Growth outlook remains modest, and that's bullish

As we emerge from the bad winter weather in the Eastern part of the country (the West has enjoyed a very mild winter), some areas of the economy—construction, factory orders, employment—are likely to pick up. But the overall outlook for the economy remains modest; growth is likely to continue in the 2 -2.5% range that we have seen in recent years, though it might tick up a bit to 3%. In any event, 2-3% growth is hardly something to cheer about when the economy continues to carry the potential to be some 10% stronger. But that's not necessarily bad news.

Here are some charts with recent updates that continue to suggest we will see 2-3% growth for at least the next year.

New orders for capital goods (above chart) have been relatively flat for the past year. Even though they have managed to eke out a new high in nominal terms, capex orders are still about 20% below their inflation-adjusted high that was reached fully 14 years ago. Business investment has been unimpressive for quite some time, even though corporate profits have reached an all-time, and previously unimaginable high relative to GDP. It is this lack of investment (driven, as I have argued, by a lack of confidence and a general aversion to risk) that has given us lackluster gains in employment and in productivity. Without new investment in productivity-enhancing capital goods, worker productivity is going to continue to be lackluster, and this amounts to a fundamental headwind to stronger growth.

If productivity continues to plod along at the 1% annual pace of recent years (see chart above), and if the labor force manages to grow 1% per year (it has only grown at about half that pace in the past two years, but it averaged about 1% annual growth prior to 2009), then we shouldn't expect to see real growth do much better than 2-2.5%. (Add the growth rate in the labor force to the growth rate in the productivity of that workforce and you get a rough approximation of overall real growth.)  

 

The first of the above charts shows the Chemical Activity Barometer, which has been calculated and published by the American Chemistry Council since 1919. As Calculated Risk has pointed out, there's a pretty good relationship between this index and industrial production, with the CAB index tending to lead. As the second of the above charts shows, there is also a pretty good fit between growth in the CAB index and real GDP growth. The CAB index has grown about 2.5-3% over the past year, and that points to real GDP growth of about 2-3%. Steady but lackluster growth.

2% or even 3% GDP is nothing to get excited about. But it could be a lot more than what is priced into the market, and if so, then a continuation of modest growth could end up being good news for equities. The chart above compares real yields on 5-yr TIPS to the 2-yr annualized growth rate of GDP. It's reasonable to think that these two variables should follow a similar pattern over time. Strong and sustained GDP growth such as we saw in the late 1990s should result in relatively high risk-free real yields on TIPS (which are guaranteed by the U.S. government), whereas sluggish growth should correspond to low real yields on TIPS. And indeed, real GDP grew at a 4-5% rate in the late 1990s, while real yields on TIPS were just under 4%. As GDP growth has ratcheted down over the years we have seen real yields also fall. But today's level of real yields seems very low compared to the real growth of the economy. Why accept a guaranteed loss of your purchasing power by buying 5-yr TIPS with a real yield of -.5%, when you can expect to earn at least a 2-2.5 real yield by buying anything exposed to real economic growth?

I think the market is still priced to very pessimistic assumptions. If I'm right, then real growth of 2 or 3% should result in equity prices—and interest rates—moving higher.