I am the eye in the sky, looking at you I can read your mind. I am the maker of rules, dealing with fools I can cheat you blind. And I don’t need to see any more, to know that I can read your mind, I can read your mind, rings out the chorus to Eye in the Sky, a 1982 song by The Alan Parsons Project from the album of the same name. One wonders if even an eye in the sky could have forecast the bumpy ride that world equity markets went through over the past couple of weeks, and while markets around the world are well off their peaks, American equities began to recover a bit after the Bureau of Economic Analysis, an agency of the Department of Commerce, put out revised GDP figures that showed the US economy growing sharply in the second quarter of 2015.
Needless to say, an overall adjustment of 1.4 points – which by the way equates to a 61 percent increase in the prior estimate of GDP growth – is amazingly large, and one has to wonder if this will hold as further revisions come out. But if the economy did in fact grow by 3.7 percent in the second quarter, this would be the seventh best quarter since the end of the recession. Many pundits and economists suggesting that the economy has started down an extended growth path in spite of the recent stock market swoon and most are singing that rosier days are ahead of us.
Unfortunately, all one needs to do is to look at the revised GDP figures in a bit more detail, and that whole story begins to fall apart. To begin with, we need to always remember that the BEA measures GDP in consumption rather than in production terms. A growing economy needs to produce more each year. Consumption is necessary for production to occur, but in the end if we all sit on the couch eating tons of chips and watching old Gilligan Island reruns the economy is not going to experience any long term growth. With that in mind, what do the numbers for the quarter tell us?
First, and most importantly, in the 2nd quarter nearly all components of measured GDP rose; however, when examined more closely, nearly all GDP growth was due to increased consumption and rising inventories. Very little of the spending in the economy went toward investments in new assets, plant and equipment which would lead to increased production in the future. Investment in business equipment like computers, machinery and trucks actually fell. This continues a trend of falling business investment since the third quarter of 2014.
Inventory growth accounted for almost 6 percent of the total change in GDP in the second quarter, in absolute terms in the past two quarters inventories have been soaring. One of the key indicators in orthodox economic theory of a coming recession is growth in inventories. This, taken with the fall in business investment is not a good sign of long term economic growth.
After having basically fallen for the past couple of years, growth in net government spending accounted for about 4 percent of overall GDP growth in the 2nd quarter. Since about 70 percent of government spending is merely transfer payments from one person to another it really has no impact on real economic activity, and growth in the government sector has a long term negative impact on future growth.
Finally, housing investment continued to be strong accounting for about 7 percent of overall growth. While recovery in the real estate markets following the recession is positive, after years of nearly negative real interest rates, there is likely another bubble starting to form in the residential real estate market, and continued growth in this sector as a percentage of GDP is not going to be sustainable for long.
So looking at the components of the economy driving GDP, it is fairly apparent that even though the headline growth figure was strong, the overall economic situation continues to be quite soft. It has now been 24 quarters (6 years) since the economy stopped contracting and that the average business cycle lasts 8 years. Since there is nothing on the horizon suggesting that there will be some sort of new growth paradigm, JDA’s prediction that we will be entering a new recessionary phase by the end of 2016 still looks probable. This taken with the fact that in spite of the massive drop in the labor force participation rate, both new claims for unemployment insurance and the new jobs numbers are reflective of a tightening labor force, we still believe that it is likely that one does not need to be able to read your mind to see that the next recession is near. For the eye in the sky the maker of rules, and can cheat you blind before you know it.
No wonder markets are so volatile.