Saturday, May 24, 2014

The "All Else" Part 4, GDP

When you hear that the economy is expected to grow at a 3+% rate in 2014, the expecters are talking about the Gross Domestic Product (GDP): the value of all final goods and services produced within a country. The result arrived at through the expenditure calculation method is the one most-cited. Its formula is:

Consumer spending + investment + government spending + exports minus imports

My goal with this series is to help you understand the data I follow. Which is why, as difficult as it is, I will resist the enormous temptation to complain about how politicians lever GDP to promote all manner of ill-conceived policies. Yes, I know, and I apologize, I have succumbed to similar temptations a time or two in this series already.

GDP is THE economic barometer for investors. Among many things, the economy's growth rate speaks to the prospects for corporate earnings and monetary policy going forward.

When investors discount the economists' consensus forecast of year over year growth of 3%, and it comes in at 0.1%---as Q1 2014's first reading did---there better be some splaining or the stock market's likely to tank. Well, the market didn't tank, which means the number was indeed splained-away---by that ever-convenient scapegoat, weather. Which, in fact, was probably legit this time around.

Notice I said "first reading", that's the advance estimate. Next comes the revised preliminary estimate, then followed a month later by the final number. As more data comes in it's becoming apparent that those revisions will send Q1 GDP into negative territory. Again, it'll be all about the weather.

The thing about GDP is that it's released quarterly, and all that goes into it is released more frequently. Meaning that, while the number itself is indeed important, I spend more time on its component parts to get a feel for the present state, and trend, of the economy.

We live in interesting times: While a faster growing economy would be a beautiful thing for profit growth, job growth, etc.---and, thus, you'd think it'd be welcomed by investors---it would also put pressure on the Fed to begin raising interest rates to ward off the attendant threat of fast-rising inflation. Which presents a headwind for the stock market; in that higher interest rates mean higher nominal yields on fixed-income investments (competition for stocks) and higher borrowing costs for companies and consumers (slowing profit growth and the economy in general).

So then, the challenge for blokes like me---who try to make the best sector allocation recommendations to investors---is trying to figure out the unfigureoutable: How much growth can the economy withstand without sparking a dangerous level of inflation? Or, is the economy growing, or slowing (depending on what I see) at a rate sufficient to justify my present sector targets? So much goes into such an analysis, not the least of which is tracking productivity (a producers output per unit of input (labor and capital). Capacity utilization (how much a facility's total capacity is being utilized), which I've written about before is another important stat to track.

Another way of putting it is: is the economy operating anywhere near its full potential? And how can we possibly know that? Well, we possibly can't! That said, the Congressional Budget Office (CBO) tries. It estimates what it believes to be the economy's full potential. The extent to which the economy isn't reaching that point is called the output gap. And, yes, it is another of the many things I track. The chart below shows the CBO's most recent findings. Notice the gap between the lower solid line and the light blue dotted line: Supposedly, the economy has that far to go to reach its 2014 full potential (and I believe that is, on balance---given present concerns over interest rates---bringing momentary peace to stock, and bond, traders):


Stay tuned...

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