By Lance Roberts
There is much hope pinned on continuing economic recovery in the United States despite a deterioration of the global economy virtually everywhere else. According to the May 2014 Blue Chip Economic Consensus Forecasts:
"U.S. real GDP is expected to increase by 2.4 percent in 2014 as a whole, 0.5 of a percentage point lower than the 2.9 percent growth rate projected in the February 2014 forecast. For 2015 the consensus forecast now expects an overall 3.0 percent growth in U.S. real GDP, same as the February 2014 forecast."
Let's do some quick math. Real, inflation-adjusted, Gross Domestic Product (GDP) for the first quarter of 2014 was -2.13% annualized after being revised slightly higher from -2.96%. The first estimate of the second quarter's economic growth was 3.89% annualized. If we average the two together, the first half of 2014 is currently sporting an annualized growth rate of 0.88%. Got it?
Here is my point. In order for real economic growth to hit the current target of 2.4% annualized for the entire year, the final two-quarters of 2014 must hit a minimum growth rate of 3.92%. The chart below shows the history of quarterly annual growth rates of the economy since 2006.
There have only been 2 out of the past 34-quarters that have yielded an economic growth rate of greater than 3.92%. There have been ZERO times that real GDP annualized growth has hit 3.92% consecutively.
While it was not surprising to see a bounce back in activity after a contractionary first quarter, there are several economic data points that suggest that sustainability of the bounce is unlikely.
The recent release of the trade deficit numbers had economists scrambling to upgrade estimates of Q2 economic growth due to a contraction in the deficit. Net exports, exports minus imports, is one of the inputs into the calculation of GDP as follows:
GDP (Y) is the sum of consumption (C), investment (I), government spending (G) and net exports (X – M).
Y = C + I + G + (X − M)
In Q2, exports rose by $265 million while imports declined by $2.86 billion dollars. Therefore, given that two negatives make a positive, the net result of $3.125 billion added to economic growth estimates.
Let's step back for a moment and take a look at the what the numbers are really telling us. First, we are already aware that the Euro Area and Japanese economies are slowing markedly. Therefore, it is not surprising to see exports only increase by $265 million in the most recent quarter.
More disturbing is the drop in imports of $2.86 billion. In an economy that is almost 70% driven by consumption, IF economic strength were gaining traction in the U.S. then consumers should be buying greater amounts of "stuff" thereby increasing imports. The drop in imports suggests differently and is confirmed by weak rates of annualized retail sales growth.
In an economy where activity is beginning to surge, there should also be a pick up in the prices of commodities as demand for those base components of production increases. As shown in the chart below this is hardly the case.
If you look at the chart above you will see the relative increase in commodity prices as the economy rebounded from the lows in 2009. However, as economic growth rates peaked in 2011 and has slipped into a sluggish pattern of "bounce and decline," the demand for commodities has waned leading to a relative price decline.
You can see clearly the rebound in commodity prices following the sluggish Q1 GDP growth; however, the current resumption of weak commodity prices suggest that Q2 may be the best economic growth we see this year.
Baltic Dry Index
I recently discussed the Baltic Dry Index in relation to inflationary pressures in the economy. (Read "Inflation, Will The Fed Move Too Soon?) To wit:
"One measure of 'real activity' on a global basis can be seen in the Baltic Dry Index, which is a non-traded index of shipping prices. Increases in demand to ship dry goods globally should be reflected in higher shipping costs."
The decline in the Baltic Dry Index also suggests that economic activity globally remains very weak. This was recently confirmed, as stated above, by the recent drops in economic growth in the EuroArea and Japan. It is highly unlikely that the U.S. can rebuff the drag created by its major trading partners in the near term which suggests that lower rates of economic growth should be expected in the quarters ahead.
Lastly, interest rates are directly tied to the annual rate of economic growth in the economy. During periods of increasing economic activity, where demand for credit rises, interest rates also increase. When the economy begins to slow down, interest rates decline. This is shown in the very long term chart below.
Since the beginning of this year interest rates have been on the decline which clearly suggests that real underlying economic activity is far weaker than statistical headline data suggests.
The Real Problem
While these alternative indicators all suggest that real economic activity is likely to be somewhat disappointing in the quarters ahead, there is a bigger issue that needs to realized by investors.
Throughout history, the largest corrections in equity markets have all occurred during recessions. The issue is that economists and analysts never include the potential of recessionary drags in their forecast. For example, the Congressional Budget Office, as shown in the chart below, estimates that:
"Real GDP is projected to grow by 3.1 percent this year, by 3.4 percent in 2015 and 2016, and by 2.7 percent in 2017.
Although CBO projects that GDP will expand at the same rate as potential GDP, CBO also projects, on the basis of historical experience, that the level of GDP will fall slightly short of its potential, on average, from 2018 through 2024."
The problem with the Congressional Budget Office, along with the OECD and most other economic forecasting agencies and economists, is that they never include the possibility of a recession in the forecasts even though they happen on a fairly regular basis.
For example, in 2000 the CBO estimated that the U.S. would be running a budget surplus in 2010 rather than a deficit in excess of $1 Trillion. The error that was made was not forecasting the likelyhood of a recession in their models which would have decreased economic activity and tax revenues and increased government spending.
The same error is once again being made. The current economic recovery is already the fifth longest in history. With already very sluggish growth domestically, declining economic growth internationally, and an inability to spur wage and employment growth above population increases, the risk of a recession in the next 24 months is rising. This risk begins to increase materially if the Federal Reserve does indeed begin to increase interest rates early next year.
Expectations are very likely well ahead of reality at the current time. This increases the risk of disappointment in the months and quarters ahead which could be a negative for the markets. This risk increases as the Federal Reserve winds down their monetary interventions in October. While there is currently nothing to suggest that the market is about to enter a major mean reverting correction, or any evidence of a recession immediately present, it is worth remembering that there was little evidence of those outcomes in 2000 or 2008 to those that were not paying attention.