Most Important Messages From 4Q GDP Report

The Most Important Messages From The 4Q GDP Report

By ContraryInvestor.Com | 1 March 2009

Quarterly GDP reports are usually not at the top of our list for intensive review. By the time this news is actually reported, it is stale at best. However, we believe there were some VERY important messages to be garnered from looking beneath the surface of the 4Q 2008 GDP report, beyond the most noticeable headline number decline.

The character change witnessed when reviewing the components of the report is the most striking we have seen in a very good while. We believe that realizing what is happening and "seeing" this character change will be very important to individual US equity sector outcomes ahead, as well as to macro investment decision making. Although we sure as heck hope not to bore you with economic minutia, we've seen little or no coverage elsewhere of the issues we’re going to cover in this analysis.

We noted what we believe are two very important bottom line takeaways from the report. First, behavioral change in the US consumer may be approaching the definition of a secular change, if current trends continue throughout 2009 and beyond. We know that sounds melodramatic, but keep an open mind as we review the historical and current relationships.

Secondly, the total character of the GDP report suggests that the current stimulus plans of the incoming Administration will be inadequate at best, if consumer behavior is shifting as the numbers in the GDP report seem to show us. Add in the proposal of significant tax increases [[but only on the rich, who will not alter their lifestyle thereby: normxxx]] and the storm clouds only darken. Let’s get to it.

Some very quick 'headline' background. Although it may have been a bit lost in the shuffle, a rise in inventories contributed modestly to the headline GDP number. As calculated, rising inventories are a positive for GDP in that they add to the number. Of course actual businesses may see it a bit differently.

Here’s what we believe to be one important observation. In almost classical terms, US recessions in the post war period have been led by inventory corrections. The key is that they are "led" by inventory corrections. Absolutely classic stuff. But in our current circumstances, we’re now supposedly 14+ months into the current recessionary interlude and yet it’s only in the last quarter that an inventory 'problem' has developed.

You can see in the chart above that the inventory-to-sales ratio was climbing a good year prior to the official 2001-recession period. We’ve seen a fair amount of commentary over the past year suggesting that corporations had kept inventories in great shape in the current cycle, and that ours has really been a financial sector led recession as opposed to a manufacturing, or consumer based inventory led recession up to this point. That’s no longer true at all. Certainly what began as a macro financial sector event has hit the heart of the US manufacturing and service sectors dead center.

Historically, inventory corrections do not abate in a quarter or two. The fact that an inventory 'problem' is occuring only now suggests we still have a ways to go before inventories and sales are once more back in alignment. The massive spike you see in the chart above also tells us that the drop in consumption [[(aka, demand destruction?): normxxx]], which caused this anomaly, has been very abrupt and sharp.

As we have been suggesting for some time, it’s the magnitude and duration of the current economic downturn that is key to the financial market outcomes this year. In our eyes, the inventory issue speaks to a prolonged duration. Does that mean we have not yet found an equity market bottom if the duration of the current recession will be substantially longer than probably most believed up to this point? Recent financial market action is suggesting as much.

Lastly, we now know manufacturing and production are being cut hard into 1Q 2009 given the very evident 4Q inventory problem. The chart above is relatively dramatic in its message. Economic reports in the current period and in the months ahead will continue to offer little in the way of comfort, or corroboration that we’ve seen the bottom of the current economic cycle (or will any time soon).

Instead, we need to extend our expectations for when the the economic cycle will bottom and the recession end. As we suggested, that means the financial markets are still in the process of trying to 'catch up' and discount this elusive bottom that has now been pushed further forward. Based on this data, the bottoming process in equities will likely last for quite a bit longer.

The next MAJOR message from the GDP report, as we see it, concerns the US consumer. It’s probably no big surprise that consumption was weak. BUT, the big surprise to us was that consumption was so incredibly weak during a period in which consumer prices were actually falling, energy prices being the keynote of this phenomenon. This is a meaningful character change for US consumers relative to that which we have experienced in the postwar period. This is what we referred to as being possibly 'secular' in our comments above.

Let’s take a quick look at final sales to domestic US purchasers. Why is this important? Because this measure excludes inventories. In the combo chart below we're doing a little mixing of apples and oranges. The top clip is the year over year change in real final sales to domestic purchasers.

Current weakness is clearly on par with every major recession of at least the last three decades. Importantly, we need to remember this weakness is occurring within the context of falling nominal prices. Every other low in this indicator over the last three to four decades occurred while headline inflation (CPI) was rising, not falling; which is a key point.

If we strip out the whole inflation adjustment in the "real" GDP and final sales numbers, we get a much better sense of consumer weakness in nominal terms. The bottom clip of the chart above does just that, as we are looking at the quarter over quarter change in nominal final sales to domestic purchasers. We’ve never seen anything like that which occurred in the 4Q anywhere over the last six decades. It’s as simple as that.

Very simply put, in a period of falling prices (falling CPI), 'real' consumer purchasing power is theoretically increasing by default (assuming incomes are flat or rising). As such, one would anticipate that inflation-adjusted consumer spending should not necessarily be all that weak. But that was not the case in the 4Q.

The prior near six-decade history of the year over year change in real personal consumption expenditures lies below. As we detail in the chart, the current 4Q number showed us a year over year decline of -1.54%. Over the prior six decades, the worst experience seen was a -1.46% drop during the very deep mid-1970’s recession. As the chart reveals, we’ve already hit a new low over the period shown.

The above is simply one expression of the magnitude of consumer weakness in the current environment.

As we have done a good number of times in the past, we’ve shown you the history of the economic stats and have asked you to imagine you were looking at a stock price chart. One more time. If what you see below were a stock chart, would it be suggesting you buy, or sell? Is a secular change afoot as we mentioned in terms of personal consumption behavior? It’s still early in the game for the current consumption reconciliation cycle, but it’s sure starting to look that way.

[ Normxxx Here:  Later, at the end, I will comment on why this should not be considered a sea change, or 'secular', change in consumer psychology/behavior, but rather a secular change in the credit and income situation of most consumers. That is, it is not consumers' propensity to borrow and spend that has materially altered; rather it is their wherewithal, principally as a function of withdrawal/diminution of credit availability. The much heralded effects of the end of the 'housing ATM', joined by the end of the credit card binge, and shortly to be joined by a drop in total wages.  ]

Perhaps one of the most important and illustrative charts underscoring our point about the incredibly weak (and meaningful?) consumer activity as seen in the GDP report, lies below. First, the chart illustrates the (unadjusted) year over year change in the CPI numbers going back to 1950 as a more accurate measure of price inflation. Second, is the same data showing the year over year change in 'real' personal consumption expenditures. However, in this latter case, we have inverted the graph. Historically, in periods of falling prices (declining rate of change in CPI), the rate of change in personal consumption expenditures normally increases (which is shown as a down movement in the chart), and conversely.

But as you can see from the current, pink shaded cycle, the (inverted) PCE is behaving anomalously, rising sharply instead of falling. Point blank, we have never seen this type of behavior in these averages in the US postwar period. This is something startlingly different. THIS is probably the key message of the GDP report which we believe to have been overlooked in the mainstream financial reporting.

Key point being, not even the markedly lower prices was able to spark (or even maintain) consumption strength. This is quite odd, as households have always used price weakness to increase real consumption. Always...until now.

Stepping back for a minute, we believe this set of circumstances implies a few very important ideas that we believe will be meaningful to our investment decision making ahead. First, consumers are not responding to 'Keynesian' type stimulus at all, at least not yet [[but of course; little or none of that stimulus has reached the consumer as yet : normxxx]]. In fact, quite the opposite. But for now, the prescription for economic recovery from the Fed/Treasury/Administration continues to be for even more Keynesian stimulus.

Second, it is clear that consumers are moving to increase their savings [[but this is more apparent than real; paying down debt is considered 'saving', even if forced: normxxx]]. We have discussed this before. You already know that a consumption dependent economy can scarcely be vibrant during a period of increased household saving. And it sure looks like this [[debt repayment: normxxx]] process has begun.

Finally, in a 'consumption challenged' economic environment, why should we expect corporations to increase capital spending? The powers that be may be begging the financial sector to lend [[even as they did in the '30s: normxxx]], but why should corporations borrow to increase productive facilities, when they see no pickup in demand, but only further decrease? It seems a good bet that consumers will also refrain from borrowing; if this level of consumption weakness continues, they will have no need [[but this begs the question of whether such loans are available to them as plentifully as before: normxxx]]. As we see it, these are critically important issues raised by just our casual review of the 4Q GDP numbers.

A few last items of interest. Following is an update of a chart we have shown in the past. 'Real' (inflation adjusted) personal spending as a percentage of disposable personal income. This relationship is simply a mirror image of the direction of the US savings rate.

For now, households are increasing their savings at the expense of consumption. If this isn’t a crisis in general consumer confidence and household balance sheet and P&L confidence specifically, then we don’t know what is. [[Lack of (effective) 'disposable' income? Lack of credit availability!?! : normxxx]] Considering the Keynesian (fiscal and monetary stimulus) tsunami of the moment, are the powers that be simply 'pushing on a string' relative to their desired influence on US households? If that’s not what’s happening, then we’re blind.

[ Normxxx Here:  Perhaps the 'powers that be' should worry less about the financial institutions making credit available to corporations and worry more about increasing the income and credit possibilities of the strapped consumer!?! In that sense, the most important part of the proposed stimulus/budget is a (significant) decrease in the tax burden on the middle and lower income earners.  ]

And a final comment about the wonderful US consumer and, perhaps, some perspective about our analysis of that 4Q GDP report. Although we may be dead wrong, US consumer behavior in the last quarter seems simply be a normal response to the anticipation of further deterioration in household financial circumstances [[both credit availability and income: normxxx]]. We have another payroll employment report coming to us next week. Personally, our key watch point right now isn't necessarily the body count in terms of lost jobs but, rather, the rate and direction of change in wages.

Although we hope we are completely wrong, we believe a very meaningful negative wage pressure that we have not yet seen so far in the current cycle has still to hit consumers. And unless our analysis of history is completely off base, we expect this significant wage pressure to play out in the lives of consumers, and in the economy and financial markets, for many months directly ahead. (The average workweek has dropped significantly. And, as we see it, employers first cut hours and freeze hiring and wages in an attempt to rationalize costs; then the layoffs begin and wage growth decreases sharply (as any new hires come aboard at markedly reduced wages[[— except fot the fat cats on Wall Street: normxxx]]).

This is exactly how past cycles have played out and provides a roadmap for what to expect in the months ahead. There has almost always been downward pressure on US wages when the unemployment rate increases significantly. Pretty much common sense stuff. Significant downward pressure on domestic wage growth is yet to come as a result of the growing slack in the labor markets.

Is this what consumers were anticipating in the last quarter of 2008? We’ll see, but wage levels and their rates of change are an absolute key watch point for us ahead. If the rate of change in wage growth begins to deteriorate markedly from here, as we believe is about to happen, then it’s a good bet the whole 'pushing on a string' concept will become the mainstream thinking. Be prepared. Not a good thing for residential real estate prices, the ability of consumers to leverage up again, forward consumption in general, equity valuations, the Administration’s vain attempt to restart an anomalistic credit cycle, etc. [[In any case, we are likely talking about a very long recession/depression; far longer than 'normal'.: normxxx]]

In summation, we believe the 4Q GDP report was one of the most informative and important pieces of information we have seen in quite some time. Consumer spending deteriorated badly and is at odds with historical patterns of the post war period. It seems unmistakable that consumers have now embarked on building up their savings[!?!] It’s a good bet that even more radical stimulus from the Fed/Treasury/Administration lies ahead as the traditional Keynesian policy measures fail to produce the desired results.

The current stimulus package is going to be nowhere near enough to get the job done. Consider the proposed tax increases and the offset to the stimulus package is huge [[but as the Clinton tax increase showed, taxing the rich is not likely to have much effect on the economy, contrary to what the neoconservatives would have us believe : normxxx]]. Unfortunately, there’s probably a lot more stimulus to come and that has direct investment implications for out year inflation and precious metals investments, etc.

As unfortunate as it sounds, protecting purchasing power is likely to be a key investment objective further ahead (once the current deflation flips to inflation). If wage growth deteriorates as we fully expect, consumption trends are not about to turn around anytime soon. Is this what the markets have been discounting this year with the continued swoon in equity prices? We need to watch out for shifting investor perceptions ahead: for a growing perception of a big delay in economic recovery and that we may once again have succumbed to a liquidity trap.

We believe the markets are indeed in process of discounting this right now.

[ Normxxx Here:  There may be some truth to the above; but my contention is that the most significant cause of what we are seeing is a very dramatic drop in household income and credit availability, especially the latter (the referenced article seems to be about the consumers' propensity to borrow, but I believe it is only reflecting the consumers' perception of the difficulty of obtaining credit). (According to the Fed, consumer credit decreased at an annual rate of 3 percent in 4Q 2008, the first negative quarter since the '90s recession.) As you can see from the following graph, household income (independently of credit availability) has dropped substantially since the start of cy 2000. Note that households typically average over two wage earners… Real Median US Household Income Growth Across Peak Years Versus 2000-Present. US median income rose as did poverty in 2007; the 2000s have been extremely weak for the living standards of most households. A U.S. household today saves only about 1½ percent of its disposable income, compared with about 13 percent in 1990. Since the mid-1990s, the national income and product accounts personal saving rate for the United States (as also Canada and latterly Japan; this is not a strictly US phenomenon) has been trending down, dipping into negative territory for months at a time during the past several years. This decline of the U.S. personal saving rate to historically low levels seems to be a real economic phenomenon and cause for concern. In particular, the low rate of net income increase over this period seems to underscore the theory that this low rate of savings is mainly due to consumers attempting to maintain an accustomed lifestyle with diminishing resources. In such a case, consumers are at the mercy of creditors/lenders and any substantial decrease in credit availability will severely reduce consumption. Why am I so certain that the 4Q results reported above were due to the 'credit crunch' hitting consumers and not, as supposed by the authors, to be a (potentially 'secular') change in consumer behavior? Simple; even allowing for human herding behavior, tens of millions of consumers do not suddenly get up one morning in October and decide that it's time to put their (individual) financial houses in order. How can I be so sure, after all, that market crash in October/November 2008 was pretty bad— maybe it panicked everyone into just such behavior? Well, it didn't happen after 911, when there was every expectation of such; and it didn't happen in July or October of 2002, which were also pretty severe crashes. So, why suddenly now? Because, by the end of the third quarter, the banks had a pretty good handle on just how badly off they were, and froze further credit to just about everybody!  ]

The U.S. Census Bureau uses the following definitions of median and mean income: "Median income is the amount which divides the income distribution into two equal groups, half having income above that amount, and half having income below that amount. Mean income (average) is the amount obtained by dividing the total aggregate income of a group by the number of units in that group. The means and medians for households and families are based on all households and families. Means and medians for people are based on people 15 years old and over with income.

[ Normxxx Here:  According to a Census Bureau press released dated August 26, 2008, median household income in the U.S. is $50,233 (up from $48,000 in 2007). (2007 dollars) But see Median Household Income. I suspect that it was down in that 4Q of 2008 (all of the BLS numbers are quite stale).  ]

US Real Median Income To 2006

Click Here, or on the image, to see a larger, undistorted image.

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Normxxx    
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