Volume 62, Number 4
The first estimate of fourth quarter GDP data released Friday have pushed us deeper into the bear camp, as they show little consumer income to drive the 70% of the economy controlled by shoppers. In many ways this is the first truly Keynesian cycle in the post-war period. After injecting significant stimulus into the economy in 2009 to jump start the cycle after Lehman, the government sector has been a persistent drag on the economy in 2010 and 2011 as they move away from deficits. In 2011, transfers fell by $10 billion, due entirely to a $30 billion reduction in Medicaid payments (a program controlled jointly with the states). Meanwhile, personal taxes rose by $208 billion over the past four quarters. This $218 billion swing in government contributions to the household sector wiped out 1.9% of disposable personal income growth. Real disposable income actually fell -0.1% during the year as inflation eroded another 2.5% growth in spending power. In the fourth quarter, real disposable income rose at just a 0.8% annual rate, despite just 0.7% annualized inflation in the consumer sector. This is simply not enough fuel to sustain growth in the 70% of the economy driven by consumer outlays for goods, services and residential investment.
Nor is there any income growth for the business sector. As we always note when the first report on GDP comes out for a quarter, the key lead indicator in a capitalist economy is profits. In the fourth quarter, weak 3.2% nominal growth (think business revenues) and a 3.8% increase in compensation suggests no profit growth in the final quarter of the year after modest 7% growth in the second and third quarters. Bottom line, corporate profits exploded in 2009 as government stimulus flowed through the household sector (as increased transfers and reduced taxes) to business, and the growth in profits has steadily abated as government stimulus has ebbed. This is normal for post-war business cycles. What has been missing is the hand off to private sector led growth once profits recovered. Even when profit growth was strong, there was little pick up in business investment or hiring. Now that profits are eroding, we see no reason to expect any acceleration in the private sector.
In the fourth quarter, private sector GDP rose at a 4.5% annual rate, after 2.3% annualized growth in the third quarter, and 1.9% growth in each of the first and second quarter. Much of the strength in the fourth quarter was inventory rebuilding, which points to weak first quarter GDP growth. Still, final sales of domestic product were 0.8% in the fourth quarter after 3.2% growth in the third – so the average was right in line with the 1.9% average over the past two years, when weak quarters were followed by strong ones or vice versa. With no new stimulus, we don’t expect stronger final sales growth in the first half of 2012 – and an inventory correction may limit first quarter GDP to just 1%. Thus, unless the drag from the government sector abates early in the year (we suspect not), first half growth is unlikely to be any better than the recent muddle through, with low nominal growth drifting the economy toward recession.
The Elephant in the Room
The real risk to the US economy is that there is an atom bomb set to go off on January 1, 2013 with the simultaneous expiration of the Bush tax cuts, payroll tax holiday (if extended), AMT patch, Doc fix, etc. and the start of the sequester plus the first round of Obama-care taxes — and just to make it more fun, the debt ceiling will expire soon after the election as well. Like in a Hitchcock movie, this horrible MacGuffin cannot be allowed to explode – and everyone in Washington knows it. However, they are lined up to a man on their side of the trenches awaiting the great final battle to be held November 6th, with no one expecting any serious legislation before the election. The entire year will be spent marshalling resources to win the Presidency. It is an accepted truth that decadal re-apportionment virtually guarantees the Republicans a majority in the House this year and for many years to come. Given the size of the Democratic wave elections in 2006 and 2008, they are also at an outsized disadvantage in the Senate elections in 2012 and again in 2014. A Republican majority only takes a change of four seats with 23 Democrats (including the 2 Independents) and only 10 Republicans seats in contention. (In 2014, it is 20 Democrats to 13 Republicans.) The current consensus is for 53 Republican Senators in 2013.
If Obama wins, there will be a massive pot of new revenues to spend given the expiration of all the tax cuts – at precisely the time everyone has a favorite group that they want untaxed or program that they want spending restored to after the sequester. How much austerity will actually occur is not at all clear, though there is a solid understanding of whose ox will get gored. Negotiations would likely begin the day after the election, as most of the key players will remain on the field with some shift in leadership. Hope springs eternal in Washington that something will be done during the lame duck session, but more likely a vote on changes would come very early in 2013 with the new Congress. Most likely a continued muddle through will result if government remains divided.
If the Republican’s win, they still will not have 60 Senators. The new President will need most of the lame duck period to make new appointments, which given the vetting process is tougher these days. Though the broad guidelines for policy change may be determined by the election, the timing of when they will become law is not. The new President will not be sworn in until after the tax cuts sunset and the sequester begins. Without 60 Senators, either the Democrat minority will retain some strength, or, more likely, the coming changes will occur through the budget process (when only 50 Senate votes are needed) but that will take months. This suggests a rocky start to the transition, which may increase the new Administration’s desire to do something large with respect to the tax code as part of a needed economic stimulus – blaming a slowdown or recession in early 2013 on Obama. Bottom line, a Republican victory suggests a rough start, but a bigger finish – potentially generating a long expansion.
The real question for 2012 is how the financial markets will treat this “fork in the road” election. Given the current degree of uncertainty about the ultimate victor, we find few investors willing to take on risk now. Perhaps that will dissipate during 2012 generating a rally, like it did in 2010 as it became clear a Republican wave election was underway. However, if uncertainty remains, the financial markets are likely to exhibit their risk aversion by selling off as they did ahead of the debt ceiling & downgrade debacle this year. Still we doubt that any sell off will be enough to spark the political adversaries toward compromise. After all, it was the resolution of the last crisis that created the atom bomb that is now ticking – specifically because everyone who is political wants this debate settled in their favor once and for all.
Nor will the US be facing this election in a vacuum. President Sarkozy is facing an uphill battle to retain his party’s leadership role in France on April 22 (or May 6th if a runoff is needed). If the Left gains control in France, it will exacerbate the resolution process there. Will Merkel blink if Sarkozy’s polls continue down? If Europe has a recession in 2012, as expected, it will help the dollar even if we are just muddling through. However, that pattern may reverse in early 2013, if Europe has a solution in place and the US is either still muddling through or taking its own slowdown between the bomb going off and the solution being put in place. With virtually every market trading the dollar as much as fundamentals, it is reading the big policy picture that will underpin successful investing in 2012.
Dear Clients and Friends,
On February 8th, the Global Interdependence Center and the University of Memphis Fogelman College of Business and Economics will present “Food and Inflation: Truth and Consequences.” McVean Trading is proud to be a sponsor of this event, which features speakers from the Federal Reserve and agricultural industry experts. Dinner, in conjunction with the Economic Club of Memphis, features Dennis Gartman, as the evening’s speaker. Registration is open to the public at:
Registration includes a one year membership in the Global Interdependence Center, which hosts a series of events in the US and abroad on topics of importance to the financial services industry. McVean Trading hopes that many of our clients and friends will take advantage of this exciting and timely opportunity to attend and debate with the experts on the key issues facing the agricultural industry and the economy today.