GDP Outlook 2011: Momentum is Building

2010 was a year of recovery for the US economy. On a year-over-year basis, nominal GDP grew 4.1%. (I will mostly use nominal GDP because I like to look at relative values. Nominal GDP represent actual cash numbers, while the individual items that make up real GDP can get distorted by quirky inflation adjustments.) Real GDP grew 2.85%, implying an economy-wide inflation rate of only 1.25%. The components of growth are as follows:

Personal Consumption: 2.7%

Private Investment: 1.1%

Government Spending: 0.7%

Net Exports: -0.5%


Within this mix, private investment gained economic share, while the rest of the components lost share. This is not surprising, because private investment is the driver of business cycles.


The preliminary estimate for Q1 GDP growth slipped to 3.7% in nominal terms and 1.8% in real terms implying an inflation rate of 1.9%, a pickup in inflation and a slowdown in growth from the pace of 2010.


I believe that the Q1 slowdown is a blip and that economic momentum is building, driven by a strong and lasting expansion of business investment. I believe that the investment boom will more than offset what I believe will be sustained long term weakness in real estate investment.

Business investment

Source:, author's calculations

Two things stand out in the above chart of private investment as a percent of nominal GDP. First, the recessions of 2008-09, 2001, 1990, 1980-82, 1974, 1970, etc. are all clearly visible. Second, it can be seen just how severe the Great Recession was, with private investment plunging to as low as 10.9% of GDP in Q2 2009, well below its long term average of 15.9%.

Private Investment can be broken down into business investment and real estate investment. The chart below shows the relative share of GDP of both long term business investment (excluding changes in inventories) and real estate. These are the forces that drive the intermediate term (5-10 year) business cycle.

Business investment is starting to recover, while real estate investment (residential and commercial) is not.

Source:, author's calculations

Notice the general 16-18 year infrastructure investment cycle (called a Kuznets cycle for you business cycle buffs). The front side of the cycle generally benefits from a powerful business investment boom, which also coincides with strong job growth. The back side of the cycle has a larger share of real estate investment and is generally associated with weaker job growth. The good news is, we are entering the powerful phase of the investment cycle, meaning the next decade should actually produce strong economic and employment growth.

Business investment reached a low of 7.0% of GDP, below the average of 8.2% since the end of the 1970 recession. This level roughly matches the lows of 7.4% hit during the 1974 and 1990 recessions. In Q1 2011, business investment was 8.2% of GDP, in line with the historical average. It is interesting that business investment is at mid-cycle levels so early in a recovery. Perhaps we really are moving to a new paradigm of more consumer saving and higher business investment, and less focus on consumer spending and real estate investment.

Real estate investment, on the other hand, has been experiencing a series of "lower highs" and "lower lows", hitting 7.2% in the 1974 recession, 6.3% in the 1990 recession and 4.0% in Q4 2010, well after the end of the 2008-09 recession. In normal circumstances, I would expect a snap-back from such a severe drop. Demographic trends are working against the real estate market, however, as Baby Boomers are moving past their peak home buying years and toward retirement while being followed by the much smaller Generation X. I expect only a very gradual recovery in real estate investment, although it's hard for it to go much lower.

Another component of business investment is the change in inventories, which tends to lead the short-term business cycle. In 2010, inventory additions added a full 1.9 percentage points of the 4.1% nominal GDP growth.

Inventory changes are clearly volatile, and have been losing share as a percent of GDP due to the decline in the relative importance of manufacturing and to the improvement in inventory management. There was some alarm with the drop in inventory additions in Q4 2010. Inventory cycles usually last at least 3-5 years, however (as can be seen in the chart above, these cycles are known as Kitchin Cycles). We should therefore expect for inventories to continue their positive trend for at least the next year.

Consumer spending

As I have noted previously, personal savings has risen to a normalized level relative to GDP, so personal consumption should now keep pace with GDP growth, as it has most of this decade.

Even as employment starts to improve, however, we shouldn't expect much of a boost from additional spending as long as savings holds at its current percent of GDP. The reason of this is that aggregate personal income hasn't really declined during the recession.

Source:, author's calculations

Wage and salary income has declined substantially relative to GDP over the past decade, but increases in government transfers and health care benefits have held total income roughly constant at about 85% of GDP. Given the imminent retirement of the baby boomers and the planned increases in government health care spending, there is no reason not to expect a continuation of the trend of a smaller wage base relative to GDP.

One threat to consumer spending is that there is a good chance that taxes will increase.

Income taxes paid as a percent of GDP is at its lowest level since the early 1960s. In addition, consumer spending (and potentially personal savings) is being temporarily goosed in 2011 by a cut in the payroll tax.


Given the budget tussles in Washington and state capitals, and the likely winding down of the wars in Iraq and Afghanistan, we can expect direct federal, state and local government spending to start declining as a percentage of GDP. We should expect the federal transfer payments that support consumption (social security, Medicare/Medicaid, unemployment benefits) to continue at relatively high levels unless some major budget revolution takes over the Federal government.


The economy is underperforming the public's expectations primarily because of the collapse in real estate investment and home values. As a result of the large drop in household net worth (from 470% of GDP in early 2006 to 347% of GDP in early 2009), household savings rapidly rose while real estate and business investment rapidly sank. The government stepped in and offered tax rebates, transfer payments and spending stimulus to prop up demand, while the Fed and the treasury propped up the banks to prevent a deflationary spiral. By mid-2009 the markets started to recover, stabilizing consumer net worth, personal saving and personal consumption. Once businesses saw the economy stabilizing and economies resuming growth abroad, business investment started to recover, first with inventory restocking and now investment in software and equipment.

Real estate investment has not recovered for obvious reasons, and this leaves a big hole in the nation's productive capacity, which is also holding back employment. The Fed continues to ease and the economy makes a gradual transition away from the real estate fuelled economy of the 2000s and employment is slow to recover. The weak dollar is helping US exporters but is causing a rise in the nominal value of imports, particularly in petroleum products, which now account for nearly our entire trade deficit. I am not quite sure what the Fed now expects to accomplish with its current course of action.

All that said, momentum is building. The American economy is very resilient and is merely in a transitional phase where the tired consumption and real estate driven economy is handing the baton to one focused on productivity and business investment. Which is a good thing.

Q1 2011 Market Review: It’s Time to Raise Interest Rates

Since the financial panic of 2008, I have generally been an interest rate and inflation dove. In my view most of the inflation damage was done from 2001 to 2007, not in the time after the financial crisis. The combination of the TARP and Fed policy halted a potentially deflationary downward spiral in prices and asset values. Now, however, the economic need for monetary support is over and business investment, which is and always has been the driver of self-sustaining economic growth, is rising again. Waiting for residential real estate investment and construction employment to recover before declaring economic growth self-sustaining would be as foolish as the mistake of the early 2000s when Alan Greenspan waited for technology investment to recover from the dot com bust even as real estate investment was roaring ahead. Today we effectively have the same situation in reverse. The market is sending its classic signals that global monetary policy is too easy. While I place more blame on the central bankers of emerging market economies like China, there are several market signals that are telling us that US monetary policy is too loose as well.

I have gradually come to the conclusion that our forty year experiment in using monetary policy to manage the economy has failed. Monetary policy has been used to drive up asset prices and support the use of financial leverage while eroding our purchasing power by encouraging inflation. Higher asset prices and supportive credit markets are great for the elites, who can use their knowledge of the financial markets and already ample capital bases to accumulate more assets. This state of affairs is harmful to the middle class, however. As inflation eats up middle class purchasing power, they have turned to borrowing to support their lifestyles. The middle class’ borrowing backfired royally with the housing bust of 2007-2011, yet the Fed’s economic remedy remains the same…encourage borrowing, support the financial sector and prop up asset values with ever-lower interest rates.

It is now time to normalize interest rates. The financial instability of wildly swinging interest rates, asset values and debt levels accrues to the benefit of the financial sector at the expense of the real business sector. If the Fed focused on policy stability, there would be far less need for hedge funds, commodities traders, bond traders, private equity funds and the seeking of profits via financial engineering. There would instead be more focus on trying to earn returns from actual investment in productivity-enhancing business investment. America has one of the most innovative and productive financial sectors in the world, but even I, a member of that financial sector, must admit that it has grown too large relative to the non-financial economy.

Interest rates

Source: Bloomberg, Vanguard Funds,

The yield curve is telling us that inflation is expected to be well higher than the Fed’s target range of just under 2% for the 10 and 30-year time horizons. 5-year Treasury Inflation Protected Securities (“TIPS”) yields are negative, and treasury yields of less than 10 years are well below their equilibrium levels, signaling that the market expects the Fed to leave rates low for too long and then lose control of inflation.

The long end of the yield curve continues to offer the most value, particularly among treasuries and munis, even with the current market view of inflation. If inflation expectations come down, we could see another rally in long bonds.

The dollar


The broad real dollar index has for the first time punched well below 85. It is also trading at the bottom of the range relative to the major currency index as well. It should be noted, however, that dollar bear markets have tended to last about 10 years (1968 to 1978, 1985 to 1995), meaning that cycle timing-wise, the dollar bear that began in 2002 may be due to end and that the dollar may be ready to enter one of its periodic 7-year bull markets (1978-1985, 1995-2002). It may be time for the Fed to tighten if only to focus on strengthening the dollar a bit.



The ratio of commodity prices (CRB futures index) to the Consumer Price Index (CPI) is at the highest level since the early 1970s. Commodity prices are a leading indicator of broader inflation.

Most are aware as well that the price of gold, widely viewed as a neutral currency, has been skyrocketing for some time now.



The housing bear market continues, but may be nearing the bottom. Expect a rounded bottom in the housing market over the next several years, regardless of Fed policy.

Source: Standard and Poor’s,,


My market valuation model (which uses inflation-adjusted trend earnings) shows stocks to be fairly valued currently.

The 6.8% return implied by today’s S&P 500 is driven by a long term inflation assumption of 2.8%. If inflation expectations drop, so will the stock market.


If interest rates get normalized on a schedule faster than the market currently expects, short and intermediate term interest rates will rise and stocks will likely fall somewhat. I don’t think the housing market would be affected, as the market is not moving higher even with the current ultra-low interest rates. So yes, tighter monetary policy would be a moderate negative for the financial markets. To this I am finally saying, “So what”? It’s time to wean ourselves off our need to surf from financial bubble to financial bubble and get back to the hard work of building the real economy.