proposed consumer protection agency, the proposed reining in of financial system leverage and other financial market reforms should discourage consumer borrowing. Long term I would expect to see Fannie Mae dismantled and perhaps an end to the favorable treatment received by corporate borrowing over equity financing. The proposed cap-and-trade scheme, for all its flaws, would also encourage the move away from imported petroleum, the biggest source of our structural trade deficit. Even health reform, if it is structured in a way that doesn't stifle innovation, will be a benefit if it levels the health care playing field between small businesses and large corporations.

One of the core tenets of Dynamism is that the American people tend to elect the right government for the times. They will shift around control of the presidency and congress to adjust for imbalances that build up. The US system also leaves the opposition in a powerful enough position that they can help prevent excessive imbalances from building up. The American people were right to favor conservative economic policies over the past 30 years. They were also right to support Obama last year. At some point, when deficits become the most important problem, they will elect a Republican congress. That time is not likely 2010, however.

GDP Outlook

Thanks to the TARP, the Fed's "unconventional measures" and some deft maneuvering by Treasury, the financial system has been stabilized, although many of its underlying problems remain. Now that the financial system is stabilized, GDP can grow. GDP always wants to grow. GDP growth is driven by business competition, which leads to innovation, which leads to investment and hiring, and so on. Business competition gets interrupted when there are financial sector problems. In business competition, there are always businesses on the rise and businesses in decline. In good times, the declining businesses are shielded a bit from their core problems. In bad times those problems are magnified. Recessions accelerate the trends that are already in place. Thus the continued shift of employment from manufacturing to health care. After a bubble, however, a recession can also mark a major turning point. I would argue that we are witnessing a major turning point in housing, energy and retail.

Residential investment has been declining as a percent of GDP since 2005, while personal consumption expenditures as a percent of GDP have been flat. Because personal consumption is less volatile than business investment, it usually rises as a percent of GDP in a recession. As an aside, also notice that the big surge in consumption as a percent of GDP came during periods of supposedly "supply-side" tax cuts in the early 1980s and early 2000s (and late 1990s, with the cuts in capital gains taxes on equities and housing).

Clearly a key pillar of demand during the recession has been the government.

While residential investment as a percent of GDP has fallen by 2 percentage points since 2005, government spending has risen by the same amount. Government spending is now back up to the levels of the 1980s and still below the levels of the 1950s and 1960s. Going forward, increased infrastructure and health care spending will likely be offset by decreases in spending on the wars in Iraq and Afghanistan and by state and local governments, meaning that government spending will likely remain in the 21% of GDP range for the intermediate term.

Where I'd like to see the next wave of demand come from would be exports.

The drag of net imports has been reduced by more than 3 percentage points of GDP since 2005, but this has been driven more by the collapse of imports than by an increase in exports.

The key will be to see if exports start increasing as a percent of GDP while imports are stable or declining. As I've said many times before, a sustained reduction in our trade deficit or the creation of a trade surplus driven by export gains would be the most effective and least painful way to reduce US public and private indebtedness.

Once the recovery has clear traction, business investment should recover.

Business investment as a percentage of GDP is at the lowest level since recessions in the 1950s, a period when business investment was effectively suppressed by government policies. The recovery in investment is likely to be "U" shaped, like in the early 1990s. I expect stabilization by the fourth quarter of 2009, but no real sustained increases until late 2010 at the earliest.


In summary, when examining GDP during the upcoming expansion, look for the following:

  1. An increase in the share of GDP by exports and government near term and exports and business investment long term.
  2. A decrease in the share of personal consumption and imports short term.
  3. If the short term pillars of economic growth are going to be exports and government spending, then expect to continue to see budget deficits, low interest rates and a weak dollar.
  4. Interest rates won't really need to rise until business investment gains traction. When it does, inflation and interest rates will rise, and the American people force the government to focus on cutting the budget deficit.
  5. The likely policy mix to both fight the budget deficit and discourage trade deficits while encouraging domestic business investment will be to raise taxes on the rich, but increasing the amount that can be saved tax-free, effectively creating a progressive consumption tax.

We should also expect to see a reformation of the corporate tax code, lowering rates across the board while eliminating some of the subsidies for old economy industries.

Politics, Parties and Electoral Cycles

Because the US Government is a very large actor in the US economy, and because many of the same principles that apply to analyzing economic cycles applies to politics as well.

Maybe Ron Paul was on to something (9/30/08)

Is the North rising again? (10/16/08)

Was 2008 a realigning election? I’m thinking it probably was. (11/5/08)

Crony Capitalism still Reigns Supreme (4/20/09)

The New Deal’s great mistake (5/3/09)

Post-Lehman: The Banking Oligopoly Reigns Supreme (9/15/09)

David Brooks backs up the Dynamist (9/18/09)

The GOP Will Not Repeal Obamacare (3/23/10)

US Politics: The Middle Class is Still Up for Grabs (10/31/10)

Q3 Market Update – A low return world

In the third quarter of 2009, we have seen some pretty significant market shifts relative to the second quarter. To refresh yourself on how my market valuation model works, please refer to this page.

Inflation and the Treasury Yield Curve

As I outlined in my May 25th post "Inflation is not a threat (yet)", I look at the treasury curve, the dollar and gold to take the market's pulse on inflation.

The TIPS spread, which is the difference between the nominal yield on bonds less the yield on the Treasury Inflation Protected Security (TIPS) has seen some interesting shifts. While the 10-year inflation rate has remained right around 1.7%, the 5-year inflation rate rose from 0.8% on May 25 to 1.7% at the end of Q2, to 2.2% at the end of Q3. The 30-year inflation rate, on the other hand, has fallen from 2.2% on May 25 to 2.0% at the end of Q3.

Embedded in these numbers is the assumption that inflation surges from zero today to average 2.2% per year over the next 5 years. Inflation is then expected to slow to 1.3% per year from 2015 to 2019, before averaging 2.1% per year for the 20 years after that. This scenario is plausible. It implies a surge in economic activity after all the stimulus currently in the pipeline, before re-succumbing to the disinflationary undertow as the economic cycle turns down several years from now.

My other near-term inflation signals are also flashing yellow. Gold has traded to slightly higher than $1000 per ounce, and the dollar is very close to the bottom of its long term trading range. They aren't yet past the point where I'll start screaming that the Fed needs to hit the brakes, but they are right at the edge.

What does a flattening of the real yield curve mean?

In my May 25th post I discussed how the proper rate for overnight money is around 2.75% if inflation is averaging 2% per year. This would deliver a zero percent after-tax, after inflation rate of return, which is what you should earn for taking no risk. That would imply an equilibrium overnight TIPS spread of 0.75%. In my equilibrium model, I have assumed an upward-sloping real yield curve of 1% for the 2-year, 1.5% for the 5-year, 2% for the 10-year and 2.5% for the 30-year. The current TIPS real yield curve is 0.5% below my "equilibrium" along the curve from the 5-year on. The difference between the 0.75% overnight real yield and the higher yields further out is driven by uncertainty regarding future inflation volatility, which increases as the time horizon gets longer. If the TIPS curve has flattened, that implies that future inflation volatility assumptions have come down.

Much of the flattening move came in the last week after Fed Governor Kevin Warsh wrote an Opinion piece in the Wall Street Journal declaring that the Fed would be vigilant about removing stimulus if inflation became a threat. In other words, they wouldn't make the mistake they made earlier this decade, when they let inflation run and were too slow to remove monetary accommodation. If a flatter TIPS curve becomes a permanent feature of the financial markets, then asset yields would come down permanently and asset values would rise permanently.

What happens to my market equilibrium assumptions?

(As a reminder, I use the yield of various Vanguard bond mutual funds for my market rates of non-treasury bonds, my treasury yield curve information is from the PIMCO web site and my S&P 500 earnings estimates come from Standard and Poors)

The rally in TIPS is catching up to the rally in the bond market generally and allowing the intermediate and long ends of the treasury, muni and corporate bond markets to be in proximity to fair value, while the short end of the curve is still overvalued.

The equity market (S&P 500) is about 22% overvalued if you feel the proper return is 7% per year. 7.1% per year would imply a 5% equity risk premium in after-tax terms to the 30-year treasury bond. The market is currently pricing in an equity risk premium of about 4.5%, which is low by historical standards, but in line with the drop in TIPS term risk premiums.

What level of S&P 500 earnings am I using?

As a reminder, I am using the long-term trend for inflation-adjusted AS REPORTED earnings. The next twelve month trend earnings number I am using is $56.56, and assume it grows at its historical inflation-adjusted rate of 1.64% plus the market long-term inflation rate of 2%. In the press you often hear a higher number for earnings, which is the operating earnings number for the next twelve months. Operating earnings allows for companies to exclude the effects of all of the poor acquisitions and perma-restructurings they conduct. The long term trend in as reported earnings gives a much more accurate view of accrual of value to the equity holders. With the S&P at 1030, the price to trend forward earnings ratio is 18, well above the long term average of about 14.  The actual top-down, as-reported earnings number projected by S&P analysts for 2009 is only $39.35.


It's tough to have conviction about this market. It's good that the embedded volatility premium in the market has declined, but if it rises again (which it very well could) valuations of bonds and stocks could fall a great deal. Rising tax rates could hit the valuations of stocks and bonds pretty well, too. With inflation signals flashing yellow, the Fed could very well start pulling back stimulation soon. I have made a series of adjustments to my investment model to justify the shifts occurring in the markets. Either we've entered into a permanently low-return world, in which case these markets make sense, or we're rationalizing the effects of cheap liquidity and are in for a rude awakening sometime in the not-too-distant future.

Given a lot of unexciting choices, I like muni bonds, hedged with cash, a bit of gold and crossed fingers.

Disclosure: I am not a financial advisor. Seek investment advice from your own financial advisor.