Equities and Growth
At first glance, there seems to be a disconnect.
As this writer noted two weeks ago, US equity markets have been rallying, to multi-year highs. This month alone is the best January for the S&P 500 index in some 24 years (up 5% from the end of 2012, and 14.5% from a year ago). For the first time in five years, funds are just beginning to flow out of the safety of US Treasury bonds (with prices dropping, and, hence, yields rising) into equities. As the S&P 500 goes this month, so goes the rest of the year (so says the January Barometer, a consistent indicator). And, further, it's not just the US financial markets that have exhibited recent strength - so have Chinese, Japanese, and even European markets.
But yesterday's first estimate of fourth quarter US GDP suggests a stalling economy, with overall output actually declining by 0.1% at an annual rate (the consensus prediction was for an expansion of 1.1%). In this weak economic environment, are financial markets irrationally exuberant?
The simple answer is no. Investors are looking beneath the headline GDP number, focusing instead on the components of the aggregate. The principal contributor to the fractional drop in GDP, other than a big swing in business inventories, was government spending, which fell at a 6.6% rate, as defense outlays dropped 22.2%, reflecting concerns over the pending fiscal cliff of scheduled tax hikes and, particularly, large budget cuts to defense. In contrast, private consumption (which accounts for two-thirds of the economy), business fixed investment, and residential construction all grew at an accelerating rate from the previous quarter. The continued strength in business investment is especially significant, given that such investment is widely recognized as being closely correlated to both employment and, more importantly, labor productivity (that is, the amount of output obtained per unit of input). With this relative buoyancy in the private sector, US corporate earnings currently being released for the fourth quarter, as well as outlooks for the coming year, are mostly beating expectations. And ultimately, it's earnings and their multiples - which have room to expand - that drive stock prices.
This is not to deny ongoing concerns. These can be described in two words - policy risks - emanating from Washington. Thus, the sequester ( large, and blunt, government expenditure cuts) now scheduled for March 1 could, if implemented, produce several further quarters of anemic GDP growth, or contraction. And then there are the postponed, but impending, debt-ceiling and federal budget negotiations, either or both of which could lead to another credit downgrade of American debt. Financial markets would not react well should this occur.