Q4 Economic Growth – Be Happy, but Worry

There is alot to like in the recently announced 5.7% rate of US GDP growth in the fourth quarter of 2009. 

While many commentators are brushing it off as a fluke tied to the vagaries of inventory trends, it is actually very normal for inventory swings to account for a good portion of GDP growth when the cycle is first turning.  The question is always whether growth can then get handed off to sustained consumption and private investment after a few quarters.  I think it can, but extreme swings in public policy could theoretically jeapordize the expansion.

The personal consumption number is encouraging, particularly given that consumer credit has been declining.  This implies that we are moving to a sustainable level of spending, complemented by a positive savings rate.  Government transfer payments tied to unemployment insurance and the stimulus package are supporting spending, of course, and my advice would be to withdraw this support only gradually in 2010, if at all.

Net Exports were actually weaker than the real GDP figures reported.  In nominal terms, the trade deficit actually widened as a percent of GDP in Q4.  Petroleum imports increased in nominal terms, but because of rising prices, fell in real terms.  On the flip side, exports grew 25% in nominal terms, meaning world trade is on the rebound and the US can benefit from a strong rebound in the manufacturing and service sectors if it can borrow excess demand from abroad.  Because both the domestic demand and supply of credit is limited, there is reason to be optomistic that exports should expand faster than imports if the dollar stabilizes at current levels.  From a purely economic point of view, it would make sense for the US tom implement policies to reduce its demand for imported oil (to go along with the environmental and security reasons to do so.)  In fact, virtually the entire trade deficit can be traced to the petroleum and auto sectors.

An increase in business investment, on the other hand, was limited purely to high tech equipment.  Traditional industrial and transportation equipment investment remains in the cellar.  There is good reason to expect investment in transportation equipment to rebound from the currently depressed levels not seen since the 1970s in real terms.  Industry, however, suffers from huge levels of excess capacity.  Many sectors of manufacturing got hammered as a whole in the downturn, and had only been skating sideways at best during the expansion of the 2000s.  The most successful manufacturing sectors in the 2000s were high tech, med tech and defense / aerospace which should all continue to thrive, in addition to housing related sectors like wood products, non-metallic minerals, furniture, appliances and fabricated metal products which are highly unlikely to thrive in the intermediate term.  Much of the rebound in manufacturing to date (again, outside of high tech) has been limited to cars, chemicals and steel bouncing from extremely depressed levels to just merely depressed.

Residential real estate investment has clearly bottomed and has added modestly to GDP in the last two quarters.  As a percent of GDP, however, it is at the lowest level since World War II.  Commercial real estate investment continues to plunge, which can be expected for another couple of quarters before bottoming out at record low levels of GDP as well.  Credit conditions, slowing demographics and recent over-investment will all conspire to keep real estate investment at record low levels for at least the intermediate term.

The huge excess capacity in construction workers and construction-related manufacturing leads me to continue to stress how beneficial it would be to focus additional stimulus on infrastructure spending.  These workers can not easily be retrained for health care, education and high tech office jobs.  The country has been behind on such spending anyway, so it would not be Japan-style "bridge-to-nowhere" investment as long as Congress can be reined in.  For this reason I like the "infrastructure bank" idea that takes some of the planning out of the hands of Congressional pork-meisters.

US Indebtedness as a percentage of GDP actually declined in Q3 from 359% to 355%, due primarily to a decline in financial sector debt.  Household and business debt each declined in Q3 as well, but were offset by an increase in US government debt, which increased to 53%, up from 36% at the start of the recession.  In general, I expect this trend continued in Q4 as well, as the US offsets private deleveraging with public borrowing.

In conclusion, the strong parts of the economy (high tech, aerospace, health care and education) are now in expansion mode, and the extractive industries (farming, mining, energy) are likely to join soon.  Those manufacturing sectors exposed to export markets like industrial equipment (think Caterpillar) should resume growth as well unless there is a major economic crisis in the emerging markets.   "Old economy" manufacturing and real estate investment remain a problem and are likely to remain so without increased infrastructure investment.  The trick for policy makers is to transition from a period of broad stimulus to one of consumer and government belt-tightening while letting business investment, infrastructure spending and exports become the primary economic growth drivers.  It would be a neat trick, indeed.

Year End 2009 Market Update

In 2008 and 2009, I honed and refined my market valuation model for equities and bonds. It has been such a wild ride that it has been very hard to interpret. By just trying to ride the bucking bronco that was the financial market of 2009, I have actually learned a great deal.

S&P 500

One great roller coaster has been S&P inflation-adjusted earnings.

From 2003 to 2004 we saw the great spike in earnings, driven particularly by financial earnings and energy earnings. Annual nominal earnings got as high as $81.96 in 2006 and fell to as low as $14.88 in 2008 (the fourth quarter of 2008 was negative due to all of the bank write-downs). Earnings rallied to $49.26 in 2009 and are projected to reach $66.99 by 2011. (Projections by S&P, top-down as-reported.)

The other was the change in the market’s long term inflation assumptions, which were at 2.5% in August 2008 when I first set up my equity market valuation model, fell to 1% by November 2008 during the financial crisis, and are now back up to 2.7%. Obviously, the S&P swung around a lot, too. It fell from 1,267 in August 2008 to 680 in March 2009 (a 46% drop), and is now back up to 1,137 (a 67% rally).

The chart below shows how the changes in equity prices (and thus yields) and inflation assumptions have affected the projected return of my valuation model. (Calculated at the various dates on which I have written about the model on the blog…for a list of these posts see here.) I use a 50% payout ratio assumption to calculate the implied yield on trend earnings, which is in line with the historical ratio.

From these numbers it’s somewhat clear that the equity market has been targeting a 7% return during this period. A 7% nominal return on the equity market equates to a 5% premium to the 10-year treasury bond on an after-tax, inflation-adjusted basis, which is in line with the historical equity risk premium.

If you think that the 2.7% 30-year inflation assumption embedded in today’s treasury yield curve is correct, then today’s equity market is fairly valued. As I’ve repeated many times, I believe that in the medium term (5-15 years) the US may struggle with deflation, in which case we could see the market retest the lows when we have the next recession and the inflation assumption falls back under 2%. In the short term, however, the equity party rolls on as the economic expansion gains steam.

Fixed Income

Using the yields of various Vanguard Funds and the treasury yield curve from PIMCO’s website, I get the following yields vs. their respective equilibrium yields:

According to this methodology, TIPS are moderately overvalued, long treasuries are fairly valued, and long-term inflation is overstated. Intermediate and long term muni bonds are roughly fairly valued and corporate bonds are mostly overvalued. Yields on the short end of the curve for all types of bonds are way below their equilibrium levels.

For fixed income, the risk lies in corporate bonds. Unless you are in the “hyperinflation” camp, treasuries and munis are an ok value, but uninspiring and at risk to a crisis in which interest rates go haywire, which is highly possible (see below).

The Dollar

The dollar against major currencies is in its long term downtrend range of 70-80:

The real dollar index against all currencies is also in its long term range of 85-95:

The dollar may drift somewhat higher this year, but there is no reason to expect it to trade out of its trend range. Generally, when the dollar is fairly valued against other currencies, it is good for exports and emerging markets.

The dollar has continued to fall against the neutral currency of gold:

In the mid-1980s to mid-1990s, the dollar had settled into a nice range around $375-400 per ounce of gold. The gold price fell during the strong dollar era of the late 1990s. It broke above $400 / ounce in 2005 and hasn’t looked back since. The reason that gold has risen so much faster than the dollar has fallen against other currencies, is that all currencies are falling against gold. It is hard to know when and where this trend will stop. I suspect it has something to do with the currency reserve-building practices of China, the Middle East, et al, which have been artificially holding down interest rates relative to the rate at which the money supply (and financial debt) has been expanding. When this practice finally unwinds…which it will someday, probably by the middle of this decade…watch out for the “final crisis of bubble capitalism”.


The oil / gold ratio is right about at its historical average, meaning oil is fairly valued given the debased value of the dollar relative to gold.

The CRB futures index, which tracks commodities generally, is actually well below its equilibrium value relative to gold:

This implies commodities could continue to rally strongly as long as the economy is spurting forward.


Outside of a trade in commodities, the market has no obvious pockets of value overall. The macroeconomic risk looming over the horizon (2012?) is foreboding, even if it can’t be felt now. The great bubble of money seems to be flowing to emerging markets, which is in turn flowing into the bubble in developed market deficit spending. If I had to guess now…I think the next great crisis will be in the Chinese banking system, which could result in them selling off their currency reserves, which would spike interest rates and cause a deflationary crisis in the US…but would also finally rebalance the world economy and lay the groundwork for renewed, sustainable growth.

Good luck and be safe.

Tyler Newton is not a financial adviser. He is only writing these posts for personal interest. Please be sure to consult with your financial advisor.