Don't Be Fooled by the GDP Report: The Economy Is Gaining Strength

As I warned in my last column, there was indeed economic news for both the bulls and the bears to feast on this week. On the surface, the negative GDP growth report was a disaster. The GDP growth rate shocked everyone with a 0.1% decline--although closer examination suggests that government bill payers and overly cautious businesses were largely to blame for an otherwise excellent report. 

In housing news, falling pending home sales and increasing Case-Shiller Price Index readings were part and parcel of the same issue: not enough inventory of homes, new or used. In fact, the new biggest threat to my economic forecast is that there aren't enough land, materials, or labor to truly step up housing starts.

While the January employment report was satisfactory and proved that no one panicked in the first month, the real news was a massive adjustment to the employment database, suggesting that we added hundreds of thousands more jobs to our economy over the last two years than was previously thought. Still, we have recovered just 5.5 million of the 8.7 million jobs lost during the recession and are only adding jobs at a 2.1 million annual pace. Though manufacturing isn't generally important enough to move the economic needle, news this week was surprisingly and uniformly positive. Excellent auto sales for January should also prove to be encouraging news for the economy and the manufacturing sector. (Now, if only  Boeing (BA) could get its act together.)

GDP Probably Not Worth the Analysis
The GDP report was a bit more confusing and convoluted than even I had hoped. And I was wrong, too, which always hurts. In fact, I didn't even get the direction right. However, I would suggest that the report has potential to move from negative to positive with two upcoming revisions. The first version of the report suggests the economy shrank 0.1% in the fourth quarter versus growth of 3.1% in the third quarter. This missed consensus forecasts for 1% growth, and my more optimistic 1.5%.

While I identified the government as a key potential detractor from the report well over a month ago, I wasn't even close to the magnitude of the impact. Inventories were the other big surprise in the report, further reducing GDP. Businesses appear to have failed to keep up with the pace of consumer spending, and they will have to make up for that in the months ahead.

GDP Report on a Roller Coaster, Real Economy Not So Much
The GDP report probably deserves a little context for those who don't deal with this grab bag of statistics on a regular basis. The table below shows the extreme volatility of the report and the almost universal phenomena of a bad quarter following a great quarter and vice versa. See if you can't discern that very trend in the table below:

Slow Government Spending and Inventory Shrinkage Overwhelms Great Consumer Data
Consumption grew a quite remarkable 2.2% (and represents 70% of GDP), far exceeding the 1.6% rate of the third quarter. Business investment, another important marker, also did far better than expected, growing by about 8%. Not bad for the cliff-obsessed business community (turns out that maybe the media was more obsessed than either consumers or businesses).

Housing did better than anticipated, growing 15%, its best showing of the recovery. The thankfully not-too-big government sector (20% of GDP) had shrunk an almost unprecedented 6% (of course, that is 1.5% for the quarter multiplied by four to get to an annual figure--perhaps exaggerating the effect). Looked at another way, slower government subtracted 1.3% from the GDP calculation. Inventories, another sore spot, also took away 1.3% from the GDP report. Net exports didn't have nearly the impact that many had feared, subtracting a mere 0.25% from GDP. 

Nothing from the report dissuaded me from my general optimism about the economy for the year ahead. My only fear is that it spooks reporters and consumers. I fielded at least a half-dozen reporter calls wondering if markets had gone mad with GDP down and the Dow touching 14,000 in the same week. Actually, the markets took the seemingly bearish but actually bullish GDP report in relative stride, and made the correct interpretation.  However, the bears will have the data at their back, at least for a few weeks. Bad weather, a bad GDP report, a temporary shortage of home inventories, and the increased payroll tax and tax refund delays are all likely to weigh on upcoming economic reports. These reports are likely to make it appear that the bears have the upper hand. Don't be fooled. The underlying strength in the economy is pretty clear if you look carefully enough.

Employment Report Contradicts Week GDP Report
The key takeaway from the employment report is that employment growth was exceptionally strong in the fourth quarter, something that would seem highly unlikely given the weak showing in the GDP report. Also, the government finally found at least some of the missing construction workers (which had previously failed to show up in employment reports despite accelerating housing starts). This and a huge revision in retail sales workers caused the government to sharply revise total employment growth for 2012, as shown in the table below:

The scope and variety of revisions make much of a detailed discussion of the month-to-month data nearly worthless. That said, construction and retail were standout performers while most other categories didn't show meaningful changes and were close to recent averages. Courier services, a volatile and difficult to calibrate category, produced an outsized decline of almost 20,000 jobs, which is likely to be reversed in the months ahead. The government lost employees yet again, this month losing 9,000 jobs. While long-term construction and retail numbers were revised upward, government took a meaningful hit in the revised data set. I am not particularly hopeful that government employment will look much better in 2013. Changing gears, cold weather didn't help the January employment results, either, especially compared with a year ago. Discouragingly, it doesn't look like February is going to be much better, weather-wise.

The January employment data was not as good as November and December with slower overall growth rates, flat hours worked, and better wages per hour. However, I am not a big believer in the huge November spike of 256,000 jobs added. I don't think we had this huge increase (in the face of an unresolved fiscal cliff) and then stumbled in December and January when the cliff issues were at least temporarily pushed aside. Rather, I think you need to look at a combined three-month period of data, as I have in the table above.

Personal Income Growth Artificially Inflated by Special Dividend Payments
The personal income and consumption report for December was one of the reports I was most looking forward to this week. Unfortunately, the government managed to muck up the report with a number of manual adjustments for special dividends issued to beat the 2013 tax increases as well as some accelerated bonus payments. These made the personal income growth data look laughably large with inflation-adjusted incomes jumping a stunning 2.8% for December compared with November. That is more income growth than we would normally get over an entire year. Excluding an approximation for the special dividends paid, personal income grew a more logical 0.6%. The government also made a special adjustment for accelerated bonus payments, but a combination of manual adjustments for the impact of Hurricane Sandy in October and accelerated bonus payments in both November and December came close to offsetting each other.

The dividend adjustment so swamped the report that even my three-month average techniques could not fully remove the impact. Therefore, I have excluded an approximation of the special dividends payment in the table below. I also removed the manual wage adjustments. The data and the relationship among total income, wages, and spending seem to make a lot more sense when I make those adjustments.

Unfortunately, the large special positive factors in December will turn into massive detractors in January. Personal income in January should be down more than 2%, reflecting the lack of special dividends. Again this is money that was paid a month or two early and doesn't represent a genuine gain and subsequent loss of income. That's even before the massive impact from a higher payroll tax in January. However, the data above shows that consumers spent absolutely zero of the December windfalls, so I doubt that there will be much curtailment in spending in January. Frankly, the weekly shopping data already suggests that January has continued see at least some spending growth despite the new array of taxes. Auto sales, too, suggest a smaller payroll tax effect.

Wage Growth, not Adjusted for Inflation, Explains Much of the Consumption Stability
Wages, not adjusted for inflation, have been a lot more stable than inflation-adjusted data. Except for a couple of year-end impacts, wage growth has been steady at 3% year-over-year growth. Inflation has been the real up-and-down influence on inflation-adjusted wages. It appears that when consumers feel inflation is going to be temporary, they dip into their savings and spend a little more rather than adjust their spending. Likewise, when prices collapse (as they did throughout the fourth quarter) they didn't go on a spending rampage, either. The fact that all consumers don't buy the complete basket of goods each month explains some of this. Only a few consumers buy an airline ticket or a car in a given month, so many consumers may not have even noticed the spike experienced in some of these categories.

As volatile as a lot of big-picture data has been, the consumer has been rock steady, as the table above shows. Consumption growth for each and every month of 2012 was either 1.8% or 1.9%. You just don't get much steadier than that. Likewise, the employment data has shown strong, consistent improvement in every month of 2012. Yet, to pick on just one data point, GDP growth ranged from negative 0.1% to 3.1% during the four quarters of 2012. I ask you, in which of these two worlds are we really living?

Manufacturing Activity Picks Up Yet Again
This week was bracketed by more good news from the manufacturing sector. At the beginning of the week, new orders for durable goods showed a surprising spike while the ISM Purchasing Managers' report on Friday also took the Street by surprise with a meaningful increase. The ISM data is closely watched (but a nearly useless indicator, at least at this part of the economic cycle). That said, durable goods orders and the many variants of the report were quite strong, and the report has grown increasingly hard to interpret because of the outsized influence of planes and cars and huge volatility. The headline new-order growth rate was 4.6% (that's month to month and not annualized), with much of that being driven by Boeing orders. Even stripping out Boeing, orders were still up 1.3%, which was ahead of consensus.

Markit and ISM Data Confirming Each Other and a Stronger Manufacturing Economy
Confirming the flash results from Markit that I discussed last week, the ISM purchasing managers' report jumped from 50.2 in December to 53.1 in January, handily beating consensus forecasts. Given continued strong consumer purchases and some improvement in China, a rebounding manufacturing sector comes as no surprise to me. If consumers buy, manufacturers don't have much choice but to build more. However, the GDP report does suggest the manufacturers badly misgauged consumer demand in late 2012 and had shrunk inventories when they probably should have been expanding them. This could reverse itself in the first quarter, providing a boost to otherwise difficult numbers. A rather broad base of indicators suggests that the worst of the 2012 manufacturing pause may be behind us. This is especially true if housing starts continue to kick up.

Auto Sales Fail to Reveal a Panicky Consumer
Despite what consumers may be telling market researchers at the Conference Board or the University of Michigan, consumer spending spigots remain open. I had some concerns that the auto sales forecast for January might have been a little aggressive. I am delighted to say that I was wrong. According to Automotive News, the seasonally adjusted annual sales rate for new cars and trucks was 15.28 million units. That is darn close to the highest month for 2012 (November at 15.5 million, which was aided by restocking after Hurricane Sandy). Some large seasonal factors certainly helped January, but weather was not nearly as agreeable as it was a year ago. Nevertheless, sales were up 14% January to January. While January isn't a particularly predictive month or even a very large month for auto sales, the 15.0 million-15.5 million unit sales forecasts for all of 2013 looks like a chip shot from here.