The news Friday that 2nd quarter GDP expanded by a tepid 1.2% from the previous quarter (annualized) marks a change that needs to acknowledged. The last two years we have seen a pattern of a weak first quarter – for which economists have been searching frantically for an explanation – followed by a second and third quarter rebound. Fourth quarters have tended to the weak side. This cycle was a kind of mini inventory cycle within the larger business cycle. Businesses, told by the Fed and Wall Street economists – possibly redundant – to expect the ever elusive economic acceleration to finally arrive, built inventories in anticipation of what never came. It appears now that US businesses may have finally reached their limit of credulity when it comes to Fed forecasting.
There was no inventory build in the second quarter; indeed inventory subtracted 1.2% from GDP in the quarter. As did almost every other investment category; intellectual property was the lone exception. That isn’t exactly comforting when one considers the nebulous nature of that category. The press almost universally reported the inventory GDP subtraction in positive terms, i.e. inventory contractions are followed by expansions of production to build them again. That is, I believe, the triumph of robotic article generation, algorithms copying what has been said in past articles, ignoring the context. It is often true that inventory contractions are followed by increases in production – but not when inventory/sales ratios remain elevated even after a contraction. And slowing of inventory accumulation has not yet reduced those ratios to levels associated with recovery and certainly not enough to warrant an increase in production.
And while everyone concentrated on the inventory numbers, the more important investment categories were mostly ignored. Gross private domestic investment contracted 9.7% from the first quarter which wasn’t exactly gangbusters either. Year over year GPDI is now down 2.5% a number not seen outside recession since the second quarter of 1967. In other words, it’s pretty darn rare. Even residential investment was down in the quarter – by a not insignificant 6.1%. Maybe last week’s new home sales report was good news – up 25% year over year – but starts and permits are down year over year and Case Shiller says prices have stopped rising. Last week’s durable goods report certainly didn’t offer any rays of sunshine for the goods side of the economy; that report was bad from top to bottom, overall down 6.4% year over year.
All the negative economic news pushed the 10 year Treasury yield down to 1.45%, not as low as immediately after the Brexit vote but continuing a relentless downtrend that started in mid-2015. I hear all the time that interest rates don’t mean what they once did – it’s different this time – because the world’s central banks are so involved in markets. There may be some truth to that but the fact is that the 10 year Treasury note yield has done a pretty good job of predicting the course of the economy. A heck of a lot better than Wall Street’s economists and embarrassingly better than the Fed. Real rates have turned negative all the way out to the 10 year TIPS maturity which sits at 0.0% as of last Friday, an indication that this is a real growth issue and not just about the lack of inflation. It isn’t coincidence either that the US Dollar peaked about the same time as the 10 year Treasury yield and real interest rates. I hear all the time that negative rates internationally are depressing US rates but if so, you sure can’t find evidence of it in the currency market.
The US economy is not in recession – yet – but it is surely slouching slowly in that direction. The drop in investment is very concerning since it is investment that leads; consumption is a consequence of growth not a driver of it. From 2012 to 2015 the economy grew at a 2.2% pace. With this quarterly release and downward revisions to Q4 2015 and Q1 2016, we now have 3 consecutive quarters of 1% growth. And I don’t expect it to get better in the third quarter either. We have an election in November and with none of the above winning in a landslide right now I would not expect a surge in corporate investment. I have never bought into the secular stagnation theory but for now, this may be as good as it gets.
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