Winter has come. A bitter winter can bring with it devastating effects and not just for Al Gore. Winter will kill crops, defeat armies and in some countries where snow falls, it will hide the green grass under a blanket of white for an entire season. Only when the season changes and the snow melts away will the grass appear greener than ever to those who look upon it.
Winter in the US this year (2015) has affected US first quarter GDP numbers in a very similar fashion as to what they did to first quarter GDP numbers last year (2014). Alongside this, we see many market participants voice continued concern over the level of valuation for US equities. Another distraction coming to market is that some market participants are questioning whether the equities market’s ascent is due to earnings growth or simply share buy backs. There is a veritable buffet of reasons, were one that way inclined, to believe that US equities have hit their peak.
The first quarter GDP numbers in 2014 painted a dismal picture for calendar 2014 in the US. Remember that in 2013, the US economy delivered a below trend annual GDP rate of 2.2%, so the Fed expectations going into 2014 were markedly higher, given the expected uplift that the pledged continuation of QE was supposed to contribute. The winter of Christmas 2013 going into January 2014 was particularly bitter across the US leading to an advanced estimate of first quarter GDP being a barely positive +0.1% (% change from 1st quarter 2013 to 1st quarter 2014). This “advanced estimate” which is allegedly seasonally adjusted was revised further downwards on May 29th 2014 to -1.0%. By the year’s end however, US annual GDP was found to have grown +2.4% through calendar 2014.
Come Christmas 2014 and going into January 2015, the US was again beset by yet another bitter winter and on top of this was forced to endure severe labour market “action”, which saw many East Coast ports shut down due to strike action. As the data would show, this would eventually blow the trade deficit out by a massive 8% change at the end of the first quarter. In regards to GDP, clearly when ports are shut down if not by winter, by strikes, then it is quite difficult to export goods which would have otherwise contributed to GDP numbers. Hence, when presented with 2015’s 1st quarter GDP number being +0.2% (a very similar number to 2014’s) some market participants are concerned that this will herald a slower 2015 than the US Federal Reserve forward projections would otherwise have us believe.
The problem here with the inaccuracy of the 1st quarter GDP numbers’ bearing on actual economic activity for the other 3 quarters of the year have been cause of much debate. “Seasonal adjustment” of the numbers is supposed to remove noise or volatility from the data due to holidays, weather and lost productivity often associated with Christmas and the winter period. However, 1st quarter GDP has been shown to average 1.6% lower than other quarters across the last 20 years. If this can be observed with regular effect, then theoretically seasonal adjustment should be “taking care of” what the human eye can do to a column of quarterly spreadsheet data.
The US Federal Reserve Bank of San Francisco by its own admission states that, “Of course, seasonal adjustment is an imprecise and uncertain statistical exercise”. This should make hedge fund managers throw their toys out of the sandpit in pure exasperation when they are using such data to attempt to make multi-billion dollar investment decisions based on the direction that the nation’s statistical body, the Bureau of Economic Analysis, is leading them.
Why is all of this so important? Without a clear read on “proper” US GDP, the market will not be able to accurately forecast (yes, an oxymoron!) what Dr Janet Yellen’s decision may be regarding the timing of a rate rise. The market has moved earlier this year from an almost unanimous decision that the Fed would raise rates in June 2015 to a possible rate rise by the end of 2015. Despite continual performance of US corporate debt markets (or perhaps because of them), investors are even more so concerned about the timing and pace of US interest rate rises. If the economy is not recovering, then the Fed will not raise rates quickly or possibly at all. If it does raise rates, what effect will that have on the wider economy? If the wider economy suffers due to an interest burden imposed by an impatient (or overly patient) Fed, then will there be any corporate profits to distribute?
People suggesting that relying on revised US GDP estimates this time round (2015) to be different may want to take a look at the data set. Although it is almost taken as gospel that the most amazing growth period the US ever experienced was through the Great Moderation of the last 30 years, this is simply not the case. Since 1930, average annual US GDP has been 3.4% (all data presented here is in chained 2009 dollars). Since 1964, the average annual GDP number in the US has been 3.0%. In the Great Moderation of the last 30 years, it has been 2.8%. This gives pause to the thought that the US economy may not be able to deal with an environment of rising interest rates. To be sure, a heightened interest rate environment will affect some industries and companies within the US economy, but if their business is only sustainable in a near-zero interest rate environment, then the question must be asked, was their business model ever really sustainable?
During the tenure of Paul Volcker at the Head of the US Federal Reserve (1979-1987) and across the Regan administration which saw off stagflation, US GDP annually averaged…wait for it…3.0%. This was at a time when Volcker raised the US Federal Funds rate from low double digits (!!) in the late 1970s to a monthly peak of 19.1% in June 1981 (US Federal Reserve FRB_H15).
Mark Twain once said that "History does not repeat itself, but it does rhyme". Well, during Volcker’s reign from 1979 to 1987, the stock market only had 2 years where it finished in negative territory. Clearly 1987 was one of those two years. So, a return of 147% in US equities across 9 years implies an average annual (but not compounded) return of 16.3%. Not bad for a period where interest rates averaged double digits. However, for the stock market to be firing, so too must the broader economy.
By the end of May (29th), time – or the Bureau of Economic Analysis – will have told.
Marcel von Pfyffer