U.S. real GDP expanded at an as-expected 2% annual rate in the third quarter in what is turning out to be a classic case of a muddle-through economy. Inching ahead but not at a fast enough pace to have any meaningful impact with regard to addressing the unprecedented amount of excess slack in the labour market.

 

To be sure, 2.0% is fractionally better than the 1.7% pace posted in the second quarter when double-dip risks began to surface. And, while a plus sign front of any GDP print may be viewed as constructive in some circles, this is an anaemic pace for this stage of the cycle because it is completely abnormal to be seeing the economy slow down heading into the second year of a recovery phase. On average, at this juncture, real GDP growth is accelerating, not decelerating, and typically advancing at a 5% clip, not 2%.

 

The major problem in the third quarter report was the split between inventories and real final sales. Nonfarm business inventories soared to a $115.5 billion at an annual rate from the already strong $68.8 billion build in the second quarter — this alone contributed 70% to the headline growth rate last quarter. If we do get a slowdown in inventory investment in Q4, as we anticipate, it would really not take much to get GDP into negative terrain. We estimate that if the change in inventories slowed to about $94.0 billion in Q4 (about $22 billion below Q3 levels), GDP would contract fractionally. In other words, it won’t take much for GDP to slip into negative terrain.

 

It would have been much more encouraging to see real final sales — the rest of the economy — do better than the tepid 0.6% annual rate gain that was posted. And that 0.6% annualized growth rate in real final sales follows a string of exceptionally weak performances — 0.9% in Q2, 1.1% in Q1, 2.1% in Q4 of last year, 0.4% in Q3 2009 and 0.2% in Q2. Historians will note that this goes down as the weakest recovery in real final sales on record, despite the fact the economy has been on the receiving end of the most pronounced dose of fiscal, monetary and bailout stimulus ever. Quite an accomplishment.

The recession may have technically ended, but outside of inventories, and the best days of the re-stocking process look to be behind us, this has been a listless recovery. At 60 basis points above zero, real final sales are just a shock away from double-dipping — a shock like looming tax hikes, accelerating fiscal cutbacks at the state/local government level or the millions of “99ers” about to fall off the extended jobless benefit rolls at the end of November.

In terms of components, the good news was that consumer spending did accelerate to a 2.6% annual rate from 2.2% in the second quarter — the best performance since Q4 2006. Non-residential construction eked out a 3.8% annualized gain, the first advance since Q2 2008. But the good news pretty well stopped there.

 

 

Capital spending came in at a decent 12% annual rate, but the momentum is clearly receding after the 20%-plus growth rates of the prior two quarters. And, as we saw with the core capex orders for September, business spending intentions are coming off the boil. Residential construction collapsed at a 29.1% annual rate in response to the expiry of the tax credits, the steepest decline since Q1 2009, and there appears to be little recovery in sight, though it stands to reason that we won’t see another decline of this magnitude again, at least not over the near-term. At some point inertia sets in, even on the moribund residential real estate sector.

 

It is also no surprise to see imports bulge when inventories did the same, but what caught our eye in the external trade portion of the GDP report was the sharp slowing in export growth, to a 5% annual rate trend — half the pace we saw in the first half of the year. Weren’t the overseas economies supposed to be providing a big lift to the U.S. economy?

 

Finally, state and local government spending dipped 0.2% — the fourth decline in the past five quarters. At a 12% share of the economy, this sector is nearly twice as large as business spending, and can be expected to be a dead-weight drag on the economy as far as the eye can see.

 

Here is the bottom line: the double-dip has been delayed but not derailed; despite widespread cries from the economic elite to the opposite. The economic recovery is extremely fragile and unless we get an improvement in real final sales, all it would take would be a modest inventory drawdown to pull real GDP back into contraction mode.

 

GROSS CALLS END OF BOND BULL MARKET ... AGAIN

 

Okay, I did not really want to respond to the Bond King’s latest musings on the bond market and how the Fed has established the end to the bull phase. But it is interesting that the very asset class the Fed intends to buy is the asset that will end up declining in price — sort of like in the old days how the Fed would cut the funds rate and then expect it to rise.

 

PROFITS AT THE MARGIN

 

If anything has managed to post a V-shaped recovery since the dark days of 2009, it is profit margins. Indeed, margins do have this nasty tendency of mean-reverting, and they will again. The question is, what will be the catalysts? Very quickly, I highlight them below:

• The U.S. economy is poised for huge deceleration and still accounts for 60% of the profit pie.
• Material costs are heading higher with limited pass-through potential at the consumer level.
• Pension and health costs are huge headwinds in coming quarters/years.
• Productivity growth is slowing visibly

 

WHEN BULLISH IS BEARISH

 

The “equity market can only go up” has certainly been the dominant thinking for the past two months, but it has now become a totally crowded view. Actually, too crowded, and hence vulnerable, even to mundane pieces of news like a leak that the Fed will “only” start off by buying $200 billion of bonds. What people need to know is that:

• The latest AAII poll (American Association of Individual Investors) shows 51.6% bulls as of the past week (up 1.6 percentage points) while the bears dwindled to 21.6% (down 3.6 percentage points). The long run averages are 39% and 30%, respectively. The market typically experiences trouble at bullish readings above 50%.

• The II (Investors Intelligence) poll flagged 45.6% bulls this past week and 24.4% bears. There are nearly twice as many bears as there are bulls. History shows that the market struggles when this bull-bear "spread” breaks above 20% and tends to recover quite nicely when it is sub-zero.

 

CLAIMS PLUNGE BUT TOO EARLY TO GET EXCITED

 

The good news: U.S. initial jobless claims plunged 21k to 434,000 for the week of October 23, much better than expected. This is the lowest level since July 2010 and the four-week moving average moved down to 453,250 from 458,750 the prior reporting week. The improvement was tempered slightly by an upward revision to the prior week’s result, now 455k versus 452k initially.

 

However, this week’s number should be taken with a few grains of salt before extrapolating about how the labour market is improving. First, before we launch into technicalities, it pays to note that this improvement was at odds with the Conference Board’s employment indicators (where the spread between ‘jobs plentiful’ and ‘jobs hard to get’ worsened to nine-month lows). So, the number didn’t exactly pass the sniff test.

 

The second point has to do with the seasonal adjustment factors surrounding the Columbus Day holiday, which is notoriously difficult to adjust. Historically, claims remain very volatile for several weeks after the holiday, so beware of some potentially large swings over the next few weeks.

Columbus Day fell later than usual and when we analyzed the seasonal factors around the holiday and the weeks surrounding it over the last decade or so, we believe the seasonal factor was too aggressive. In other words, about 20-25k of the improvement in claims was model related — hardly organic improvement. If history is a guide, we should see claims drift higher over the next weeks, in the 450-460k range.

To continue reading, go here (free site registration required).

(c) Gluskin Sheff

www.gluskinsheff.com