For investors these days, the Macro-economy is everything. With a self-sustaining economic recovery still uncertain and significant risk from Europe and China remaining, behind almost any play is an implicit assumption, one way or another, about where the economy will end up. In this article, I will do my best to sketch out the current macro-picture, and explain why I think there is significant trouble to come in 2012.
My first worry comes from a little known indicator known as GDI, Gross Domestic Income. Google it, and you will be autocorrected, leading to the results for its brother statistic GDP (Gross Domestic Product). Though it exists because GDP is so much more popular as a search, Google's substitution is actually quite accurate: GDI and GDP measure the economy from two different directions, using two different data sets. GDI is a measure of the income earned by the economy, using payroll data and such, whereas GDP measures the value of all final goods and services produced by the same. As economists understand it, these two values are the same by definition, and differ only in the quality of the data they are drawn from. Indeed, history shows that GDI and GDP have followed each other with extreme precision, with revisions bringing them together and very few genuine divergences.
Why does this matter? Because for the second and third quarters of this year, GDI growth was .2%, inches away from negative growth. As the second and third estimates come out, it appears that GDI may have been closer to the truth... it remains at .2% after revisions, while the estimate of third quarter GDP growth has gone from 2.5% to 1.8%. Adding salt to the downgrade, the BEA said that they resulted from "a downward revision to personal consumption expenditures that was partly offset by an upward revision to private inventory investment," meaning essentially that inventories were higher and personal consumption lower than previously estimated, both bad news for growth in the fourth quarter. With the market focusing myopically on GDP rather than its equally valid brother measure of economic growth, there is a tremendous underestimated downside risk to the economy that many investors are likely unaware of, and its a historical, not future, risk. Based on my own analysis of the past convergences of GDP and GDI, including during the 2008 downturn when GDI was more accurate, I feel that GDI is closer to the true figure, and that economic growth is indeed much slower that we have been led to believe.
That is irrelevant, of course, if the future looks bright, and on some measures it does. Housing has finally taken a turn for the better, and the Europeans have found a back door solution to their short term sovereign liquidity problems, giving banks billions in exchange for risk free investments in risky foreign debt. In the long term significant structural problems remain in the Eurozone (take a look at Italy's ten-year yields recently if you want evidence of that). However, I believe that the economic shock caused by the crisis early this fall will have potentially crippling effects in the first quarter of 2012 and beyond. Europe is already in recession, further exacerbating its problems and introducing an exogenous shock to the United States, but we have our own problems. The Economic Cycle Research Institute has been heavily assaulted for its early-fall recession call, and while it remains to be seen how the data will settle it doesn't appear that economic growth is negative yet. For the first quarter of 2012, though, there is reason for concern.
To explain why, I'll use a concurrent situation. In 2010, there was a patch of economic weakness similar to our current one. ECRI's weekly leading growth index was negative from June to December. This weakness didn't show up in GDP data until Q1 2011, when growth dropped from 3.1% in Q4 2010 to just .4%, a level from which it has gradually recovered. This year, the ECRI index again when negative, this time two months later in August. The downturn has yet to subside at the time of this writing, and there is no trend to suggest it will any time soon. This leaves us with a second shock, at least equal in magnitude to the shock from last year... except we are starting much weaker. Average growth in 2010 was 2.7%; so far this year it has averaged just over 1%. If the shock comes through as the weekly leading growth index predicts it will, the US Economy will almost certainly experience negative growth in the first quarter of 2012... regardless of how the European situation ends up. When viewed in this light, the ECRI recession call makes much more sense, and as an investor you should be very worried.
What all this means, in my humble estimation, is that calls that the economy is now growing strongly and for the foreseeable future are probably (though of course not certainly) wrong. There is a high likelihood of future downward revision in third quarter GDP data, and as the economic effects of this fall's chaos make their way into GDP early in the New Year we will probably see growth go negative.
For those whose portfolios represent implicit long-bets on the US Economy, I recommend you reevaluate critically with an eye (or two) toward the risk a moderate recession would cause to your portfolio.
Additional disclosure: I am currently invested in line with the predictions I tentatively make here.