Submitted by Peter Tchir of Brean Capital,
The Linoleum Economy
Before reading further, just pause and think about what linoleum means to you. If flooring isn’t your thing, go ahead and think about Formica cabinets or anything else that fits the genre.
To me, it is something functional, which looks okay from a distance, but doesn’t stand up well to closer inspection. It conveys the disappointment of something that looked good, but turns out only to be a thin veneer covering cheap particle board.
That is how I see the economy right now. I think that at the moment we are getting a bit of a “bounce” from the disastrous first quarter, but that it is far lower than it should be if the underlying economy was strong. Even worse, is I think there is a real chance that the economy slows again, driven by a weakness in housing, and the Fed has very few useful tools left, if that happens.
But before going into more detail on why I have that view of the economy and what I think it means for the market, let’s look at what others are thinking.
The 2007 Recession
I won’t spend more than a moment on this, but I still find it “perplexing” if not insane, that the recession that started in December 2007 wasn’t “identified” until December 2008. We were only told that we had been in a recession for a year AFTER Lehman failed and AIG was bailed out.
I understand the saying “better late than never” but seriously, this is a bit ridiculous. It really shouldn’t have taken a -765,000 NFP print to confirm to the powers that be, that the economy had already been sucking wind for a year.
I am not saying that the same thing is happening again, but I would not be handing out any awards for seeing what is right before your eyes to the group of prognosticators responsible for seeing bad things in the economy.
Q1 2014 GDP
Which brings us right to Q1 2014 GDP.
I do not know what the expectations were back in January of this year. But I do know that by the time the first release of GDP came out, we all knew the weather had been bad.
Expectations had been ratcheted down to 1.5%, yet the number was an appallingly low 0.1%. A huge miss.
As more data came out, the economists could refine their forecasts. They came in at -0.5% and once again the estimates were too optimistic as the actual number was -1.0%. Maybe not quite as embarrassing as the initial miss, but...
While I have heard some “positives” like inventory build will help Q2, I have heard any things that show we may have gotten lucky to “only” be at -1%. It seems many people were surprised how much of a “positive” impact Obamacare had on the numbers. There is also a debate that is getting louder by the day, that the real inflation rate is higher than the reported inflation rate, artificially making Real GDP seem higher than it is.
Fool me once, shame on you, fool me twice, shame on me.
They had two chances to get this number right and missed both times by being too optimistic. Why are we so eager to believe the optimism most share for the first quarter? The fool me once phrase resonates with me right now.
Mailing it In
I promise I am almost done picking on our “ability” to forecast GDP, but I cannot resist showing this one last chart on the street’s view of GDP.
Consensus GDP Forecasts
GDP is fully expected to bounce back to just over 3% for Q2 and then settle into a nice cozy run rate of 3.0%. All is good, right?
Not so fast. The data just looks careless. The prior 5 quarters have been 1.1%, 2.5%, 4.1%, 2.6%, and -1%. The average isn’t anywhere close to 3% and the numbers have shown no consistency.
I would be much more comfortable with the chart if I saw some peaks and valleys in the estimates. I would like to see some evidence in the data that the estimates include any seasonal adjustment issues the data is experiencing (post Lehman, many adjustments seem to fail frequently as they are not good at adapting to 7 standard deviation moves). Maybe there is something that should be helping drive one quarter versus another quarter. (Obamacare? Heck even a new iPhone).
There is little evidence much real work has gone into these projections, but then again, why should there, when the Fed is already telling us what to expect and has no shame in being wrong.
The Fed’s Forecasts
Enough picking on the little guy. Let’s move straight to the Fed. The Fed has become the single biggest market driver. Between zero rates, forward guidance, QE, taper, and whatever else the Fed chooses to throw at the market, they drive the market more than ever.
With more than $60 billion of annual interest income, just from their treasury holdings alone, they are the biggest single player in the treasury market.
What they say and think matters. This almost omnipotent entity must have the ability to analyze and forecast the economy better than anyone else. Surely, anyone with so much power must be basing their decisions on analysis that time and again comes true. And clearly if the Fed says the economy is going to be okay, then it has to be okay.
So what is the Fed telling us? Fortunately, on June 18th we will get updated projections for the Federal Reserve, but for now let us look at what they are currently telling us.
Where to start with this data?
We will ignore the member who didn’t get the memo that growth is “good” and made the mistake of picking 2.1% for 2014 rather than the party line of “just about 3.0%”
To get 3.0% for this year, after a quarter of -1% we need to average 4.3% for the remaining 3 quarters. Seems highly unlikely when even the “bounce” quarter is tracking sub 3% so far as I can tell.
How we jump to 3.1% next year remains unclear to me, especially as QE and any impact it had will be gone
I am not exactly sure how 2.9% this year, 3.1% next year, and 2.75% in 2016 leads to a “longer run” average of 2.25%. 3 years of well above average growth, followed by some indeterminate amount of time [insert some hand waving here] then finally settling into a very stable long term future, much below any current levels we are told to expect.
Maybe we should ignore their near term projections and assume that their “in the longer run” projections are what they really believe is achievable and not the near term stuff they are using to try and use optimism as a policy tool. I find it far more believable that the economy is currently hovering around a 2.25% trend (still high, but at least believable). A 2.25% trend, when couple with some level of cyclicality, and some element of randomness in the data, should produce some negative quarters alongside some 4% quarters (exactly what we seem to be getting).
But maybe I am not giving the Fed enough benefit of the doubt. Maybe they really believe the near term will outperform the sustainable long term rate by so much. Maybe it is carefully thought out analysis that leads them to the conclusions. Maybe they are just that much better at this than anyone else.
So here we are back in December 2012 – not even 18 months ago.
2013 came in at 2.5%. Lower then their central tendency of 2.65%. Honestly, not a bad guess on their part.
But 2014 was going to be a breakout year hitting 3.25% and 2015 was going to be 3.35%. Those have already started to be nudged down. Maybe the Fed knows something about 2015 weather that we don’t?
The “low” guess (I really can’t keep calling these estimates with a straight face) for 2014 was 2.8%. That fell to 2.1%.
Even more worrisome to me is that the “longer run” number, which I believe they think is the real sustainable level, dropped on average since their 2012 projections. Some wild eyed optimist thought the long run could be sustained at 3%. That person either didn’t understand long run, has left the Fed, or has to come to their senses put in 2.4%.
So in the long run, no one at the Fed thinks a rate higher than 2.4% is sustainable.
Another good time to pause. We are supposed to get a few years of 3% growth when no one believes that the longer run potential best case is above 2.4%. When wondering whether the short term numbers are a realistic assessment of any real data, or just wishful thinking meant to encourage the public, I would be leaning heavily towards the latter.
I will point out that last June, someone thought that the average guess of 3.25% was so low, they submitted a 3.6% guess for 2014 GDP.
Last June’s report was actually the one report that really got the “growth juices” flowing. The Fed looks like they were wrong. Again.
I will say it again, “fool me once, shame on you, fool me twice, shame on me”.
Don’t Get Fooled Again
I was wondering how I could turn this note a little more upbeat, and if I can’t do it with the content, at least I can put a loud song into your head for the weekend.
But the message is serious:
- Economists missed the first quarter GDP by a wide margin, not once, but twice
- The Fed has missed growth expectations repeatedly and has been ratcheting down longer term growth forecasts
- While GDP estimates are being revised up or 2014 estimates are now only “going forward” estimates, look around and see if it makes sense.
When your sources consistently overestimate growth, you can either continue to go along for the ride, or you can “adjust” the expectations down, which is what I am doing.
The Linoleum Economy
If everything is so “good” then why are we getting data points such as the following
Maybe you can see the pattern of accelerating growth, but I can’t.
Again, I look at the data, and I can see some evidence of being better than prior years, but I think I would rather have back 2011’s data. Maybe this spike in March is creating some new trendline, or maybe, just like every other March for the past 4 years, it will be a local high as some adjustment process isn’t working.
Whatever bounce we got, after a horrific December seems to be fading, and wasn’t as strong as some earlier bounces. This does not look like a longer run average affected by weather, it looks like a longer run average affected by the inability to the unwillingness of people to purchase homes.
Are Stocks Pricing in too Much Growth?
I believe the answer is yes, and it is important this time, because QE has become more than just a monetary policy of dubious quality, it is becoming a political issue, domestically and internationally, so it won’t be run in a way to help the markets like it was last time.