Submitted by Lance Roberts of STA Wealth Management,
There is much hope that after a dismal Q1 GDP report of -1% annualized growth in the domestic economy, that Q2 will see a sharp rebound of between 3-4% according to the bulk of economists. The Federal Reserve is predicting that the U.S. economy will grow as strongly as 2.8% in real terms for the entirety of 2014. The achievement of the Fed's rather lofty goal would require a real 4% annualized growth in each of the next three quarters. The problem with this assumption is that the last time that the U.S. economy grew at 4% or more, over three consecutive quarters, was in 1983.
It is very likely that the Federal Reserve will curtail their GDP growth forecast at their next meeting. However, this should come as no surprise as this has been the "modus operandi" of the Federal Reserve since they began publishing their economic and policy forecasts 2011. The chart below shows the history of the average range of their forecasts versus actual economic outcomes.
"Why did God create economists? To make weather forecasters look good."
However, as I discussed in regards to the recent NFIB survey, the current economic recovery is starting to show signs of age. What most economists and analysts have failed to include in their ever ebullient forecasts is the lifespan of an economic and business cycle.
Economies and businesses do not operate on a rational basis of only producing exactly what is necessary to sustain the current demand. Instead, as demand rises, supply is rapidly increased to the point of excess. At some point the excess supply, or supply glut, leads to a down cycle until that excess is reduced to excessively low levels. It is at this point that the cycle renews as demand exceeds supply creating the next up cycle.
It is from this point of view, real supply versus real demand, that I am suggesting that current economic activity may indeed be far weaker than headline statistical reports currently suggest. (I recently wrote a deeper discussion on this topic - read here.)
There are a few important indicators, in my opinion, that reflect upon the actual strength of economic activity. Rail traffic, shipping of bulk dry goods, and some very specific commodities such as lumber and copper. The two I want to focus on specifically in this missive are shipping and copper.
According to Wikipedia:
"The Baltic Dry Index (BDI) is a number (in USD) issued daily by the London-based Baltic Exchange. Not restricted to Baltic Sea countries, the index provides 'an assessment of the price of moving the major raw materials by sea. Taking in 23 shipping routes measured on a timecharter basis, the index covers Handysize, Supramax, Panamax, and Capesize dry bulk carriers carrying a range of commodities including coal, iron ore and grain.'"
Since this is not a "traded" index, it is void of the volatility that can be created by financial market activity. Most directly, the Baltic Dry Index measures the demand for shipping capacity versus the supply of dry bulk carriers. The demand for shipping varies with the amount of cargo that is being traded or moved in various markets (supply and demand).
"The supply of cargo ships is generally both tight and inelastic—it takes two years to build a new ship, and a ship's fixed costs are too expensive to take out of circulation the way airlines park unneeded jets in deserts. So, marginal increases in demand can push the index higher quickly, and marginal demand decreases can cause the index to fall rapidly.
Because dry bulk primarily consists of materials that function as raw material inputs to the production of intermediate or finished goods, such as concrete, electricity, steel, and food; the index is also seen as an efficient economic indicator of future economic growth and production.
Howard Simons, an economist and columnist at TheStreet.com. 'People don't book freighters unless they have cargo to move.'"
Therefore, it would seem to be a reasonable assumption that IF economic growth was indeed on the cusp of rapid acceleration, that the demand for raw materials would be rising thereby increases the cost of shipping. The chart below shows the Baltic Dry Index (monthly basis) as compared to real, inflation adjusted, gross domestic product.
The currently declining levels of the index confirms much of the recent economic data that has been a continuation of the "struggle through" economy rather than an acceleration of organic economic growth.
The same holds true for copper. Because of copper's widespread applications in most sectors of the economy - from homes and factories to electronics and power generation and transmission - demand for copper is often viewed as a reliable leading indicator of economic health. This demand is reflected in the market price of copper. Generally, rising copper prices suggest strong copper demand and hence a growing global economy, while declining copper prices may indicate sluggish demand and an imminent economic slowdown.
The chart below is a comparison between spot copper pricing and real GDP.
Like shipping prices, copper prices are also suggesting that current economic data may also be overstating the actual underlying economic activity.
If this is indeed the case, this could present a potential issue for the Federal Reserve as it reduces its economic support due to the statistical strength in government produced data. It is highly likely that at the next FOMC meeting there could be an acceleration of the "taper" from $10 billion per meeting since the beginning of the year to $15 billion. This would also move up the actual termination date of the program to September from October. As I published earlier this year in "FOMC Purchases Vs. S&P 500":
"The chart below shows the historical correlation between increases in the Fed's balance sheet and the S&P 500. I have also projected the theoretical conclusion of the Fed's program by assuming a continued reduction in purchases of $10 billion at each of the future FOMC meetings."
"If the current pace of reductions continues it is reasonable to assume that the Fed will terminate the current QE program by the October meeting. If we assume the current correlation remains intact, it projects an advance of the S&P 500 to roughly 2000 by the end of the year. This would imply an 8% advance for the market for the entirety of 2014.
Such an advance would correspond with an economy that is modestly expanding at a time where the Federal Reserve has begun tightening monetary policy."
With the market already approaching the 2000 mark currently, the Fed reducing support, and market exuberance hitting levels normally associated with bull market peaks, any disappointment in actual economic activity could lead to a fairly sharp correction in the financial markets. While I AM NOT suggesting that the Baltic Dry Index or Copper prices are predicting an economic "disaster," I am suggesting that there is an increased risk of disappointment in the coming months.
Considering that the markets have now gone 26 months without a correction of 10% or more, a historically long span, the probability of such is exceedingly high. All that is lacking is the catalyst to induce "fear" into an overly complacent marketplace.