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The first estimate for fourth quarter GDP was expected to show that the US economy grew at its slowest pace in nearly 3-years, that consumer spending was the weakest in more than a decade, and that the overall economy grew by just 2.8% in the fourth quarter. As if these expectations were not dreary enough, the actual headline GDP number - which was released earlier today and came in at +1.1% - was significantly below even the lowest economist prediction. Bad news for stocks, right? Wrong. Following today’s GDP report stock prices moved sharply higher.
The optimistic spin following today’s GDP report was that the US economy may already be rebounding in 2006, that the report represents “a glitch, not a trend”, and that weaker growth is great news since it will force the Fed to stop raising interest rates sooner rather than later. On this last point the spin is obvious: Bernanke takes over for Greenspan next week - a day after the Fed is expected to raise interest rates - and, thanks in part to today’s GDP report, there is now the expectation that Bernanke will not raise interest rates again when the Fed meets in March.
Will all of this spin following a weaker than expected GDP report really be enough to shape a positive reality for the US economy and stock prices in 2006 and beyond?
Consumers hand baton off to Corporations
While it is certainly no surprise that the US consumer finally took a breather in 4Q05 – something they did not do even during the 2001 recession – it is unexpected that so few seem concerned about the threat that 4Q05 represents a key shift in consumer spending habits and not just a 1-quarter anomaly (this threat that was present even before today’s GDP release). In the latest blue chip survey the consensus estimate for growth in 2006 was a solid 3.4%, earlier this week the US commerce secretary said the economy should grow by 3.5%, and yesterday the CBO estimated that GDP would reach 3.6% in 2006. Last year, during what was the strongest year ever for the US housing market, an up year in most major stock markets, and year when consumers continually saved less and less money to fund their reckless spending habits, the US economy expanded by 3.5% (down from 4.2% in 2004). Why in the world should the US economy perform stronger in 2006 than in 2005?
I don’t have the answer to the above question. Moreover, the answer given by most – that capital spending can make up for any shortfall in consumer spending - is simply not realistic. Rather, while corporations do have cash at their disposal and surveys have indicated that business managers are looking to spend more in 2006 than in 2005, the actual size and/or importance of business spending should be kept in perspective. Standard and Poor’s estimates that when the numbers stop rolling in that capital spending will have gain 12.7% in 2005 versus 2004, or nearly a $40 billion increase. This would represent the first double digit increase since 2000. Now, lets assume corporations are feeling really giddy in 2006 and they increase capex from $342 billion to say $392 billion (+$50 billion!). Great news, right? Wrong. This total would not even equal half of the expect decline in mortgage cash-out refinancing for 2006 (Freddie).
Suffice to say, capital spending can certainly help the US economy, but it is overly optimistic to assume that capex will be what drives the US economy towards 3+% growth in 2006. The actions of US consumer will decide how the US economy performs in the near term, and with the US consumer going wrong in late 2005 this should be cause for concern, not celebration.
Ominous News By Some Other Name
Already in 2006 reports of widening US housing slow down have arrived, crude has jumped to nearly $70 a barrel, the US yield curve has remained inverted, and the Iran threat has intensified. As for the yield curve being influenced by nontraditional forces and/or its recession predictive powers suddenly vanishing, it makes absolutely no difference why the yield curve is inverting. To be sure, it is curve itself that determines whether or not bank margins and carry trades increase or decrease (i.e. borrowing at 4% and lending at 4% does not make institutions want to lend, and borrowing at 4% and investing at 4% does not make investors want to borrow).
“The flattening or inversion of the yield curve, which occurs when longer-dated Treasury notes pay lower yields than those with shorter maturities, has been lamented by analysts and investors because it has been associated with recessions in the past. But this time is different, many Wall Street professionals say, because the pressure on the 10-year note stems from the robust demand of Asian central banks and other buyers, rather than a slowing economy and rising inflation.”
http://www.washingtonpost.com/wp-dyn/content/article/2006/01/21/AR2006012100158.html
Also on the negative side of things, earlier in January it was announced that consumer credit contracted for two months in a row (October and November 2005) for the first time in 13-years, there has been major layoff announcements from automakers, revenue misses from tech giants, and dismal outlooks from major cyclicals (i.e. Dupont). These negatives, even when combined, lack the major knockout punch that the popping stock market bubble handed the US economy 2000…but they nonetheless pack quite a whollap.
Why are economists not really concerned with the heavily indebted consumer, the yield curve, oil, and other growing imbalances? Because recent history has proven that the US consumer is always ‘resilient’, and because any ‘temporary’ negative will not stand in the way of the US economy’s natural ‘tendency’ to grow. In other words, - and I am simplifying the consensus here – the US consumer will keep spending because any attempt to claim otherwise has been proven wrong time and time again. Why try to look at the situation objectively when recent history can be your guide?
Conclusions
The spin following today’s weaker than expected GDP report is, essentially, based upon an unyielding faith that the Fed can bailout the US economy and financial markets from any problem. The story goes that although the US consumer is showing unprecedented signs of stress, the Fed can simply stop raising/start cutting interest rates to orchestrate a fabled soft landing.
This just in: although Greenspan is credited for orchestrating a soft landing following the 2000 stock market bust and brief 2001 recession, very few investors were not punished by the 2000-2002 bear market. With this in mind, news that Bernanke may not raise interest rates in March and that capital spending will help support the US economy in 2006 should not be regarded as bullish: the last time capital spending increased by double digits was in 2000, and the last time everyone expected a soft landing because the Fed was done tightening was in 2000.
Flashback: The US stock market peaked in March 2000, the Fed hiked rates one final time in May 2000, and, at the time, nearly everyone was optimistic about the future would bring. By Christmas 2000 it had become clear that the new economy had gone bust and - to little or no fanfare, the Fed started cutting interest rates in January 2001. A recession followed and stocks didn’t bottom until October 2002.
Flash forward to 2006: the Fed looks prepared to stop raising interest rates early this year, stocks could top out before or soon after 1Q06 earnings season (or the end of the earnings boom), and nearly everyone is optimistic about what the future will bring. This time around there is no ‘new economy’, but there is still the debt hungry US consumer – even less prepared to deal with one of their major assets deflating than in 2000!
Suffice to say, the only conclusion to make is that if no major US asset class can provide the US consumer with the ability to keep spending more than they earn the US economy will continue to slow down. Forget the spin -- a slow down is a slow down is a slow down.
Good luck Mr. Bernanke, and be sure to thank Greenspan for the recurring headline that will be sure to cause you many sleepless nights during your tenure: ‘borrowing less’.
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