Ignore 3Q Noise: Growth Outlook Still Bleak

Executive Summary

The growth outlook remains bleak, despite the third-quarter revision. However, stocks are still attractive.

I have been bearish on the growth outlook for quite awhile. On Friday, third quarter growth was revised upward to 4.1%, which is billed as “the strongest advance in nearly two years”.  Supposedly this is a signal for strong growth going forward.

My reaction? That’s nice, but I’m still bearish on the growth outlook. The revised growth number is the annualized rate of growth in the third quarter, i.e., the growth rate between June and September. Annualized quarter-to-quarter growth is highly volatile and often reverses direction. I don’t think it can tell us very much.

I look at the year-on-year growth numbers which give us the growth rate over twelve months, and provide a better sense of the economy’s longer-term trajectory. That data tells a very different story. On a year-on-year basis, third quarter real growth was 2% and nominal growth was 3.4%. I’ve been saying that you can’t have 4% real growth with 3-4% nominal growth, and I still say it: the economy needs 6-7% nominal growth, which requires 3-4% inflation, which isn’t happening under this Fed.

Five years after the Crash,  the economy remains in “low”: low money growth, low inflation, low nominal growth, low real growth, low employment growth. I would observe that YoY growth in M2 has recently fallen below 6%, its lowest rate of growth since mid-2011, and that PCE inflation is now 0.7%, its lowest level since the Crash (and 35% of the target rate). Employment growth has been stuck below 2% for the past two years. There are few bullish signals buried in the data. The one ray of sunshine is household deleveraging, which has finally ended. The Minsky cycle may be turning.

Investment conclusion

Stocks remain in value territory relative to bonds, but underlying earnings growth will slow, given 3% nominal growth. Negative earnings surprises are likely to begin to exceed positive surprises. Nonetheless, it would be prudent to remain highly exposed to US equities. The outlook for metals is bleak. The value of a hedge declines as the probability of the adverse event declines. The risk of an inflation surprise is low.