Everyone knows that the economy is weak, and that this recovery has been the weakest ever. So weak that the Fed believes it is going to have to keep interest rates at zero and continue buying bonds by the bushel for the next several years. So it is rather surprising to look inside today's third quarter GDP revision and discover three under-appreciated areas of strength: nominal growth last quarter was the strongest in over 5 years, inflation is running above the Fed's target, and corporate profits are extremely strong.
As the above chart of quarterly GDP shows, in the third quarter the economy posted its fastest rate of nominal growth in over 5 years. The last time nominal GDP grew by more than Q3/12's 5.55% pace was the second quarter of 2007, when it registered 6.5% annualized growth. On a nominal basis, Q3/12 growth was a good deal better than the 4.0% average pace of quarterly growth since the current recovery started in mid-2009. And at 2.7%, real growth in the third quarter was comfortably better than the 2.2% average for the current recovery. Despite almost universal gloom, last quarter stands out as one of the best in the current recovery.
The above chart shows the quarterly annualized rate of inflation according to the GDP deflator, the broadest measure of inflation available. The latest reading for the third quarter was 2.8%, and that is above the Fed's professed inflation target of 1-2%. Taken together, both growth and inflation in the third quarter were non-threatening. So why is the Fed still panicked?
What worries everyone, of course, is that the economy has fallen way behind where it could have been if this recovery had been a normal one, and if the economy's potential growth rate track were the same as it has been for most of the past 50 years. With an output gap (see above chart) of as much as 13%, there aren't enough jobs to bring the unemployment rate down to healthy levels. The Fed wants to close the actual/potential GDP gap since that will increase jobs and reduce the unemployment rate.
The question everyone should be asking is whether monetary policy is capable of accomplishing such a feat. Is the economy struggling because there is a shortage of money? Can zero interest rates on cash convince small businesses to hire more people? No one really knows, but neither has anyone ever argued that monetary policy was an effective tool for generating real growth. The Fed is in uncharted territory, with regards to the magnitude of its quantitative easing efforts and the scope of its policy objective.
The chart above compares total after-tax corporate profits (as calculated by the Bureau of Economic Analysis) to the level of nominal GDP. The two y-axes are calibrated so that both show a similar range. Note how strong profits have been during this recovery, and over the past decade. The growth rate of profits appears to be tapering off, but profits are still up 4% over the past year.
As this next chart shows, corporate profits have displayed unprecedented strength in this recovery. Never before have profits been such a big percentage of GDP (with the exception of last year's fourth quarter).
This chart of PE ratios is constructed using the S&P 500 index (normalized) as a proxy for the value of all corporate businesses (the P), and the after-tax corporate profits measure shown in the preceding two charts for the E. PE ratios by this measure have rarely been lower, even though profits have never been stronger.
For purposes of comparison, the chart above shows the traditional measure of the PE ratio of the S&P 500 index, using trailing 12-month reported earnings. Both this chart and the one above it tell the same story: PE ratios are substantially below their long-term average, despite record-setting profits. The only explanation for this anomaly is that the market apparently believes that the current level of profits is not sustainable, and that profits will likely revert to their mean (e.g., 6% of GDP) in coming years—which would entail a huge decline in nominal terms.
The chart above compares total corporate profits to nonfinancial domestic corporate profits. which make up about half of total profits. This shows that the strength of corporate profits is broad-based, since both measures have increased by a similar order of magnitude in the current recovery.
This last chart compares corporate profits to global GDP. Here we see that profits are not unusually high at all, and not much different from their long-term average. This casts doubt on the need for, or the likelihood of, a big, mean-reverting decline in profits in coming years, and that further suggests that the market may be much too pesssimistic about the outlook for profits. U.S. companies now make a much larger percentage of their profits from overseas, and that is to be expected since the world has become much more integrated and many foreign economies are experiencing exceptional growth (e.g., India, China). The global marketplace has expanded much more rapidly than the U.S. economy, and U.S. corporations are benefiting from that expansion. Over the past decade, U.S. exports have grown 40% more than U.S. GDP.
So two puzzles remain: if corporate profits are so strong and there is little reason to expect them to collapse, why are PE ratios so low, and why aren't corporations using those profits to boost GDP by investing in more plant, equipment, and personnel?
I'm compelled to note here that total after-tax profits of U.S. corporations have averaged about $1.3 trillion per year since the recovery began in mid-2009, and that this happens to be almost identical to the annual federal budget deficit over the same period. Think of it this way: corporations have generated over $4 trillion in profits during the recovery, and substantially all of those profits have been borrowed by the U.S. government to finance what for the most part has been a huge expansion of transfer payments and a shortfall of tax collections (due to the output gap and the reduced level of employment). Corporations may not have directly funded the federal deficit, but the funds they have saved and supplied to the credit markets, being fungible, have in effect found their way into Treasury notes and bonds. Since the U.S. government is highly unlikely to be able to spend $4 trillion as productively as corporations could, much of the money has, in a sense, been squandered. Collectively, we have not spent those funds in a very productive manner, so it is not surprising at all that the recovery has proved to be unusually weak.
Of course, that still leaves unanswered the question: Why aren't corporations using their profits to expand? The only sensible answer to that is that there is still a great deal of uncertainty about the future, which in turn stems from 1) the possibility that taxes on capital could increase dramatically in coming years, 2) the fact that Obamacare imposes significant new taxes on many people and significantly higher costs on small businesses, 3) the strong likelihood that regulatory burdens will be increasing, especially with the implementation of Dodd-Frank, and 4) concerns over the ability of the Federal Reserve to reverse its massive quantitative easing program in time to avoid a significant increase in inflation. All of these represent uncertainties, higher costs, and headwinds that weigh on any business' decision to put capital at risk.
In the end, the story boils down to this: government spending is a tax, and too much of it can smother an economy's growth potential. Japan is the prime example. Having engaged in massive deficit-financed public sector spending over the past few decades (enough to make ours look tame by comparison), it is not surprising that Japan's economic growth has been much weaker than ours.
We must find ways to reduce projected federal spending, especially on entitlements, if this economy is going to regain its former luster.
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