Although the market celebrated today’s releases on weekly unemployment claims and the ISM Manufacturing Index, the trajectory of this weak economic recovery has probably not changed. Both of these indicators are affected by the difficulty the government has in gauging the seasonal adjustment factors in this part of the year as a result of the timing of the annual auto industry shutdowns for re-tooling. In our view the 1st and 2nd quarter GDP results offer a much more representative outlook for an economy that seems to be losing steam rather than picking up as most observers believe.
The unexpectedly large increase in the ISM Index was propelled mainly by a 6.4% rise in orders and an 11.6% jump in production. On a seasonally unadjusted basis the respective increases were -1% and +2%. While these were both better than usual for July, the seasonal adjustments, as compared to the past, seem unusually generous, and the reported number is most likely an outlier that also appears inconsistent with most other economic reports. Similarly, the weekly unemployment claims number is usually choppy in July, and we would take it with grain of salt unless it is confirmed in subsequent weeks.
The GDP results for the first half are a more accurate indicator of how weak the economic recovery has become. While 2nd quarter growth of 1.7% was a mild upward surprise over expectations, 1st quarter growth was marked down to 1.1% from a previously reported 1.8% and a preliminary report of 2.4%. Even so, there is reason to believe that the 2nd quarter was actually weaker than the 1st. An unexpectedly large rise in inventories accounted for 24% of 2nd quarter growth, while consumption was up only 1.2%, compared to a still anemic 1.5% in the prior quarter. Final demand was up only 1.3% in the 2nd quarter and 0.3% in the 1st. The need to work off the excess inventories will tend to impede second half growth. In addition government spending was down less than expected, indicating that further layoffs related to the sequester are still ahead. We note that GDP would have to rise 3.5% in the 2nd half in order to meet the Fed’s last forecast.
Another factor to consider is that nominal 2nd quarter GDP growth of 2.39% was actually lower than the 2.83% reported in the prior quarter. The adjusted result was based on applying a price deflator of only 0.71% in the 2nd quarter, down from 1.67% in the 1st. Had the same deflator been used in the 2nd quarter, real GDP growth would have been only 0.7%.
In assessing the prospect for growth, it is also important to mention the much-discussed concept of “stall speed”, the point at which the economy can no longer maintain momentum and, therefore, falls into recession. In post-World War II recoveries whenever the 4-quarter growth rate of GDP has declined to below 2% the economy has gone into recession within a short time. In this regard, it is noteworthy that 2nd quarter GDP growth was only up 1.4% from a year earlier. This does not bode well for the widely expected pickup in the 2nd half, particularly in view of the headwinds from the coming political fight over the budget and debt limit, the possible tapering of QE, and the numerous problems facing the global economy.
In our view the stock market is overvalued, overly bullish and in a state of denial about the shaky economic recovery. We believe that the potential for a severe downturn is too great to ignore.