GDP Outlook 2011: Momentum is Building

tylerdynamistLeave a comment

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: Economy.com, 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: economy.com, 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: economy.com, 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.

Government

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.

Conclusion

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

tylerdynamistLeave a comment

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, tylernewton.com

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

Source: economy.com

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.

Commodities

Source: economy.com, tylernewton.com

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.

Source: economy.com

Housing

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, economy.com, tylernewton.com

Stocks

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.

Conclusion

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.

Why the Fed Likes Inflation (And What it Means For You)

tylerdynamistLeave a comment

Why would the Federal Reserve Bank, who is holding interest rates at zero, be purposely trying to whittle away the purchasing power of savers in this country? Below are a few simple rules to understand how the Federal Reserve operates, why interest rates will likely remain low for a while, and why that’s good for stocks and commodities.

The remainder of this article can be found at the website Man Of The House.

You Need Skills to Pay the Bills

tylerdynamistLeave a comment

The economy has gone haywire and politicians and economists are in total disagreement as to what to do about it. Regardless, the key to getting ahead is to look at the world how it is, and not how it ought to be. The world is tilted toward those that are well-educated or highly skilled and jobs will continue to shift from classic middle-class occupations like manufacturing and back-office work toward technology, education, health care and leisure services. There are two choices: complain about the trend or join it.

The remainder of this article can be found at the website Man Of The House.

 

Catalyst Investors Blog: Real Time Bidding and the Rise of Mid-Tail Content

tylerdynamistLeave a comment

For those of you interested in online advertising technology, my colleague Susan Bihler and I have written a two-part series on the Real Time Bidding ecosystem and its effects on online and offline media. The second part is a discussion about how RTB will help the Mid-Tail publisher, how RTB will hurt traditional TV and cable advertising and how Google is well-positioned to dominate the market. (click link to see the article)

Market Review: Beware an Emerging Markets Inflation Crisis

tylerdynamist1 Comment

Right now the only assets that aren't overvalued (according to my model) are long term treasury bonds and long term municipal bonds. You can be confident that this is likely true because it feels the most wrong. Global monetary policy is supporting stocks and commodities right now, even though they are artificially overvalued, and they should be expected to keep rising until the policy trend comes to an end. We should expect the trigger event for the next market takedown to be an emerging markets inflation crisis, which would cause the existing global policy trends to go in reverse.

Fixed Income predicts continued malaise

The bond market has changed very little from the end of 2009, although there was a wild ride in between.

(Data from Bloomberg.com, Vanguard Funds, Economy.com)

The fixed income market is telling us that the Federal Reserve will likely keep the Fed Funds rate very low for at least two years and maybe more. Policy should be normalized sometime between year 2 (2013) and year 5 (2016). After year 5, however, the market expects an extended period of higher-than-equilibrium interest rates all the way through year thirty (2041).

While the Fed's bond-buying program may be affecting the short-to-intermediate end of the nominal treasury curve, the Fed is not manipulating the inflation-protected market ("TIPS") which are pointing to low real interest rates and a return to normalized inflation after only several years of aggressive monetary policy.

The basic message that the market is sending is that the economy and the financial system will underperform for at least the next two years. This is consistent with my view that housing will remain weak through at least 2012. Housing weakness affects the collateral values that underpin most consumer and small business lending. Thus the deflationary undertow of real estate on the financial system will weaken both the supply and demand for these certain types of credit.

Housing remains overvalued

The Case-Shiller house price index points to real house values being 5-10% overvalued relative to their long term trend (which is about 100).

The Fed Gets It

The Fed understands all this, however. The Bernanke Fed is performing quite well under the extreme circumstances. All the hoopla blaming the Fed for inflation (which so far is showing up only in commodity prices), is misplaced. The real culprits in grand market manipulation and inflation-creation are the central banks in emerging market economies. They are refusing to rein in monetary policy by the proper amount because they don't want to let their currencies appreciate and potentially weaken their export-led growth models. It is rapid demand growth in emerging markets that is driving up commodity prices, not overheated monetary policy in developed markets.

The "Virtuous" Market Circle

So now we have a policy framework that is about as beneficial for equity and commodity markets as possible. Weakness in the real estate and banking markets in the developed world result in low interest rates. Corporate America, which is relatively unaffected by the real estate markets, is racking up profits as emerging markets expand and productivity surges. Emerging market policy makers are over-expansive for fear of hurting their export machines. Emerging market central banks thus purchase developed world assets, keeping interest rates low and asset prices high.

Stocks are still overvalued – but may remain so for a while

The S&P 500 is priced to deliver only a 6.6% long term return today.

Earnings are well above trend, as the playing field is tilted in favor of multinational companies at the expense of labor and small business. If domestic or foreign government policy toward multinationals was to change, today's record margins would shrink and earnings would return to their long term trend level.

This policy mix keeps interest rates artificially low, stock and commodity prices artificially high, and is artificially holding up housing prices. Stock prices are probably only one recession away from becoming cheap, however.

Historically, earnings yields (inflation-adjusted trend earnings divided by the S&P 500 level) in excess of 6% imply a safe time to buy stocks with a long-term buy-and-hold strategy. We're not quite there, but should expect the end of the secular bear market that began in 2000 to come with the next recession.

Beware an Emerging Markets Inflation Crisis

What would bring the policy circle to an end would be an inflation crisis in emerging markets, which would force them to let their currencies appreciate to slow their overheated growth. While this change would put an end to the great economic imbalances that bedevil the global economy today, a sudden policy reversal could be very disruptive. Interest rates and the dollar would rise and stocks and commodities would fall as liquidity dried up. My recommendation to world leaders would be to start making the necessary adjustments now. This is essentially the argument that the US and EU have been making to the likes of China for years and it has been falling on deaf ears. For now, the Fed will continue to stick it to the emerging market central bankers and stocks and commodity prices will continue to rise.

Investing in Bonds – Keep it Simple

tylerdynamistLeave a comment

Investing in bonds doesn’t have the same macho appeal as investing in stocks. Bonds aren’t always about betting on price appreciation; they are usually purchased for the simple purpose of generating interest income. It is possible to make money with price appreciation in the bond market, however, it means taking on a little bit of risk.

The remainder of this article can be found at the website Man Of The House.

Simple Rules for Investing in Stocks

tylerdynamistLeave a comment

Forget the hype. Investing in stocks is not a game. Unless you are a professional trader or a trained financial analyst on Wall Street, you should be wary about investing in and trading individual stocks. There is an army of well-paid professionals on Wall Street that are paid to trade and analyze stocks for a living, and they don’t beat the market as a whole.

Two rules for investing in stocks: keep it simple and diversify.

The remainder of this article can be found at the website Man Of The House.

Where to Put Your Money: The Basics

tylerdynamistLeave a comment

“Asset allocation” may sound like the kind of term used by rich money managers and Ivy League university endowments. In fact,  anyone with a savings account,  a 401(k),  a pension plan or real estate should be thinking about asset allocation. “Asset allocation” is just a fancy way of saying “don’t put all your eggs in one basket." By putting your money in several different baskets, you can reduce risk and potentially increase returns by diversifying your investments.

The remainder of this article can be found at the website Man Of The House.