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Commonfund Economic Worldview  

Behind the Economic Data: Be Careful of Headlines
by Michael Strauss, Chief Economist and Chief Investment Strategist

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Published February 12, 2013


  • The recently released estimate of fourth quarter real GDP growth (-0.1 percent) made for bold headlines, but a closer look at the data suggests that the government underestimated economic activity last year.
  • The true economic story is simple; corporate America prepared for a slowdown in spending that failed to materialize, resulting in an unanticipated depletion of inventory positions that will need to be replenished in 2013. 
  • It is also clear that from the latest employment release that the Government Can’t Count as annual benchmark revisions and the recalculation of payroll employment combined to produce an almost 650,000 upward adjustment to the nonfarm payroll employment series.

The True Outlook for GDP
Although the advance real GDP print for 2012:Q4 came in much weaker than expected (-0.1 percent) most market participants and economists have appropriately recognized that this reading was not an accurate representation of economic activity due to a distorted 22.2 percent plunge in defense spending (-$42.4 billion), a $40.3 billion decline in inventories, and a $26.9 billion decline in exports.   Consumption spending, business investment, and residential investment—the three key demand components in the economy—posted solid gains that should fuel a production-induced rebound in economic activity in early 2013.  Moreover, a closer look at the data suggests that the government underestimated economic activity late last year. 

A portion of the decline in inventories and in net exports in 2012:Q4 reflected quirky distortions associated with Hurricane Sandy that temporarily curtailed production and shipping early in the quarter.  As conditions return to normal, these declines should either be tempered in subsequent revisions and/or partially reversed in early 2013.  Interestingly, the trade report for December provides evidence that the government's calculation of trade component for real GDP in 2012:Q4 was wrong.  The trade deficit in December plunged to $38.5 billion, well below the $45.4 billion estimate incorporated into the source data used to compute the advance real GDP estimate that was released two weeks ago.   The narrowing in the trade gap in December reflected a 2.1 percent increase in exports and a 2.7 percent decline in imports.  The revised data to this one component will increase real GDP for 2012:Q4 by about 0.7 percentage points. 

The massive decline in defense spending also provided a portion of weaker-than-expected real GDP as this one component reduced real growth by 1.3 percentage points.  Although some might argue that this drop in defense spending was a sign of fiscal responsibility unfolding in Washington, a closer review of the report shows that the cut was largely a result of fiscal policy ineptness.  The big drop in defense outlays in 2012:Q4 was in part due to a decision by the Treasury to delay payments ahead of the potential year-end fiscal cliff challenges and to change the timing of certain defense payments from an annual to a quarterly basis (in part to avoid hitting the debt limit at year end).  Net, the associated hit to real GDP in 2012:Q4 should either be revised away (similar to the adjustment that occurred in 2012:Q3 when a +1.7 percent real GDP print was ultimately revised to +3.1 percent) or we will get a partially offsetting boost to real GDP in 2013 as government bills that have been incurred are paid.        

Back to the most important components of GDP to watch -- personal consumption expenditures and business equipment & software investments -- posted strong gains that accelerated from the prior quarter.  More specifically, a rebound in durable goods purchases fueled a 2.2 percent gain in real consumption spending (up from a 1.6 percent gain in 2012:Q3).   Equipment & software investment surged 12.4 percent in 2012:Q4, significantly reversing a 2.6 percent decline in the prior quarter.  Finally, even with the challenges associated with Hurricane Sandy, residential investments climbed 15.3 percent in 2012:Q4, besting the solid 13.5 percent gain in the third quarter.   In fact, the best way to analyze economic activity in the fourth quarter of last year is to focus on the still solid 2.7 percent gain in final sales to domestic purchasers.  The true economic story is simple; corporate America prepared for a slowdown in spending that failed to materialize, resulting in an unanticipated depletion of inventory positions that will need to be replenished in 2013.
Confirmation that the Government Can’t Count
Back in April 2012, we noted flaws in how the government calculates employment data -- nothing has really changed.  Nonfarm payroll employment rose 157,000 in January as private payrolls gained 166,000 workers in January, while government jobs declined by 9,000 workers.  However, the big story in the latest employment release was the confirmation of our longstanding view that the Government Can’t Count as the incorporation of the annual benchmark revisions and the recalculation of payroll employment combined to produce almost a 650,000 upward adjustment to the nonfarm payroll employment series.   In the most recent months, the December payroll reading was increased from +155,000 to +196,000, while the November reading was boosted from +161,000 to +247,000.

These revisions provide another sign that the latest GDP report for 2012:Q4 was not an accurate reflection of economic activity.  Moreover the data confirms that the government’s birth/death job model for net new business formation has been understating the unknown gains in nonfarm payroll employment for the last 12 to 24 months.  The annual benchmark adjustments to the payroll report revealed a massive upward revision to the nonfarm payroll series, providing a bit more support to underlying economic activity.  The nonfarm payroll employment level for March 2012 (the base month for the adjustment process) was revised upward by 422,000.  Moreover, since March 2012 the government added another 225,000 jobs to the payroll series.  For all of 2012, the revised nonfarm payroll data showed upward adjustments in 10 of the 12 months, with the average monthly increase boosted about 28,000 to an increase of almost 181,000 per month.  Moreover, a significant portion of the upward adjustment to the payroll readings took place in the final three months of 2012 when 150,000 jobs were added to the payroll series, producing an average monthly gain of 201,000 in 2012:Q4.  The net result of the stronger labor data provides another sign that the benchmark revisions to the GDP report (which will be released this summer) will likely include an upward adjustment to real income, the savings rate, and real GDP.

What Does This All Mean for the Financial Markets?
With the S&P 500 Index posting its best January since 1997, many people are once again talking about the January Barometer…As goes January so goes the year.  Since 1950, the January Barometer has registered only seven wrong signals, the last one occurring in 2001, when a 3.5 percent gain in the first month of the year for the S&P 500 Index was followed by a sharp selloff over the balance of the year as the stock market ended down 13 percent.  The stock market’s gain in the first month of 2013 was fueled by several issues including the resolution of the fiscal cliff, at least a temporary solution to the debt limit, a series of generally solid domestic sales and earnings reports, a further sign that the housing and industrial sectors were accelerating, better news out of events in China and Japan, and, possibly most importantly, growing signs that investors were too bearishly positioned in the equity market.   TrimTabs reported a record $77.4 billion inflow into stock mutual funds and ETFs last month, representing the first major inflow into equities in several years.  If inflows into the equity market continue to unfold it would likely provide an added boost to the equity market.  Interestingly, since the 1950’s the S&P 500 Index has been up in January by five percent or more 11 times and in 10 of these 11 instances the S&P 500 Index ended up posting double digit gains for the year.  The only exception was in 1987 when the events associated with the Black Monday crash on October 29 tempered the yearly gain to just two percent.

The big challenge for the markets in the months ahead will be corporate earnings, and specifically whether they can continue to reflect solid growth in the midst of on-going macro risks.  For several years we have held the view that corporate America would continue to do better than the economy and the results for the fourth quarter suggest that this will once again be true.   Through Friday, February 8, almost 69 percent of reporting companies in the S&P 500 index had released earnings for 2012:Q4.  Of those, 255 have surprised to the upside on an earnings-per-share basis, with more than 67 percent reporting positive growth and an overall average growth rate of positive 8.64 percent.   Top line revenue growth also improved as 242 companies reported an increase in sales, with the average sales growth at a positive 3 percent.  Looking ahead, we expect 2013 earnings growth of 7 percent, EPS of $110 and a multiple of 14X -- not spectacular growth, but sufficient we believe to support equity values for at least the near term, especially if inflows continue into the equity market.    

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