Kamis, 27 September 2012

Slow growth is not necessarily bad news

Second quarter GDP growth was slow to begin with, and has now been revised to even slower (1.3% vs. 1.7%). That's a relatively modest downgrade (the number is annualized, so the downward revision to the level of GDP was only about 0.1%), but it's pretty slow growth, both in real and in nominal terms.

Since the U.S. economy has enjoyed an annualized growth rate of 3% or so for over 50 years leading up to the last recession,  the current recovery is downright miserable. By my calculations, the economy is about 12% smaller than it should be. If the economy were growing at its long-term trend, national income would be about $2.1 trillion higher than it is today. That's a lot of lost jobs and lost tax revenue. Weak growth is thus the principle source of our ongoing $1 trillion plus annual deficits.

Despite all the disappointing news, though, it's nothing that the market hasn't expected, and that is an important thing to note. Abysmally low Treasury yields are symptomatic of a market that expects very weak growth for as far as the eye can see, and by the looks of these charts, we're on track for exactly that.

One very bright spot in this otherwise dim picture is corporate profits, which have grown at an impressive rate over the last decade, despite the slowdown in overall economic growth. Corporate profits are now close to an all-time high, both in nominal terms and relative to GDP. Despite this excellent news, most observers look at the top chart and argue that profits are mean-reverting to nominal GDP; since they have averaged 6.2% of GDP for the past 50 years, the current level (9.5%) is unsustainably high and must inevitably decline. But as the second chart suggests, the market is priced to just such a decline, because PE ratios are significantly below their long-term average. (This chart uses a normalized S&P 500 index as the "P" and after-tax corporate profits from the National Income and Products Accounts for the "E".) In other words, the market seems quite confident that future profits are going to be much weaker than current profits.( The 12-mo. trailing S&P 500 PE ratio is currently 14.7, which is also substantially below its long-term average of 16.6.)

I look at the above chart, in contrast, and argue that it is no longer meaningful to compare corporate profits to our domestic economy at a time when the U.S. economy is more integrated than ever before with a global economy that is growing quite rapidly (e.g., China and India). When you compare corporate profits to global GDP, the current level is unremarkable and therefore sustainable. Consequently. it seems reasonable to conclude that the market is very pessimistic and therefore valuations are quite attractive. Assuming, of course, that we are not on the cusp of another substantial recession. I think that even a continuation of today's disappointingly slow growth could be enough to move equity prices higher—the market can only ignore record profits for so long. As long as we avoid a recession, the market is likely to move higher, albeit modestly. Should we get a meaningful pickup in growth next year, however, then Katie bar the door.

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