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March 01, 2009

The Most Important Messages From The 4Q GDP Report

Although quarterly GDP reports are usually not at the top of our list in terms of intensive review given the fact that by the time this news is actually reported it is stale at best, we believe there were some VERY important messages to be garnered from looking at the totality of 4Q 2008 GDP report, above and beyond the more than noticeable headline number decline. The character change witnessed when reviewing the components of the report is some of the most striking we have seen in a very good while. We believe realizing what is happening and "seeing" this character change will be very important to individual US equity sector outcomes ahead as well as macro investment decision making. Although we sure as heck hope not to bore you with economic stat details, which can easily happen in a heartbeat, we saw little to no coverage anywhere in the mainstream financial media of the issues we're going to cover in this discussion.

We come away with what we believe are two very important bottom line takeaways from the report. First, behavioral change in the US consumer may be approaching the definition of secular if indeed current trends continue throughout 2009 and beyond. We know that sounds melodramatic, but keep an open mind while you look at the historical and current character relationships we'll cover in this discussion. Secondly, the total character of the GDP report is suggesting to us that current stimulus plans being proffered by the incoming Administration will be inadequate at best if indeed consumer behavior is very importantly shifting, as the numbers in the GDP report show us is occurring. Add in the proposal of meaningful tax increases and the storm clouds only darken. Let's get to it.

Some very quick headline background. Although it may have been a bit lost in the shuffle, a rise in inventories contributed modestly to the headline GDP number. Academically, rising inventories are a positive for GDP in that they are additive to the number. Of course actual businesses may see it a bit differently, no? Here's what we believe to be one important observation. In almost classical terms, US recessions in the post war period have been led by inventory corrections. The key character trait is "led" by inventory corrections. Absolutely classic stuff. But in our current circumstances we're now supposedly 14+ months into the current recessionary interlude and it's only in the last quarter that an inventory problem is now occurring.

You can see in the chart above that the inventory-to-sales ratio was climbing a good year prior to the official 2001-recession period. We've seen a fair amount of commentary over the past year suggesting that corporations had kept inventories in great shape in the current cycle, and that ours has really been a financial sector led recession as opposed to a manufacturing, or consumer based inventory led recession up to this point. That's no longer true at all. Certainly what began as a macro financial sector issue has hit the heart of the US manufacturing and service sectors dead center. At least as per the message of history, inventory corrections do not abate in a quarter or two. The fact that an inventory problem is showing itself to us now suggests we have a ways to go before inventories and sales are back in alignment. The massive spike you see in the chart above also tells us the drop in consumption, which caused this anomaly, has been very abrupt and sharp. As we have been suggesting for some time, it's magnitude and duration of the current economic downturn that is key to financial market outcomes this year. In our eyes, the inventory issue speaks to elongated duration. Does that mean we have not yet found an equity market bottom if indeed the duration of the current recession will be longer than most perhaps believed up to this point? Recent financial market character is clearly suggesting as much.

Lastly, we now know manufacturing and production is now in the midst of being cut hard into 1Q 2009 given the very evident 4Q inventory issue. The chart above is relatively dramatic in its message. Economic reports in the current period already have and in the months ahead will continue to offer little in the way of comfort or corroboration that we've seen the trough of the current economic cycle. In bottom line terms, we need to push out expectations for an economic cycle trough and ultimate recession conclusion. As we suggested, that means the financial markets are still in the process of trying to discount this elusive economic bottom that has now been pushed forward perceptually. The bottoming "process" in equities will continue based on this data.

The next MAJOR message from the GDP report, as we see it, concerns the US consumer. It's probably no big surprise at all that consumption was weak. BUT, the big surprise to us was that consumption was as incredibly weak as witnessed within a period in which consumer prices were actually falling, energy prices being the keynote poster child example of this phenomenon. In many senses this is very meaningful character change for US consumers relative to what we have experienced in the postwar period. This is what we referred to as possibly being secular in our comments above.

Let's take a very fast look at final sales to domestic US purchasers. Important why? Because this measure excludes inventories. In the combo chart below we're doing a little mixing of apples and oranges. The top clip is the year over year change in real final sales to domestic purchasers. Current weakness is clearly on par with every major recession of the last three decades at least. Importantly, we need to remember this weakness is occurring within the context of falling nominal prices. Every other low in this indicator over the last three to four decades occurred while headline inflation (CPI) was rising, not falling. Absolutely key differentiation point.

If we strip out the whole inflation adjustment caught in the "real" GDP and final sales numbers, we get a much better sense of consumer weakness in nominal terms. The bottom clip of the chart above does just that, as we are looking at the quarter over quarter change in nominal final sales to domestic purchasers. We've never seen anything like what occurred in 4Q anywhere over the last six decades. It's as simple as that.

Again, very simply, in a period of supposedly falling prices (falling CPI) real consumer purchasing power is academically increasing by default. As such one would anticipate that inflation-adjusted consumer spending would not necessarily be all that weak. But as we said, that was not the case at all in 4Q. The prior near six-decade history of the year over year change in real personal consumption expenditures lies below. As we detail in the chart, the current 4Q number showed us a year over year decline of (1.54)%. Over the last six decades, the worst experience seen prior to the present was a (1.46)% drop during the very deep mid-1970's recession. As the chart reveals, we've hit a new low over the period shown.

The above is one expression of character in terms of magnitude of consumer weakness in the current environment.

As we have done a good number of times in the past, we've shown you the history of economic stats and asked you to imagine you were looking at a stock price chart. One more time. If what you see below were a stock chart, would it be suggesting you buy, or sell? Secular change afoot as we mentioned in terms of personal consumption behavior? It's still early in the game for the current consumption reconciliation cycle, but it's sure starting to look that way when reviewing so many US consumer character points.

Maybe one of the most important charts of this discussion that illustrates our point about incredibly meaningful consumer weakness evident in the current GDP report lies below. First, we are charting the very simple year over year change in the CPI numbers going back to 1950 simply as a proxy for price inflation. Alongside is the very same data used to construct the chart above that documents the year over year change in real personal consumption expenditures. But this time we have inverted the year over year change in the real PCE numbers. Important point being, history tells us that in periods of falling prices (declining rate of change in CPI), the rate of change in personal consumption expenditures increases, and vice versa. Again, because the consumption numbers have been inverted in the chart below, it looks like historically consumption rises when CPI rises, but it's exactly the opposite.

You can see that we've shaded in the anomaly that is the current cycle. Point blank, we have not seen this type of a dichotomy anywhere in the US postwar period. For now, this is something completely different. THIS is probably the key message of the GDP report that we believe has been virtually completely neglected in mainstream financial reporting. Key point being, not even lower prices could spark consumption strength. This is quite the oddity in the post war period shown as households have always used price weakness to increase real consumption. Always...until now.

Stepping back for a minute, we believe this set of circumstances implies a few very important ideas that we believe will be meaningful to our investment decision making ahead. First, consumers are not responding to Keynesian type stimulus at all, at least not yet. In fact, quite the opposite. But for now, the prescription for economic recovery from the Fed/Treasury/Administration continues to be even more Keynesian stimulus. Second, it is clear that consumers are moving to increase their savings. We have discussed this many a time over the recent past. You already know that a consumption dependent economy will not be vibrant during a period of increased household saving. And it sure as heck looks like this process has begun. Finally, in a consumption challenged economic environment, just how the heck can we expect corporations to increase capital spending? The powers that be may be begging financial sector institutions to lend, but why would corporations borrow for capital spending purposes when the facts we have laid out are more than clear to them in terms of the behavior of consumers? It also seems a pretty darn good bet consumers will likewise refrain from borrowing at the trough if indeed this level of consumption weakness continues. As we see it, these are the very important issues and questions generated by our little review of the 4Q GDP numbers.

A few last items of interest. The following is an update of a chart we have shown you in the past. Real (inflation adjusted) personal spending as a percentage of disposable personal income. Believe it or not, this relationship is really a directional mirror image of the US savings rate.

In very simple terms it's telling us that for now, households are increasing their savings at the expense of consumption. If this isn't a crisis in general consumer confidence and household balance sheet and P&L confidence specifically, then we don't know what is. Again, set against the Keynesian (fiscal and monetary stimulus) tsunami of the moment, are the powers that be pushing on a string relative to their desired borrow and spend influence on US households? Again, if that's not what's happening, then we're blind.

Last comment about the wonderful US consumer and maybe some perspective about the facts we've now seen in the 4Q GDP report. Although we may be dead wrong for all we know, US consumer behavior in 4Q may indeed be very correctly anticipating a further deterioration in household financial circumstances still to come. We have another payroll employment report coming to us next week. Personally, our KEY WATCH POINT right now isn't necessarily the body count in terms of lost jobs, but rather the rate of change in wages. Although we hope we are completely wrong, we believe yet to come for consumers is very meaningful wage pressure we have not experienced so far in the current cycle. And unless history is to be completely off base in terms of helping us "see" what is to come ahead, we expect significant wage pressure to play out in the months and quarters directly in front of us.

The average workweek has dropped meaningfully as of late. As we see it, employers first cut hours in an attempt to rationalize costs, they then temper wage growth significantly. This is exactly how cycles past have played out and provide a roadmap for what we expect to come in the months ahead. Simplistically, history tells us there has been downward pressure on US wages when the unemployment rate increases meaningfully. Pretty much common sense stuff, isn't it? Right now, history is suggesting very meaningful downward pressure on domestic wage growth still to come directly as a result of growing slack in labor markets that is caught up in the rhythm of the unemployment numbers. Is this what consumers are anticipating with their behavior in the last quarter of 2008? We'll see, but wages are an absolute key watch point for us ahead. If the rate of change in wage growth begins to deteriorate markedly from here, which we believe is what is exactly about to happen, then it's a very good bet the whole pushing on a string concept will become much more mainstream thinking than not. Be prepared. Not a good thing for residential real estate prices, the ability of consumers to leverage up again, forward consumption in general, equity valuations, and the Administration's vain attempt to restart an anomalistic credit cycle, etc.

In very quick summation, we believe the 4Q GDP report was one of the most important pieces of information we have seen in quite some time. Consumer spending deteriorated badly and stands at significant odds with historical patterns of the post war period. It seems unmistakable that consumers have now embarked on building up their savings. It's becoming a good bet that even more radical stimulus from the Fed/Treasury/Administration is still yet to come as Keynesian policy measures so far have failed to produce desired results. The current stimulus package is going to be nowhere near enough to get the job done. Consider the proposed tax increases and the offset to the stimulus package is huge. Unfortunately, there's probably a lot more stimulus to come and that has direct investment implications for the precious metals, the potential for out year inflation, etc. As unfortunate as it sounds, protecting purchasing power is set to be a key investment objective ahead. Finally, if wage growth deteriorates as we fully expect, consumption trends are not about to turn around anytime soon. Is this what the markets have been discounting year-to-date with the further very meaningful swoon in equity prices? We need to watch out for shifting investor perceptions ahead. Perceptions of a big delay in economic recovery and the whole thought that the powers that be are now pushing on a string. We believe the markets already see and are discounting this right now.

Market Observations
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