The Right Perspective: Understanding What’s Going On - or - The Correct way to view GDP
Guest post by Mordecai Grun:
In order to invest it's important to understand the economic fundamentals. In the long term it's like gravity, there's no way to escape whatever is really the truth. This holds true in Bearish and Bullish markets.
Economists and investors alike are looking at the GDP number as a way to understand whether the economy is growing and by how much. However not all GDP is created equal. It is important not only to look at the GDP but also to look at where it's coming from to assess its quality. Take, for example, the following two neighbors. One is a hard working immigrant that earns 100,000 in annual income, but lives in a simple home and is saving 40%of his income for retirement, his children's education and to have cash available for any future business opportunity that may come his way. His neighbor is in the public sector also earns 100,000 per year however he just took on a mortgage to purchase a brand new home for 800,000 and between credit cards is living on 135,000 per year (Spain 2000-08). Obviously from a GDP perspective the latter is creating way more GDP, but from a sustainability and quality perspective the reverse is true. In a theoretical world, growth in GDP would come from improved productivity and investment. However, in reality, GDP growth can come from a variety of sources. Increases in consumer debt, public sector debt, asset price inflation (ex. housing or equity markets, Bond Markets), foreign money entering the country to purchase assets, are all sources of GDP.
Under any of the above scenarios simulucrum of what seems like quality GDP will also be created. For example during the housing bubble auto sales and manufacturing were also very high. In short, since lenders and manufacturers increase supply with demand they really don't look at where and how the money is created or where it comes from. The same is true for government. As state taxes, for example, grow during a boom the politicians raise their spending (actually outpacing the growth rate of the boom) and don't question whether it's possible long term to have so many real estate agents during a housing boom or to sustainably have retail sales growth outpace economic growth. When the inevitable blow comes everyone is surprised and acts as if economic depressions are unpredictable, sort of like tornadoes.
So, let's analyze what current GDP really looks like. Let's assume 1 trillion in Deficit spending (includes all levels of Government) and 1 trillion in QE and assume the banks have increased their lending by the QE amount. Yes, I know these figures are not precise and that the banks may be hoarding liquidity, however from the froth out there it actually seems like the QE maybe having a multiplier effect at this point and while not precise it is ballpark. As such at a 15 trillion dollar economy and a GDP growth of 3% the true GDP would be a negative -10.3%. This does not include the multiplier effect of all the QE and the fiscal deficit. For example, now the auto and retail sales and manufacturing inudstries are very strong. Had there been no QE or public sector debt increase there's no question that services and the manufacturing sector would be doing much worse. Thus making the GDP even more negative than the -10%. SCARY!!
In short had we consumed only what we produced and not printed money, things would be very ugly out here right now. This goes a long way to explaining the angst still felt on main street USA. The fed is very aware of this and therefore very reluctant to take the foot off the gas. The hope is that this will act like a starter to an engine and once it purrs it will go on its own. This has never yet been tried and done successfully, at least to my knowledge. It should work when there's a confidence or liquidity crisis, but won't work when there's a structural mathematical reason the economy is doing poorly.
From this vantage point the US has not been producing real, healthy GDP growth in a long time. Most growth in GDP prior to 2008 was just an increase in household debt and asset inflation spending due to the increased valuation in housing and bonds (and now equities) due to the shift to ultra-low interest rates . Take these factors out and we certainly would be in a significant recession since at least 2001 and perhaps earlier.
What are the structural defects to the economy? As we illustrated earlier policy makers don't know or understand the sources of economic activity and their sustainability or quality. One such example is the tremendous amount of US manufacturing that was shipped overseas pre-2008 . This was barely a political issue, due to the fact the economy was going strong and unemployment was low. In short, who cares about 15 dollar an hour furniture factory jobs when mortgage brokers are making 300 thousand plus? So to the trade deficit does not matter when trillions of foreign money is pouring into US assets. Commodity production? Always a dirty and unneighbourly affair, why go through the mess if everyone is happy and making hay? Import duties to protect domestic production? VAT taxes to balance the budget? Policies that promote more people in the work force? Policies that create low cost electricity and energy? Why go through all this when everything is hunky dory?
At present the policies in place make it extremely difficult to PRODUCE things here or increase productivity. The trade deficit and high fuel prices (even when going to domestic sources) and a government and service sector that is too large for the productive economy are like air being let out of the balloon while it is being pumped.
So how long can this go on for? It's anyone's guess, however since most of the Global Economy is doing, or will be doing fiscal stimulus and QE, combined with the fact that we are the world's reserve currency this may go on for quite a while. Though a bond market where the fed purchases most or all of treasury issues may happen sooner rather than later.
What does this mean for investors? The bull market in equities may still have a long course to run and as in the previous housing or other bubbles the market insanity can go higher and longer than anyone sane can imagine. Especially in this case where as the QE kicks in, government debt will go down and GDP up. Even manufacturing may have a strong run as a spinoff of all this misplaced optimism and debt. It will feel almost as if the economy is healing.
Many market participants are concerned that QE will end. This is having a negative impact on precious metals and commodities and to a much lesser extent equities. However, if this thesis is correct, long term we are in for infinite QE. The Fed may taper down for a short while, but the economic results will be so dire, that the fed will reintroduce QE with a double dose. Even to the extent of buying treasuries at significant percentages below the true inflation rate. This will lead to huge increases in precious metals, real estate, and some inflation resistant equities, while being a big drag on corporate debt, or any bonds that the Fed isn't buying. The Fed will put a floor on treasury prices by promising to purchase at a certain price. Basically the premise of this article is that eventually either massive inflation, or a severe recession/depression or a fundamental productive economic shift needs to take place. Given the choice , QE Fiscal stimulus and eventual inflation are ahead of us.
Unfortunately the fundamental shift that needs to take place namely that we produce MORE than we consume and SAVE the difference and invest it in productive assets has not taken place. Nor are there any policies being put in place that would encourage this.
Gravity will hit at some point and the later it will be the harder. So enjoy the party as it really is a good one and their handing out free spiked fruit punch. But stand near the exit so that when the floor begins to buckle you step out of the way.
Disclosure: I am long GLD, SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Mordecai said "Basically the premise of this article is that eventually either massive inflation, or a severe recession/depression or a fundamental productive economic shift needs to take place. Given the choice , QE Fiscal stimulus and eventual inflation are ahead of us."
Well, that's given the choice. In reality, many of us really don't have a choice, particularly when someone else is pulling the purse strings. Not given the choice, the prognosis is as I have said throughout 2010 and 2011. Hmmm... What happens when wages and earning assets go down in value as input prices increase? I have warned of the stagflationary scenario several times in the past as the most likely outcome of the battle between the deflation camp and the inflation camp.
- Economic contractions AND rising prices, dare Reggie utter the "I" word - Enter a global phenomenon
- Reggie Middleton's Take on Investing for Inflation, pt. 1
- Reggie Middleton's Take on Investing for Inflation, pt. 2
- Reggie Middleton's Take on Investing for Inflation, pt. 3
- Reggie Middleton's Take on Investing for Inflation, pt. 4
- Reggie Middleton's Take on Investing for Inflation, pt. 5
- More on my stagflation rant
- Deflation, Inflation or Stagflation - You Be the Judge!
- Is My Warning of the Risks of a Stagflationary Environment Coming to Fore?