US gross domestic product (NYSEMKT:GDP) soared at an annualized pace of 5.7 percent in the fourth quarter, its fastest rate of growth since 2003. GDP grew by 2.2 percent in the third quarter, and the consensus was looking for 4.7 percent in the fourth; today’s news represents a meaningful acceleration for the economy and was far better than consensus expectations.
This is further evidence that the US economy exited recession over the summer of 2009 and is now seeing a recovery, a view I’ve espoused for the past six months. Long-term headwinds for the US abound, but investors need to respect the power of the business cycle; the time-honored path of the stock market leading an economic recovery is replaying once again.
Long-term readers know I like to look inside economic data releases to get more color regarding what factors are driving better-than-expected data. Let’s start by taking a closer look at the one of the data points I’ve been highlighting for months in PF Weekly, the change in private inventories.
Source: US Department of Commerce Bureau of Economic Analysis
Inventories accounted for a whopping 3.39 percent of the total 5.7 percent change in fourth-quarter GDP. In the third quarter inventories added just 0.69 percent.
You can see from the chart above exactly which forces are at work. In 2008 and early 2009, as the financial crisis intensified and the economy continued to deteriorate, businesses stopped ordering new stock and focused instead on selling off the inventory of goods on hand.
After all, with final demand for most products so weak no business wanted to get stuck with a huge overhang of excess inventory. On the chart, you can clearly see that inventory liquidations acted as a net drag on GDP for much of 2007, 2008 and the first half of 2009.
In fact, businesses liquidated inventories at an historic pace. By the middle of 2009 inventories across most industries were lean; there just wasn’t much additional scope to keep selling off stocks on hand.
As is often the case, businesses may have gone too far, liquidating inventories down to uncomfortably lean levels. The financial crisis was undoubtedly a scary time for companies, and it’s not unreasonable to expect that some businesses made the assumption that the depressed conditions of late 2008 and early 2009 would become the new norm.
Inventories typically help reinforce growth as the economy exits recession, and this cycle is no different. However, the faster-than-normal pace of liquidations amid the financial crisis likely means there’s more room for inventories to snap back. That’s why I’m not surprised to see inventories make such a strong contribution to the fourth-quarter GDP number.
And, as I’ve pointed out in the past, just because inventories are adding to GDP doesn’t mean that inventories are actually rising. In fact, as a whole, liquidations are ongoing.
Source: US Department of Commerce Bureau of Economic Analysis
This chart shows the real change in private inventories in terms of billions of dollars. While inventories were the most important driver of fourth quarter GDP growth, inventories actually fell a further $40 billion in the quarter. But the drop in the fourth quarter was less than a third of the record inventory liquidation in the second quarter and the near-record draw in the third.
Inventories fell across most of the industry groups covered by the US Dept of Commarce Bureau of Economic Analysis (BEA). One exception was automobile and parts dealers. Car dealers actually added $30 billion in inventories in the quarter, reversing a string of massive declines that started in the fourth quarter of 2008. Between the fourth quarter of 2008 and the third quarter of 2009, auto and parts dealers liquidated nearly $800 billion in inventories; in that light, the $30 billion build in the fourth quarter looks almost insignificant.
Some of that $30 billion is likely due to the lingering impact of last summer’s “cash for clunkers” program, which drove a temporary jump in auto sales and depleted dealers' lots to the extent that they had to order more stock. This increase in inventories is likely due, in part, to that activity.
Of course, as I’ve pointed out in recent issues, auto sales surged due to “cash for clunkers” then collapsed in after the program ended; the subsidy simply pulled forward sales that would have likely occurred in future months. The good news is that sales have since continued the gradual improvement that was underway before the artificial boost.
Given that inventories remain lean and continue to fall, there’s significant scope for inventory restocking to add to GDP growth in coming quarters. This is one major reason I wouldn’t be at all shocked to see growth surprise to the upside this year.
When listening to commentary about GDP data you’ll often hear inventories discussed almost dismissively, as if this weren’t an important, or “real,” driver of growth. That’s absolutely ridiculous.
Consider that if an auto dealership orders more cars to restock inventories then the manufacturer must boost output to meet those orders. The manufacturer might, in turn, have to hire back workers or increase hours worked; the resulting improvement in the jobs market helps drive consumption.
Real final demand must ultimately drive increased output, as inventories can only build up to a point before an inventory glut develops and begins to have the opposite effect on GDP. But the pro-cyclical push from inventory restocking can have a real impact and has historically been one of the key drivers of growth as the economy emerges from downturns.
In addition to inventories, a few other factors in today’s report are worth noting. First, trade actually added 0.5 percent to GDP in the quarter after subtracting more than 0.81 percent in the third. This was due to the fact that US exports of goods and services jumped 4.25 percent in the quarter, while imports only grew by 2.53 percent; exports add to GDP, while imports subtract from output.
The jump in exports was led by an increase in exports of goods rather than services; exports of food and beverages soared 8.4 percent, while sales of computers and parts jumped 6.2 percent and autos and automobile engine exports shot up 18.3 percent. Sales of civilian aircraft, a number than can distort export figures, grew less than 5 percent in the quarter.
The improvement in trade figures reflects a few key trends. One is that a less profligate US consumer spells a moderation in demand for imports. Perhaps more importantly, the jump in exports suggests that economic growth abroad is helping to fuel the US economic recovery through higher exports. A weak US dollar also likely has an effect because it makes US goods more attractive abroad. It will be instructive to watch this figure in future quarters, particularly in light of the recent jump in the dollar.
Some pundits have also noted that personal consumption expenditures (PCE)--basically the consumer--added only 1.44 percent to GDP in the fourth quarter compared to 1.96 in the third. But that’s due to the fact that motor vehicles and parts consumption added 0.81 percent to third-quarter GDP and subtracted 0.57 percent in the fourth. This was undoubtedly due to the distortions caused by the “cash for clunkers” program that pushed up third-quarter auto sales. Almost every other category of PCE showed either an improvement in the fourth quarter or was essentially flat.
As regular readers know, I have deep, long-term reservations about the health of the US economy. My concerns center on the still-excessive levels of debt in the system and the increasingly overbearing role of the government in the economy. As I explained in the Dec. 11, 2009, PFW, A Tale of Two Nations, the current situation educes comparison with the United Kingdom in the 1960s and ’70s. Nonetheless, the cycle now favors growth, and it’s strengthening. The best advice I can give is not to fight the proverbial tape.
Of course, some readers will undoubtedly wonder why the market didn’t react particularly well to the better-than-expected GDP data. More broadly, earnings released to date have been better than expected, and companies are showing real revenue growth rather than just earnings driven by cost-cutting. Yet, the S&P 500 has pulled back more than 5 percent off its mid-January high.
The simple answer is that the market is a forward-looking animal, or, as the old saw states “buy the rumor, sell the news.” Recall that the S&P 500 hit bottom in March 2009, months before the economic data began to improve; at current levels it has undoubtedly priced in some of the improved earnings and economic data we’re seeing today.
What the market is now experiencing is a classic growth scare: Investors are fretting over the potential for the improvements to continue. Adding to those fears is the increased talk of regulations and “reform” from Washington, DC; the Obama administration has taken a decidedly populist and arguably anti-business turn in recent weeks following some stinging setbacks. These factors, taken together, are enough to prompt some to take some profits off the table after last year’s big run-up.
Such action isn’t at all uncommon. Markets rarely proceed for long in a straight line. And I’ve been warning of the potential for a meaningful correction of as much as 10 to 15 percent in the first half of this year. The S&P 500’s negative reaction to positive news is a red flag suggesting the correction may have already begun.
I doubt this is the end of the line for the S&P 500. Given the economic improvements and recovery in corporate profits, I expect this correction to ultimately offer investors an outstanding buying opportunity. Among my favorite sectors to play the upturn: energy, technology and health care.
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Elliot Gue is Editor of Personal Finance, The Energy Strategist, and Co-Editor of MLP Profits.
Disclosure: "No Positions"