Does Good News Mean Bad News?

As happy as I was to see the strong 5.7% real GDP growth rate for the fourth quarter, the number spooked some sectors of the economics community. For the month, the market gave up 3.5% despite stellar economic news and generally better-than-expected earnings from the likes of behemoths  Amazon (AMZN) and  Microsoft (MSFT).

While I am excited about what a stronger economy could mean for employment and corporate profits in the months ahead, others worry that this week's results could be too much of a good thing. Some analysts worry that a stronger economy will lead the Fed to raise interest rates, a move that could tighten the tourniquet even further on the already struggling housing market. Others worry that as the U.S. economy begins to grow faster than other developed economies, the dollar may strengthen, depressing U.S. exports sales. A stronger economy has already led some businesses to report that input prices are going up a bit faster than the recent past, potentially depressing corporate profit margins.

Many of these concerns are legitimate, but a little premature in my opinion. Offsetting some potential cost issues, I believe revenue growth and operating leverage can combine to keep profit dollars and earnings per share moving upward for some time. Given huge pent-up demand in both the housing and auto sectors, which I discuss below, I believe the economy has more runway in front of it than most people anticipate, even with higher rates and a stronger dollar.

GDP Shows Broad-Based Growth, ex-Government
This week's real GDP number was even better than I had anticipated in last week's column. The 5.7% increase did indeed spark the headlines I expected, trumpeting GDP growth greater than at any time since 2003. This compares to a small decline in the second quarter and 2.2% growth in the third quarter.

Who said this was going to be a slow recovery? The recovery was much more broad-based than I had anticipated. Consumer spending, which accounts for more than two thirds of GDP, was up 2% (versus general expectations of just 1%) even though consumption numbers were inflated by the cash for clunkers program in the third quarter and then deflated in the fourth quarter. The much smaller investment sector experienced 39% growth, led by smaller inventory declines. Net exports for the quarter surprised me, with a net positive contribution to GDP as exports soared and imports were surprisingly muted (maybe this one will get revised.). The total government sector was one of the detractors in the quarter, as government spending shrunk 0.2% for the quarter. Examining smaller sectors, just commercial buildings, durable goods (autos), and various government sectors showed declines.

Detractors, skeptics, and naysayers cite the large contribution from the inventory component as the primary contributor to GDP growth. Indeed 3.4% of the 5.7% GDP growth during the quarter was from a slower draw-down of inventories. That could give one the impression that inventories were built-up and gathered dust during the quarter.

Nothing could be further from the truth.

Inventories declined, but they did so at a much slower rate than during the previous quarter. That second order effect is exactly what goes into the GDP calculation. If inventory levels stay exactly flat in the first quarter, GDP would benefit by about 1.0% compared to the 3.4% contribution this quarter. If inventories expand, as they often do in a recovery, the effect could be even greater.

Stimulus Schemes Hit GDP Growth This Quarter
This quarter's performance is also interesting in that it was a period where some of the stimulus effects were running in reverse. New home sales were off during the fourth quarter compared to the third quarter, as the potential expiration of the new homebuyers' credit shoveled sales into the third quarter and then fell in the fourth. New home sales are a meaningful component of the investment account in GDP calculations.

Existing home sales were positively affected in fourth quarter (because one could buy an already standing home up until the last minute and still get the credit without having to leave lead time for the construction of the house). However, existing home sales do not have the direct effect on GDP that new home sales do. Instead, existing home sales tend to benefit things such as furniture, appliances and remodeling, with a three- to 12-month lag. Strong existing home sales in October and November did not come soon enough to impact the furniture account (which actually showed a decline in the quarter).

Looking forward, I still expect that GDP growth for all of 2010 will be 4% or higher, with housing, autos, inventory restocking, and exports leading the way. The news from our analysts and our companies this week bolsters this view.

Companies Sounding More Bullish
Adam Fleck, our industrials analyst, recalls that  Caterpillar's (CAT) quarterly press release indicated housing starts in 2010 could approach 1 million units compared to just 554,000 units for all 2009. Executives cited high affordability, record low inventories and past recoveries as the basis for their forecast. Given that housing tends to create a lot of jobs, Cat's prediction is a ray of sunshine on the otherwise drab employment landscape.

Although much smaller than the housing industry, the news out of the auto industry has been surprisingly robust, too. David Whiston, our auto analyst, noted that Automotive News is reporting that North American auto production in the first half of 2010 could be approximately equal to the production for all of 2009. Comparing the second half of 2009 schedule to the first half of 2010 schedule shows a jump from 5.1 million units to 8.5 million units, an increase of 66%. Given that robust prediction, I think there is a lot more upside in the economy than people think over the next several quarters.

Chicago Purchasing Managers' Survey Knocks the Cover Off the Ball
Other exciting news this week included the Chicago Purchasing Managers Survey, whose news was stunningly positive. The combined index moved from 58.7 to 61.5, which bodes well for the national survey that is due out Monday. Almost all the individual components, including production and new orders, were up strongly. Even the prickly employment component jumped to 59.8, the first expansionary number of this recovery. In fact, it was the best employment number in five years. The whole release is a fun read, at least for an economist. Here is a quote from the last page:

Consumer Sentiment Looking Up...
Although sentiment surveys are not my favorite indexes, this week's University of Michigan report was also surprisingly strong. The index moved from 72.5 to 74.4 and is now well off its low of 55.3 in November and is at its highest reading in more than two years. I have always contended that it is the confidence of the 90% of citizens that have jobs and that group's willingness to spend more that will bring us out of the recession.

...Consumers Have More to Spend, Too
Given that they can muster the desire, the consumer will also have the wherewithal to do that spending. Buried in this week's GDP report was news that real personal disposable income jumped 2.1% during the fourth quarter after declining 1.4% in the third. No wonder consumers are feeling a little better. The savings rate in the quarter moved up 0.1% to 4.6%, which I view as being in the Goldilocks range, not too high and not too low. If the consumers feel like splurging, it appears that they have some savings to spend as the savings rate has remained elevated for several quarters.

Housing Funk Continues
As I anticipated last week, this week's roster of housing reports was uniformly down. Existing home sales were off over 16%, new home sales declined 8%, and even the Case Shiller price index showed a tiny decline. Poor weather, seasonal factors, and shenanigans related to the tentative expiration of the first time homebuyers' credit and its subsequent renewal all weighed on these results. None of these numbers come as a surprise and are explained more fully in last week's column. It is also entirely possible that these numbers may remain in a funk for another couple of months.

Employment Could Be Up for January
Next week brings lots of data, but Friday's employment number is the big kahuna. I was optimistic that we would see job growth in December (and I was wrong), but I think January may be the charm that breaks the economy out of its employment funk and into the more welcoming landscape of job growth.

If January falls short, growth will happen sometime during the first quarter. My optimism is based on the various purchasing managers' survey employment components. The Chicago report was particularly optimistic, as I noted above. Offsetting the positive hiring news was the announcement this week of some high profile layoffs including some at  Wal-Mart (WMT).

Monday we will see monthly personal income and savings numbers for the month of December (this week I analyzed the full fourth quarter numbers). I suspect personal income will be up 0.4% from the previous month. Also on Monday is the ISM's purchasing manager survey--that should increase to 56 or more from 54.9, based on the strong regional reports I've looked at so far this month.

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