By
Calafia
Beach Pundit
:
Everyone knows that the economy is weak, and that this recovery
has been the weakest ever. So weak that the Fed believes it is
going to have to keep interest rates at zero and continue buying
bonds by the bushel for the next several years. So it is rather
surprising to look inside Thursday's third quarter GDP revision and
discover three under-appreciated areas of strength: nominal growth
last quarter was the strongest in over 5 years, inflation is
running above the Fed's target, and corporate profits are extremely
strong.
(click to enlarge)
As the above chart of quarterly GDP shows, in the third quarter,
the economy posted its fastest rate of nominal growth in over 5
years. The last time nominal GDP grew by more than Q3/12's 5.55%
pace was the second quarter of 2007, when it registered 6.5%
annualized growth. On a nominal basis, Q3/12 growth was a good deal
better than the 4.0% average pace of quarterly growth since the
current recovery started in mid-2009. And at 2.7%, real growth in
the third quarter was comfortably better than the 2.2% average for
the current recovery. Despite almost universal gloom, last quarter
stands out as one of the best in the current recovery.
(click to enlarge)
The above chart shows the quarterly annualized rate of inflation
according to the GDP deflator, the broadest measure of inflation
available. The latest reading for the third quarter was 2.8%, and
that is above the Fed's professed inflation target of 1-2%. Taken
together, both growth and inflation in the third quarter were
non-threatening. So why is the Fed still panicked?
(click to enlarge)
What worries everyone, of course, is that the economy has fallen
way behind where it could have been if this recovery had been a
normal one and if the economy's potential growth rate track were
the same as it has been for most of the past 50 years. With an
output gap (see above chart) of as much as 13%, there aren't enough
jobs to bring the unemployment rate down to healthy levels. The Fed
wants to close the actual/potential GDP gap since that will
increase jobs and reduce the unemployment rate.
The question everyone should be asking is whether monetary
policy is capable of accomplishing such a feat. Is the economy
struggling because there is a shortage of money? Can zero interest
rates on cash convince small businesses to hire more people? No one
really knows, but neither has anyone ever argued that monetary
policy was an effective tool for generating real growth. The Fed is
in uncharted territory with regards to the magnitude of its
quantitative easing efforts and the scope of its policy
objective.
(click to enlarge)
The chart above compares total after-tax corporate profits (as
calculated by the Bureau of Economic Analysis) to the level of
nominal GDP. The two y-axes are calibrated so that both show a
similar range. Note how strong profits have been during this
recovery, and over the past decade. The growth rate of profits
appears to be tapering off, but profits are still up 4% over the
past year.
(click to enlarge)
As this next chart shows, corporate profits have displayed
unprecedented strength in this recovery. Never before have profits
been such a big percentage of GDP (with the exception of last
year's fourth quarter).
(click to enlarge)
This chart of P/E ratios is constructed using the S&P 500
index (normalized) as a proxy for the value of all corporate
businesses (the P), and the after-tax corporate profits measure
shown in the preceding two charts for the E. P/E ratios by this
measure have rarely been lower, even though profits have never been
stronger.
(click to enlarge)
For purposes of comparison, the chart above shows the
traditional measure of the P/E ratio of the S&P 500 index,
using trailing 12-month reported earnings. Both this chart and the
one above it tell the same story: P/E ratios are substantially
below their long-term average, despite record-setting profits. The
only explanation for this anomaly is that the market apparently
believes that the current level of profits is not sustainable, and
that profits will likely revert to their mean (e.g., 6% of GDP) in
coming years - which would entail a huge decline in nominal
terms.
(click to enlarge)
The chart above compares total corporate profits to nonfinancial
domestic corporate profits. which make up about half of total
profits. This shows that the strength of corporate profits is
broad-based, since both measures have increased by a similar order
of magnitude in the current recovery.
(click to enlarge)
This last chart compares corporate profits to global GDP. Here
we see that profits are not unusually high at all, and not much
different from their long-term average. This casts doubt on the
need for, or the likelihood of, a big, mean-reverting decline in
profits in coming years, and that further suggests that the market
may be much too pessimistic about the outlook for profits. U.S.
companies now make a much larger percentage of their profits from
overseas, and that is to be expected since the world has become
much more integrated and many foreign economies are experiencing
exceptional growth (e.g., India, China). The global marketplace has
expanded much more rapidly than the U.S. economy, and U.S.
corporations are benefiting from that expansion. Over the past
decade, U.S. exports have grown 40% more than U.S. GDP.
So two puzzles remain: if corporate profits are so strong and
there is little reason to expect them to collapse, why are P/E
ratios so low, and why aren't corporations using those profits to
boost GDP by investing in more plants, equipment, and
personnel?
I'm compelled to note here that total after-tax profits of U.S.
corporations have averaged about $1.3 trillion per year since the
recovery began in mid-2009, and that this happens to be almost
identical to the annual federal budget deficit over the same
period. Think of it this way: corporations have generated over $4
trillion in profits during the recovery, and substantially all of
those profits have been borrowed by the U.S. government to finance
what for the most part has been a huge expansion of transfer
payments and a shortfall of tax collections (due to the output gap
and the reduced level of employment). Corporations may not have
directly funded the federal deficit, but the funds they have saved
and supplied to the credit markets, being fungible, have in effect
found their way into Treasury notes and bonds. Since the U.S.
government is highly unlikely to be able to spend $4 trillion as
productively as corporations could, much of the money has, in a
sense, been squandered. Collectively, we have not spent those funds
in a very productive manner, so it is not surprising at all that
the recovery has proved to be unusually weak.
Of course, that still leaves unanswered the question: Why aren't
corporations using their profits to expand? The only sensible
answer to that is that there is still a great deal of uncertainty
about the future, which in turn stems from 1) the possibility that
taxes on capital could increase dramatically in coming years, 2)
the fact that Obamacare imposes significant new taxes on many
people and significantly higher costs on small businesses, 3) the
strong likelihood that regulatory burdens will be increasing,
especially with the implementation of Dodd-Frank, and 4) concerns
over the ability of the Federal Reserve to reverse its massive
quantitative easing program in time to avoid a significant increase
in inflation. All of these represent uncertainties, higher costs,
and headwinds that weigh on any business' decision to put capital
at risk.
In the end, the story boils down to this: government spending is
a tax, and too much of it can smother an economy's growth
potential. Japan is the prime example. Having engaged in massive
deficit-financed public sector spending over the past few decades
(enough to make ours look tame by comparison), it is not surprising
that Japan's economic growth has been much weaker than ours.
We must find ways to reduce projected federal spending,
especially on entitlements, if this economy is going to regain its
former luster.
See also
Forex: The EUR/USD Tests 1.3200 After Peaking To
8-Month Highs
on seekingalpha.com