Still far too early to say US recovery is on a solid footing

SERIOUS MONEY: Analysis reveals that a V-shaped recovery and big equity market gains are wishful thinking

JOHN PIERPONT Morgan, the great US financier, orchestrated the rescue of several financial institutions at the height of the panic of 1907.

The measures taken by the 70-year-old and semi-retired banker pulled the financial markets back from the brink and investors, who had suffered capital losses of 45 per cent from the market peak in early-January to the trough in mid-November, went on to enjoy price gains of more than 46 per cent the following year.

Fourteen months after the rescue, and half a year into economic recovery, Morgan told a circle of friends and business associates at the Chicago Club that: “Any man who is a bear on the future of this country will go broke.”

More than a century later, Morgan’s words, which have long since become Wall Street lore, appear to be right on the money, as the more than $10 trillion of government support alongside near-zero interest rates, has successfully pulled the US economy from recession and returned it to its normal upward trajectory.

Data released by the Bureau of Economic Analysis (BEA) last week show that the US economy expanded at the most rapid clip in more than six years during last year’s final quarter, and that the growth rate, at 5.7 per cent annualised, is the seventh strongest in the past two decades.

Investors correctly anticipated the turn of the economy last summer when stock prices bottomed earlier in the spring. Perhaps the almost 70 per cent bounce off the low correctly incorporates a V-shaped recovery – but then again, perhaps not.

The headline number may look impressive at first glance, but when viewed in proper context, the report card reads “could do better”.

The US economy has now managed two consecutive quarters of positive growth following four consecutive quarterly declines that saw real GDP drop at a 4 per cent annual rate. However, the recovery’s credentials to date have been far from eye-catching.

The annualised growth rate of 4 per cent is almost five percentage points below the average registered during the first two quarters of the previous 10 economic recoveries, and outranks only the tepid stop-start recoveries of 1991 and 2002.

The economy’s recovery performance so far can only be described as pitiful when viewed in nominal terms year-on-year, which serves as a basis for comparison with corporate revenue numbers.

Nominal GDP declined by more than 2 per cent year-on-year during last year’s third quarter, almost seven percentage points below the average recorded during the first quarter of the previous 10 economic recoveries.

Year-on-year growth did turn positive in the fourth quarter but, at less than 1 per cent, the rate of increase is outpaced by each of the previous 10 recoveries and is six percentage points below average.

The sub-par performance is disappointing in its own right but particularly so given the generous doses of fiscal stimulus and monetary accommodation provided.

If the headline numbers offer little cause for comfort, the details only add to the angst.

The real economy may have advanced at an eye-popping rate during the final three months of 2009, but a rapid slowdown in the pace of inventory liquidation was the driving force behind the improved performance.

Private businesses in the US reduced inventories by $34 billion in the fourth quarter compared with a reduction of $139 billion in the previous three months, and this alone contributed more than half, or 3.4 percentage points, to the quarterly growth rate.

The boost to growth, however, was accompanied by a more than half percentage point slowdown in final domestic demand during the quarter to 1.7 per cent annualised.

Given the significant headwinds to both consumer spending and business fixed investment, it is far too early to declare that the recovery is on a solid footing.

It is also worthy of note that not only was the more than 5 per cent growth due primarily to inventory changes, but it also occurred in the face of rising unemployment.

This atypical combination has happened before – during the first three months of 1981 when inventory changes contributed 6.4 percentage points to the quarterly growth rate, and once again during the first quarter of 2002 when the BEA’s initial estimate showed that the real economy received a 3.1 percentage point inventory boost to growth.

The first instance succumbed to a double-dip as demand failed to materialise, while the latter was followed by a significant downward revision to the headline GDP number, and the economy subsequently sputtered through the remainder of the year.

Economic conditions are clearly very different today than in 1981, but hefty downward revisions to the headline number, as in 2002, cannot be ruled out.

Indeed, the 5.7 per cent growth rate implies that labour productivity increased at a more than 6 per cent annual rate in the fourth quarter given the half of one per cent drop in the aggregate work week.

Although the cost-containment measures by corporate America have been impressive through the recession, it is hard to believe that output per man-hour has improved so noticeably given the lack of productive investment and technological progress in recent years.

The price action from the market low last spring and the subsequent strength of recent economic data suggest investors may have been right to bet on America, but closer analysis reveals that a V-shaped recovery and outsized equity market gains are wishful thinking.

The atypical combination of a substantial inventory boost to robust economic growth and rising unemployment has happened before – most notably in 1981 when the late John Lennon topped the charts.

The album was Double Fantasy. Investors should take note.