US Perspectives: It's All in the Hands of Inflation Now

Inflation continues to take a toll, but consumers haven't flinched just yet.

Robert Johnson, CFA 04.05.2011
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The big news last week was Thursday's GDP report. While the headline growth rate of 1.8% was in line with expectations (and below the fourth quarter's 3.1%), there was a lot of positive news imbedded in the report.

 

The slowing was due largely due to shifts in government defense spending and weather-related construction spending. Meanwhile, consumer spending fell far less than expected, and growth in business spending on equipment and software actually accelerated in the first quarter.

 

In other words, consumers' haven't flinched just yet. However, inflation continued to take its toll on both businesses' and consumers' incomes. The devastating effects of inflation showed up in the earnings reports of many consumer products companies, including Procter & Gamble and Clorox, who both reported lower-than-expected margins due to rising commodity inputs.

 

Consumer income reports continue to show healthy top-line growth, but when adjusted for inflation, incomes grew at a weak 1.2% annualized rate during the month of March. The trajectory of the income for the year ahead will be determined by the long-term trend of inflation. Who will ultimately prove right: Ben Bernanke and the Fed, who believe the commodities-driven inflation bubble will pop by year's end, or the commodities markets themselves, which seem to be expecting inflationary disaster? It seems to me that better agricultural conditions, increased supply of some raw materials, and a slightly softer economy might have a shot at containing inflation to current levels. So far, consumers have been coping better than I would have expected.

 

Government Statistical Reports Catching Up to the Real World

The last few months, the economic data reported by the government haven't jibed well with other private reports, Morningstar's analytical staff analyses, and corporate commentaries. In previous column I highlighted why the economy might be stronger than the normally comprehensive and rigorous GDP report might suggest. I highlighted a number of variables ranging from employment to retail sales to purchasing manager data that suggested the economic activity was accelerating and not decelerating as a number of government reports suggested. Two major reports were revised last week to the point of being unrecognizable. The government didn't even get the positive/negative sign right in some instances. Real consumer spending that was allegedly down in January (by 0.04% to be exact) was revised to a positive gain of 0.13%. For February, the government got the sign right but the magnitude of the revision was even bigger, revised to a gain of 0.48% from 0.25%. The durable goods order report for February initially had the wrong sign as well.

 

After the report on February data, I wrote in my March 26 column, "New Orders for Durable Goods Puzzlingly Weak." This month, the February data were revised from a decline of 0.6% to a gain of 0.7%.

 

My point here is not to make fun of the government's statistic mills. Their jobs are thankless, complicated, and based on data submissions that are often less than complete. Rather, I am encouraging our readers to look at a breadth of data to form their opinions on the economy. Headline writers sometimes grab just one month's numbers without looking for the details of the reports, the revisions, and the context of what corporate America is saying.

 

Another problem with data revisions is that they sometimes cause the most current month to look like a disappointment. For example, the latest consumer spending number of 0.2% growth was termed disappointing by some because it "just matched" expectations and represented a sharp slowdown from the 0.5% number for February. Well of course the growth will look less robust when the previous month's growth estimate was doubled. When one does the entire math, the March consumption number (total dollars) was considerably above expectations. All of this leaves aside the point that the government has noticeably underestimated consumption growth for several months in a row and may again have to revise up March's number.

 

Consumer, Business Investment Portions of GDP Report Surpass Expectations

While headline GDP growth of 1.8% in the first quarter may have been relatively uninspiring, the details of the report showed surprising strength. The U.S. consumer, who was widely expected to show spending growth of 1.0%-2.0%, showed a surprising 2.7%, not that far off the 4% of the fourth quarter. Given my fundamental belief that the U.S. consumer is the key driver of economic performance, this strong performance in light of all the headwinds renews my confidence in my 3.5% growth forecast for all of 2011. Growth in business investment spending was up 11% in the first quarter, up from the fourth quarter's 7% growth report. I had suspected this portion of the GDP report might have been stronger than expected based on strong reports out of the tech sector. Therefore, the two most important parts of the GDP report did better than expected: consumer and business investment spending. Net exports, while a negative for the quarter, were not as bad as feared.

 

Government and Construction Weigh on GDP Temporarily

What all the nay-sayers missed in the GDP report is that if one adds back the negative 1.1% GDP contribution from government, that GDP in the first quarter would not have been much different than it was in the fourth quarter. Government spending was indeed down about 5% (which comprises about 20% of GDP) for the quarter. However, a healthy portion of that was a decline in federal defense spending that may well prove to be transitory. Don't get me wrong--state and local governments were down, too. But they accounted for less than half the decline in government spending.

 

Weather appeared to be the key culprit in disappointing commercial and residential construction results. Business-related construction took almost 0.6% off of the GDP number, and residential construction, despite its miniscule representation in the GDP calculation, managed to take 0.1% off of GDP. Both categories were small contributors to GDP in the fourth quarter. Based on comments from our industrials team earlier, commercial construction already appeared to be on the mend by the end of March.

 

Consumer Goods Spending Powers the Quarter as Exports Wane

Below are two different tables that I used to analyze GDP growth. The first table breaks down the contribution to GDP by category. This table effectively weights the actual growth by how much it represents of GDP. So while the equipment and software category grew by 11%, its contribution was less than the consumer goods category, which grew only 5% but represents a larger portion of GDP. The key takeaway from this table is that the consumer goods category continues to be the key driver of this recovery, while the positive effects of exports appear to be waning.

 

Consumer Spending on Physical Goods Continues to Dominate GDP Growth

 

1Q 2009

2Q 2009

3Q 2009

4Q 2009

1Q 2010

2Q 2010

3Q 2010

4Q 2010

1Q 2011

Whole Recovery

Consumer Goods

0.4

-0.3

1.6

0.4

1.3

0.8

0.9

2.1

1.1

2.2

Consumer Services

-0.8

-0.8

-0.2

0.3

0.0

0.8

0.7

0.7

0.8

0.8

Business Structures

-2.0

-0.8

-0.4

-1.0

-0.5

0.0

-0.1

0.2

-0.6

-0.4

Equip & Software

-2.5

0.0

0.3

0.9

1.2

1.5

1.0

0.5

0.8

1.6

Residential Construct

-1.2

-0.5

0.3

0.0

-0.3

0.6

-0.8

0.1

-0.1

-0.1

Inventory

-1.1

-1.0

1.1

2.8

2.6

0.8

1.6

-3.4

0.9

1.4

Exports

-3.6

-0.1

1.3

2.6

1.3

1.1

0.8

1.1

0.6

2.2

Imports

6.5

1.6

-2.7

-0.7

-1.6

-4.6

-2.5

2.2

-0.7

-2.7

Government

-0.6

1.2

0.3

-0.3

-0.3

0.8

0.8

-0.3

-1.1

0.0

Total GDP Growth (annualized)

-4.9

-0.7

1.6

5.0

3.7

1.7

2.6

3.1

1.8

 

Total Recovery
GDP Growth

 

 

 

 

 

 

 

 

 

4.9

Highlighted in red are two best categories for the period.

Source: Bureau of Economic Analysis, Morningstar Calculations

 

Business Investment Grows the Fastest, Consumer Services Accelerating

Just looking at the growth categories doesn't necessarily tell you much about their impact because the categories are so different in size. This is why I always place the contribution table first. However, sometimes it's a lot easier to spot trends by looking at the raw growth rates by category. The key takeaways from the second table are that both business spending and consumer services spending accelerated from the fourth quarter to the first quarter. The recovery in the services category has been lackluster this recovery, so I was pleased to see some improvement this quarter, especially since it is the single largest category in the list below.

 

Spending on Equipment and Software Wins the Growth Prize

Annualized % Growth
by Category

4Q 2009 (%)

1Q 2011 (%)

Consumer Goods

9.0

4.7

Consumer Services

1.5

1.7

Business Structures

7.5

-23.9

Equipment & Software

7.5

11.1

Residential Construction

3.2

-4.2

Inventory

NA

NA

Exports

8.3

4.9

Imports

-13.2

4.3

Government

-1.7

-5.4

Total GDP Growth (annualized)

3.1

1.8

Total Recovery GDP Growth

 

4.9

Source: Bureau of Economic Analysis, Morningstar Calculations

 

Inflation-Adjusted Personal Income Data Softening More Than I Like to See

Last week we also received the personal income and spending report, although most of the data in those reports were included in the GDP report released the previous day. The key theme in this report is that over time, consumers tend to spend what they earn, but that isn't necessarily true on a monthly basis. Over the past six months, real disposable income grew at a 2.6% annual rate while spending grew modestly faster at 3.3% (both adjusted for inflation). While nominal (not adjusted for inflation) incomes have continued to move ahead at the same steady pace as last year, rising inflation is beginning to corrode some of that growth. A single month of "apparently" healthy income growth in March of 0.6% turned into a measly 0.1% rate when the inflation adjustment is made. Either inflation has to begin to moderate--as the Fed hopes--or incomes have to begin growing faster for the consumer to continue to move the economy ahead.

 

Strong Durable Goods Report Bodes Well for the Manufacturing Sector

Eric Landry, head of our industrials team, summarized last week's bullish durable goods reports as follows:

 

Durable goods orders show manufacturing heated up in March. A 3.7% seasonally adjusted sequential climb in nondefense capital goods (excluding aircraft) was the strongest since December and was far better than the weak results seen in January and February. Importantly, machinery orders climbed more than 4% in the month, after posting negative results in the prior two periods. Although year-over-year growth slowed to 9% from the double-digit gains seen in the previous 12 months, we attribute much of this to more difficult comparisons. We expect further strong performance for the remainder of the year as the industrial economy continues to rebound. As we've mentioned before, we expect a multiquarter period of very strong growth in capital spending, and these results seem to confirm that, at least for now, our thesis is intact. However, investors should note that a capital spending pickup is almost always more indicative of the late stages of an economic cycle than the beginning of one. And while we expect this cycle to remain robust in the near to intermediate term, the best buying opportunities are now well in the rearview mirror.

 

More Mixed Data on the Housing Front: Sales Up, Prices Down

New home sales finally showed some signs of life after the difficult and weather-stricken first two months of the year. Single-family home sales managed to nudge ahead to the 300,000 level during March, an 11% increase from the previous month. Year-over-year results were still down, potentially because of last year's homebuyers' credit that is not available this year.

News on the price front continued to be disappointing as the Case-Shiller housing price data mirrored the disappointing official government data I discussed the week before last week. The index showed a 0.2% decline for the three months ending in January. The only good news here is that the decline was tiny and slightly smaller than the 0.25% decrease reported during the prior month. Eric Landry, our housing analyst, also noted that some of his real-time listing data wasn't showing many signs of lifting this spring either. This measure is often an effective indicator of the Case-Shiller Index in the months ahead.

 

Employment Report on Tap

A lot of this week's data for April will reveal whether Japan has had much effect on the U.S. economy. Last week's elevated employment claims seem to indicate that some of the Japanese supply problems may begin to show up soon. However, with manufacturing still going strong, a late Easter and better weather, I still expect decent employment gains for April that will be announced this Friday. While employment growth probably won't reach the 216,000 level of a month ago, a range of 150,000-200,000 seems very doable.

 

In other news, I suspect that the purchasing managers' survey, which has been on a real winning streak, is probably due for a pause this month. The regional reports were mixed, but the most influential--Chicago--was down slightly. Therefore, I would expect a small decline in the national number on Monday. That should not alarm anybody at all. Auto sales will be very interesting to watch, to determine whether consumers are finally beginning to lose their confidence and the effects of a shortage of some Japanese cars.

 

 

This is an edited version. The article originated from Robert Johnson’s column at Morningstar.com.


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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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