Thursday, September 27, 2012

Slow growth is not necessarily bad news

Second quarter GDP growth was slow to begin with, and has now been revised to even slower (1.3% vs. 1.7%). That's a relatively modest downgrade (the number is annualized, so the downward revision to the level of GDP was only about 0.1%), but it's pretty slow growth, both in real and in nominal terms.

Since the U.S. economy has enjoyed an annualized growth rate of 3% or so for over 50 years leading up to the last recession,  the current recovery is downright miserable. By my calculations, the economy is about 12% smaller than it should be. If the economy were growing at its long-term trend, national income would be about $2.1 trillion higher than it is today. That's a lot of lost jobs and lost tax revenue. Weak growth is thus the principle source of our ongoing $1 trillion plus annual deficits.

Despite all the disappointing news, though, it's nothing that the market hasn't expected, and that is an important thing to note. Abysmally low Treasury yields are symptomatic of a market that expects very weak growth for as far as the eye can see, and by the looks of these charts, we're on track for exactly that.

One very bright spot in this otherwise dim picture is corporate profits, which have grown at an impressive rate over the last decade, despite the slowdown in overall economic growth. Corporate profits are now close to an all-time high, both in nominal terms and relative to GDP. Despite this excellent news, most observers look at the top chart and argue that profits are mean-reverting to nominal GDP; since they have averaged 6.2% of GDP for the past 50 years, the current level (9.5%) is unsustainably high and must inevitably decline. But as the second chart suggests, the market is priced to just such a decline, because PE ratios are significantly below their long-term average. (This chart uses a normalized S&P 500 index as the "P" and after-tax corporate profits from the National Income and Products Accounts for the "E".) In other words, the market seems quite confident that future profits are going to be much weaker than current profits.( The 12-mo. trailing S&P 500 PE ratio is currently 14.7, which is also substantially below its long-term average of 16.6.)

I look at the above chart, in contrast, and argue that it is no longer meaningful to compare corporate profits to our domestic economy at a time when the U.S. economy is more integrated than ever before with a global economy that is growing quite rapidly (e.g., China and India). When you compare corporate profits to global GDP, the current level is unremarkable and therefore sustainable. Consequently. it seems reasonable to conclude that the market is very pessimistic and therefore valuations are quite attractive. Assuming, of course, that we are not on the cusp of another substantial recession. I think that even a continuation of today's disappointingly slow growth could be enough to move equity prices higher—the market can only ignore record profits for so long. As long as we avoid a recession, the market is likely to move higher, albeit modestly. Should we get a meaningful pickup in growth next year, however, then Katie bar the door.


Anonymous said...

I appreciate the insight of comparing U.S corporate profits to world GDP. My liberal friends (what few I have left) always demonize corporations. I respond with thank heavens somebody is doing well in the economy because those doing well can support the rest of us. (Then they say, it is off the backs of the workers. Then I say…then they say…then I say and then I lose one more friend).

So, corporate profits are the one thing holding up GDP above recession levels. Overall, everything else must be doing poorly. Thus, the FED will attempt to create inflation. I would prefer slow steady growth so we can adapt rather than risk another bubble.

Benjamin Cole said...

Interesting posts of late. As usual, I should add

The record on corporate profits is amazing. The private sector will do more for less every year. The public sector, including the military, will do less for more every year.

Why the public does not "get it" I don't know. But the Dems want welfare, and the GOP wants $1 trillion a year in defense, VA and homeland security waste.

And Ron Paul has not a prayer.

steve said...

corporate profits have always been mean reverting and given that they're at all time highs suggests a pullback. that's why stock prices are "only" up 17% ytd.

RichmondG30 said...

Because of uncertainty due to exploding federal government spending and Obamacare, corporations are sitting on hoards of cash instead of investing the cash in growing and expanding and hiring workers and this is not bad news. Interesting take...

Gloeschi said...

"Slow growth is great news" - Beach Pundit.
"Recession is even greater"
Chicago PMI?
@JC: All those "dumb" friends... Like your candidate's biggest supporter (Sheldon Adelson). When "family man" Gingrich was his preferred choice, he helped finance a movie, depicting Romney as a "predatory corporate raider".

bt1138 said...

I am all for corporate profits. The odd thing is that many corporations can't find anything to do with those profits, other than sit on them.

It might make sense at some point for companies to pay out some of those profits to the workforce, who might then go on out and do some spending, which might just make for some growth. As Ford Motor did way back in 1913.

For the last 20-30 years a lot of growth in profits has come through restricting or lowering wages, though not for the executives who remain in control. Working class Americans need more spending power, or we will end up looking like a 3rd world society.

It would be great if the free market could find some solutions to the problem of stagnant wages for the non-Romney-ish parts of society, wouldn't it?

Scott Grannis said...

You can't spend your way to growth, nor can you spend your way to prosperity. Growth and increased prosperity come from working harder and smarter and more efficiently, and by investing in things that facilitate that. It involves risk and/or effort.

Also, don't overlook the fact that the profits that corporations have not spent are always invested in something. They aren't just sitting under some mattress. They are invested in Treasuries, corporate bonds, MBS, loans to other businesses. The profits pile does not represent resources that have been taken away from the economy. They are simply resources that have not been put to work expanding the company they belong to. Presumably because many companies do not have the confidence in the future to take the risk of expansion, or they just don't see opportunities that are more profitable than the investments the profits are currently parked in.

Gloeschi said...

Companies are not investing because of all the regulation, which creates so much uncertainty. Oh wait, that doesn't make sense.
Ah, now I know: It's the uncertainty about the question if Anne Romney will be able to deduct $77,000 from taxes for her pet horse once the campaign is over. It's a huge uncertainty for the horse.
If Romney wins, will I be able to deduct the $77,000 from my squirrel business? I have a couple of them in my backyard. I raise them for racing, you know. But the uncertainty is holding me back from investing in a major backyard upgrade for those creatures.

bt1138 said...


If profits parked in financial vehicles, which are in turn pumped into other financial vehicles for various arbitrage activities, or for speculation in commodities, or perhaps are pushed offshore, perhaps to China is very different than if they are used to purchase things, or are spent as wages to workers who might purchase things.

What the money is used for, and where it is put makes a very real difference.

The best case for why the profits are piling up in the bank, and not being reinvested directly is that the demand for goods and services in the USA (and world) is insufficient.

William said...


A measure of future U.S. economic expansion continued to improve last week, and the annualized growth rate reached its highest level in over a year, a research group said on Friday.

The Economic Cycle Research Institute....said its Weekly Leading Index rose to 126.7 in the week ended Sept. 21 from a revised 125.3 the previous week. That was originally reported as 125.4.

The index's annualized growth rate jumped to 3.8 percent from 2.7 percent, hitting the highest level since June 2011.

William said...

Lipper US Fund Flows


Equity Fund Inflows $1.1 Bil; Taxable Bond Fund Inflows $4 Bil

xETFs - Equity Fund Outflows -$1.3 Bil;
Taxable Bond Fund Inflows $3 Bil


Equity Fund Outflows -$12.3 Bil; Taxable Bond Fund Inflows $30.4 Bil

xETFs - Equity Fund Outflows -$13.4 Bil;
Taxable Bond Fund Inflows $26.4 Bil

William said...

American Association of Individual Investors Sentiment Survey

Bullish 36.1%____down 1.4

Neutral 27.4%____down 1.3

Bearish 36.5%____up 2.7

William said...

Schaeffer's Investor's Intelligence

Percent Bullish Percent Bearish



McKibbinUSA said...

QE3 is at least an attempt by the Federal Reserve to invest in Main Street, albeit at the expense of big government and the military-industrial complex -- regretfully, Federalism has morphed into a spectacle staged by big government Democrats and military-industrial Republicans that is akin to fascism -- Main Street has not been part of the stage play that we now watch on television news channels -- the biggest problem we have in America is political and not economic, and that is the battle between big government Democrats and military-industrial Republicans over sovereign borrowing rights to fund their mutually exclusive agendas -- my humble view is that politics must resolve to make Main Street the engine of economic growth vice black hole initiatives that poor our nation's scarce resources into the big government Democrat's and military-industrial Repubican's vision of the future -- Federalism costs too much at this point, and that cost is not just economic, but our liberties as well -- whatever we the people resolve to do economically as a nation must not concomitantly lead to a fascist union between big government Democrats and military-industrial Republicans, and if that means ending Federalism as it now exists, so be it -- we should all keep an eye on civil liberties at this point -- thank you for the opportunity to comment.