The Shifting Tide of Economic Growth

Investors endured another volatile week on Wall Street courtesy of yet another round of European uncertainty with, again, a positive ending at the end of the week (at least when I went home on Friday night). Whatever happens, I don't believe a weakening European economy is enough to sink the United States economy, although the potential impacts on the worldwide banking industry should give anyone pause before making aggressive investments. Frankly, no one knows the state of the banks for certain. But, I would wager, the U.S. banks are in much better shape now than they were going into the recession at the end of 2007. I can't say the same for the European banks, which were not recapitalized as aggressively as their counterparts in the U.S.

Trade and Jobs Look Slightly Better
On the economic front, the U.S. trade deficit improved modestly, potentially aiding third-quarter GDP revisions. The improvement came despite a slowdown in exports to Europe. There were also a number of minor employment reports this week that seemed to indicate a continued improvement in the U.S. job market. Reported job openings were at their best level since 2008. On the negative side of the ledger, the European Commission took a hatchet to their 2012 growth estimates while retaining their 2011 outlook.

The limited flow of U.S. economic data this week allows me a little time to talk about two themes: a shifting in the source of U.S. growth and the potential divergence between U.S. GDP growth and S&P 500 operating margins.

Sources of GDP Growth Shifting Quickly
While I was out in September and October, GDP numbers were revised, and we received the first estimate of the third-quarter's GDP growth rate. The report came in a lot higher than the consensus when I left and basically in line with my more optimistic outlook.

However, the composition of GDP growth has shown a major transition over the past two quarters. This week's economics video highlighted that changes are occurring in economic patterns that had been in place since the beginning of the recovery. Exports are no longer the key driver of the U.S. economy, services are finally outperforming manufacturers, and inventory changes are now hurting economic growth instead of helping. Even construction--both business structures and residences--has managed to stop hurting economic growth. The table below shows how some of those effects are moving GDP growth rates.

Don't Confuse Economic Bullishness with Stock Market Bullishness
I can tell from my comments section that some readers believe because I am bullish on the economy, I must be bullish on stocks. First, I generally like to leave the stock-picking and individual stock valuation to our team of analysts. My charter here is usually to comment on the economy. That said, I think we could see at least a brief period where the economy performs better than both corporate earnings and the stock market. Strong overseas growth has enabled revenues and earnings growth for multinational corporations to expand dramatically faster than the U.S. economy. With slowing non-U.S. growth rates, I suspect that overseas exposure is going to begin to harm some corporations instead of help. I'll explore that phenomenon later in this article.

Are Consumers Gaining the Upper Hand?
Second, I suspect corporate margins could begin to shrink as consumers start to gain the upper hand. Consumers are fighting every price increase tooth and nail, with the possible exception of the very high end of the market. The most recent example comes in the banking industry, where a pushback by consumers forced several major banks to cancel proposed increases in debit card fees.

Another example of consumer price sensitivity is the market for gasoline, which saw declining volumes for three quarters in row as prices rose. Then volumes increased modestly in the third quarter when prices fell. Below I update a previously published table that shows how strongly consumers react to price changes for both big-ticket items like cars and small-ticket items like apparel.

Trade Deficit Falls in September, August Revised Downward
The U.S trade deficit fell to $43.1 billion in September from $44.9 billion the prior month (August's deficit was revised down from $45.6 billion too). The falling deficit was the result of exports growing faster (+1.4%) than imports (+0.3%). The expectation had been for a deficit of $45 billion. At the quarterly level, the deficit shrank from $145 billion in the June quarter to $133 billion for the third quarter and was virtually unchanged from year-ago levels. The deficit is running considerably below where it was prior to the last recession.

The trade deficit came in meaningfully below what the government had expected when they made their first estimate of third-quarter GDP. The revision, taken by itself, could result in real GDP growth for the third quarter being revised up to nearly 3% from 2.5%. However, a surprise fall in inventories, which was not in the official first GDP estimate, is likely to erase a good part of that gain.

The report did show that the European crisis was beginning to affect trade. While exports to Europe grew a robust 5.9% in the month of August, that growth rate was just 0.5% in September.

Europe Brings in Its Growth Expectations
Speaking of Europe, this week the European Commission cut its inflation-adjusted GDP growth rate estimate for 2012 from 1.8% (projected this spring) to a meager 0.6%. The decline is a combination of government austerity programs and poor private sector demand as consumers lose confidence.

Interestingly, this seems to be a slow-acting crisis: The growth forecast for 2011 was virtually unchanged at about 1.5% between the May and November forecast dates. None of the three largest economies in the eurozone (Germany, France, and Italy) is expecting growth better than 0.8%. Portugal and Greece are expecting outright declines. For comparison, last month the U.S. Federal Reserve reduced its U.S. GDP growth rate forecast to a range of 1.6%-1.7% for 2011 and 2.5%-2.9% in 2012, both down meaningfully from their June forecasts.

A Weak Europe Will Hurt S&P 500 Companies More than U.S. GDP
I have said many times that I don't believe a weak Europe by itself could ruin the U.S. recovery and overall GDP growth. Total exports to Europe account for just over 3% of the U.S. GDP, much of that being necessities such as food, and those revenues aren't going to go away unless things get really bad in Europe. 

However, the situation may not be as positive for U.S. multinationals. Many of these firms derive 20%-40% of their revenues from Europe. Since many of those goods are produced in Europe or in other non-U.S. markets, they are not counted in the U.S. GDP calculations and don't directly add to U.S. employment. Therefore, a weak Europe could significantly affect U.S. companies even if it doesn't make a dent in U.S. GDP growth rate. This is the exact opposite of what we have seen over the past several years as revenue growth and earnings at S&P 500 companies has far outstripped U.S. GDP growth rates.

Employment News Looking Better this Week
There were three data points this week that suggested continued improvement in the employment market, albeit at a glacial pace. Initial claims for unemployment fell to 390,000, one of the lowest readings of the year, and even the four-week moving average touched the 400,000 mark for only the second time during this recovery. Even if businesses aren't going crazy with hiring, it appears that layoffs continue to slow.

Second, a number of stores appear to be expanding their hours in an attempt to lure more shoppers. Target (TGT) is among those opening for more hours around Thanksgiving. And late and early hours around the Veteran's Day holiday seem to be a new fixture on the retail scene. This should help either employment data or the hours worked portion of the monthly labor report.

Finally, the Labor Department's job openings report showed a rise in job openings from 3.13 million jobs in August to 3.35 million jobs in September. That number is up 22% from year-ago levels but still well shy of the 4.15 million openings at the top in 2007. Nevertheless it is still the highest reading since August 2008.

Inventories Still Under Control
I usually don't bother to comment on inventory data, but it doesn't appear that inventories are ballooning as they often do going into a recession. The inventory/sales ratios across manufacturers, wholesalers, and even retailers appear to be under very tight control. Inventory/sales levels are basically where they were at the beginning of the year and have barely budged. If demand were to pick up much from here, I think some companies would be hard-pressed to meet it. 

The only bad news about low inventories is that this tends to depress GDP (the P is for production, whether an item is sold to a final customer or it gets stuck in inventory it is counted in the GDP calculation). The slower build in inventory levels trimmed over 1% off of the third quarter's GDP report, and a series of recent inventory reports suggest that inventory trimming will take even more off when the third-quarter GDP is revised again at the end of the month.

Prices, Manufacturing, Housing, and Retail Sales on Tap for Next Week
I think the biggest news next week will be a dramatic slowing in the rate of inflation. The consensus believes that both consumer and producer price indexes will be flat for October, marking the third consecutive monthly slowing in the rate of inflation. Though consumer incomes have done better on the surface, when one adjusts for inflation, those gains disappear. We desperately need a few more months of restrained inflation to put consumers back in the driver's seat.

Retail to Slow After Last Month's Boom
Based on falling gasoline prices, modestly softer data from the International Council of Shopping Centers, and an unusually favorable September, I don't think Monday's official government retail sales report will be anything to write home about. Growth was a stunning 1.1% for the month (not the year) of September and the consensus believes that we won't do much better than 0.2% for October, which still isn't awful given my low inflation forecast.

Housing Starts Likely to Fall
Housing starts were shockingly strong at 658,000 annualized units in September on the back of the very volatile apartment sector. That isn't expected to persist in October. Consensus is for housing starts of 605,000, not far off of recent trends. This doesn't move the economic needle either way.

Manufacturing Should Look a Little Better
I suspect news will be a little better on the manufacturing front with the industrial production figures expected to show 0.4% growth after last month's lethargic 0.2% rate (I am assuming it's too early for Thailand-related supply chain issues to have much impact yet). Next week's regional purchasing managers' reports could look a little better than they did in the previous month, but not by a lot. These reports tend to be relatively volatile. Slightly negative news out of any of these reports probably wouldn't change my overall economic outlook.