Friday, March 30, 2012

GDP Growth: the Road Ahead and the Investment Climate

The second revision of the fourth quarter GDP number was released this past week and everything pretty much stayed the same.  The year-over-year rate of growth for the fourth quarter came in at 1.6 percent…following a third quarter of 1.5 percent growth and a second quarter of 1.6 percent growth.  In the following chart, the trajectory for real economic growth in the United States is shown since the beginning of the recession in December 2007.

A very nice cycle is shown in the chart as the recovery has been going on since June 2009.  The two major differences between this recovery and many previous recoveries are the strength of the major revival and the level at which the economy continues to grow.

In many previous cycles, year-over-year growth initially jumped up over 5.0 percent sometimes reaching 6.0 percent.  This time, economic growth in the United States only reached a level of about 3.5 percent. 

In the early 2000 recession, the upswing began in November 2001 and economic growth reached a height of a little more than 4.0 percent before leveling off.

In terms of the second difference, economic growth, year-over-year, currently seems to be running modestly below 2.0 percent.  I have argued that, as we go forward, growth will continue above 2.0 percent but will probably stay somewhat below the 3.0 percent level. (See my post

Economic growth leveled off in 2004 through 2006 period in the 3.0 percent range but dropped off to about 2.0 percent in the period preceding the beginning of the last recession in December 2007.

The point is, in our recent experience, economic growth is not anywhere as robust as it was in the last half of the 20th century and my guess is that it will not regain that robustness for some time.

The current economic situation is also mirrored in the year-over-year growth rates for industrial production.  We see, in the following chart, that although the growth rate of industrial production is greater than the growth rate of real GDP for the same period, the trajectories of the two charts are roughly the same.

I believe that this is the economic environment that we will continue to face for the near future.  The general economic situation is dominated by the fact that there still is a tremendous debt overhang in the economy, where under-employment will continue to remain high, and where the state of the housing market has not yet bottomed out.  As a consequence, economic growth will remain tepid. 

The Federal Reserve will be continue to make sure that the economy has plenty of liquidity to avoid any major problems in the banking system (  However, as I quote in this previous post, Harvey Rosenblum, the head of the research department at the Dallas Federal Reserve Bank has written: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” 

In other words, the Fed cannot have much impact on economic growth when the banks are in the condition they are…but the Fed needs to keep the banks liquid enough so that the banking system causes no further disruption to the growth that has already been started.

This environment should be a positive one for investments, although one still needs to be cognizant of all the possible “bumps in the road” that exist, like the European recession, a slowdown in China, higher gas prices, and so forth.  Burton Malkiel, in the Wall Street Journal, argues that common stocks should return around a 7.0 percent yield, calculated from the dividend yield on stocks (around 2.0 percent) plus the long-run growth of nominal corporate earnings (around 5.0 percent).  And, this gives a “five-percentage point equity risk premium (over the 10-year Treasury yield now around 2.0 percent)” that “is close to the historical average.” (

Malkiel goes on that “Only the so-called Shiller price/earnings ratio (based on the past 10 years of earnings) would suggest that stocks are too high.  But the average earnings over the past 10 years are likely to be well below the current nominal earning power of U. S. corporations.”

Thus, the Shiller “ratio” (CAPE) will revert to the mean, but because corporate earnings are rising in the current economic environment, not because stock prices should fall.  Furthermore, an index of market liquidity and a confidence index related to market performance are both supporting rising stock prices at this time, re-enforcing the argument that stock prices should rise in the near-term future. (See my   

Bottom line: I think common stocks are a good place to invest right now.)

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