From 1950 to 2007 (i.e. before the Great Recession) the US economy grew at an average rate of 3.5%. Fully, 0.5 percentage points of that growth came from the government sector (federal, state and local). In the next month or two, the brains trust in Washington should come to some agreement regarding the level of taxation and federal government expenditures.
Reduced dependency on government provision
Since the President does not want to raise taxes on 98% of taxpayers, the proposed tax increase on the top 2% of tax payers will not raise enough revenue to materially impede the accumulation of federal government debt. Consequently, the bond market will eventually require a reduction in the rate of growth in federal spending. Therefore, it seems unlikely that future economic activity will see as much of a contribution from government spending as in the post-war history of America.
Since the US likely won’t be as dependent on government spending to drive growth, we have chosen to look through reported economic data to focus more closely on private sector economic activity to measure changes in the strength of the economy.
From this perspective, we reduce reported 2.7% third quarter GDP growth by the 0.67% contribution from the government sector. By this measure, the private sector grew at a rate slightly above 2%. A still higher quality representation of economic activity would be domestic, private sector final demand, which would eliminate net trade and inventories from reported GDP. This measure equates to a paltry 1.12% growth in the third quarter, which is substantially lower than the 2.3% pace that we derived for the first half of 2012.
Corporations seem to have adopted a cautious posture towards capital investment in the face of global economic uncertainty. Consumers, on the other hand, seem more comfortable making capital investments than they have in recent years. Over time, either businesses will have to increase investment to keep pace with more ebullient consumers, or consumer confidence will likely roll over as the next logical step for corporations may be reductions in employment.
The 2.7% rate of growth reported by the Bureau of Economic Analysis for the third quarter was increased from the initial reading of 2% largely because of a swing in inventories from an initially reported reduction of 0.12 percentage points to a contribution of 0.77 percentage points. Personal consumption expenditures were also revised down a bit and net trade was revised up, but the bulk of the improvement in GDP from the first look to the first revision can be attributed to inventory accumulation.
Slow, if any, improvement
As noted last month, many of the conference calls regarding third quarter corporate earnings reports cited economic uncertainty emanating from three sources: 1) a decline in the rate of growth in Asia; 2) the European recession; 3) uncertainty in the rate of growth in the US because of the pending fiscal cliff.
Unfortunately, fourth quarter economic activity probably won’t show much of an improvement over the third quarter. On top of fiscal cliff-induced corporate paralysis, economic activity in November was surely impaired by hurricane Sandy, which hit the most densely populated area of the country.
Despite the currently soft economy, we believe the previously noted factors that have conspired to impede industrial activity have the potential to wane in the first few months of 2013. Growth in China, for example, may be poised to re-accelerate.
The HSBC PMI for China rose to 50.6, which marks the best reading for that measure in 11 months. While it may be too early to call a turn in Europe, economic activity has most likely stabilised. Perhaps, most importantly from the perspective of corporate investment, the fiscal cliff is likely to find a solution in the coming months. If not, the stock market may decide to increase the pressure on Congress to bring this issue to a resolution.
Meanwhile, despite economic anxiety in the corporate executive suite, consumers seem to be quite content. According to Lynne Franco of The Conference Board: “The Consumer Confidence Index increased in November and is now at its highest level in more than four-and-a-half years.” This renewed sense of optimism is likely the result of a continued improvement in the housing market. We believe a demographic wave of first time home buyers will sustain the housing recovery, and drive a meaningful increase in the rate of economic activity in the US.
When Congress finds a solution to the fiscal cliff, corporate executives should follow with improved confidence in making capital investments. Economic activity and corporate earnings growth have the potential for further improvement if China has indeed begun to re-accelerate, and Europe has stabilised.
