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Affluent Investor | June 23, 2017

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This is a Trickle Down ‘Recovery’

(Photo by bfishadow) (CC BY) (Resized/Cropped)

(Photo by bfishadow) (CC BY) (Resized/Cropped)

The Bureau of Economic Analysis elevated its estimate of third quarter GDP from 2.9% to 3.2% last week. They intend the decimal points to give an illusion of accuracy when they know there is a lot of slack in the numbers. Corporate profits rose in the third quarter on a year-over-year basis 2.8%, the first rise in profits in five quarters.

Tossed with expectations about Trump’s spending and tax cuts we should have a salad that promises improving health for the economy. It should end business cycles and bear markets, except for the fact that we have seen similar scenarios before. Mainstream economists gathered around the casket of the business cycle in the late 1990s, just before the recession of 2001. Bear markets are wedded to recessions for the most part, so the death of business cycles would mean the death of bears, too.

If that sounds too good to be true, then join me in looking into the numbers a little more closely. The Bureau of Economic Analysis (BEA) explains the jump in GDP this way:
The increase in real GDP in the third quarter primarily reflected positive contributions from personal consumption expenditures (PCE), exports, private inventory investment, and federal government spending, that were partly offset by negative contributions from residential fixed investment and state and local government spending. Imports, which are a subtraction in the calculation of GDP, increased…
Considering job gains, wage increases and low debt levels, Bloomberg quoted Russell Price, senior economist at Ameriprise Financial Inc. in Detroit on the topic:
Growth is going to remain heavily reliant on the consumer, but consumers are in very good position to lead that charge…Overall, it’s an encouraging sign for the path ahead.
So basically, the GDP jumped because of greater consumer and government spending, some building of inventories before the Christmas season and an increase in exports. Those of us with ears finely tuned to the beautiful music of economics from Vienna, the noise of greater consumption strikes a dissonant chord.

We know that investment, not consumption, spurs a growing economy. Businessmen in the medieval period thought that spending by the nobility caused growth. It was the original “trickle-down” economics theory. Pieter De la Court destroyed that nonsense in 1662 in his book The True Interest and Political Maxims, of the Republic of Holland. Adam Smith added to de la Court’s wisdom and the subject was dead among real economists until Keynes used his electric personality to shock the monster back to life.

An increase in consumer spending triggers the Ricardo Effect. Profits rise in the consumer goods sector, as we saw last quarter, and pull investment from capital goods to consumer goods. At the same time, the prices of inputs, such as labor and materials, rise and thus squeeze the profits of capital goods producers. And as the Bloomberg article reported:
Corporate spending on equipment decreased at a 4.8 percent annualized pace in the third quarter, more than the initially estimated 2.7 percent and subtracting 0.28 percentage point from growth, the report showed. Those outlays had declined 2.9 percent in the prior three months.
As the Ricardo Effect predicts, greater consumption reduces spending on equipment that boosts productivity. So while costs are rising for those equipment makers, sales are falling because consumer goods makers are hiring more people instead of buying equipment to boost productivity. Many businesses continue to buy back their own shares instead of investing in new equipment because they don’t see as rosy a future as most investors see. Buying back shares is a form of increasing dividend payments without the share owners having to pay taxes unless they sell.

The lack of investment has kept this recovery from tanking sooner. Past expansions have been shorter because businesses rushed to invest and caused the longed for spike in GDP right after a recession. But that increased investment causes more workers to chase a limited amount of consumer goods and thereby boost prices and profits in the consumer goods sector. By withholding investment in the recent expansion, businesses unwittingly extended the expansion even if the rate of increase has been disappointing.

Keep in mind the BEA’s definition of GDP:
Gross domestic product (GDP) is the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production.
GDP is net spending, not gross. Seventy percent is consumer spending and 25% is federal government spending. That leaves 5% for investment and production. So by definition a GDP jump tells us that consumers and governments are consuming more while investment has fallen.

With all of that in mind, I still expect a recession next year and a bear market with it. In the short run I have some money in natural gas because production has fallen so much and winter is coming. Meanwhile, I’m hanging on to gold and silver. If you happen to still be in equities, you might want to consider some downside protection through options.

 

Originally published on ABCT Investing

 

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