2Q GDP tough to swallow: Needs a grain of salt or two
The upward revision in second quarter real GDP to a 3.3% annual rate from 1.9%
initially looked impressive, until you dig beneath the headline. Fully 85% of the
revision came from a revised upward estimate to net exports and a lower
estimate for the inventory liquidation than took place last quarter.
Consumer spending remains weak at +1.7% at an annual rate particularly given
stimulus check delivery of an annualized $320 billion (was +1.5% in the advance
GDP report published a month ago); capex was still negative at -3.2% (was -
3.4%), and housing was actually nudged down to -15.7% from -15.6%. In fact,
our estimate of the total private domestic demand guts of the economy, consumer
spending+ capex+ housing + nonresidential construction, actually contracted at a
0.7% annual rate in 2Q, the third decline in a row. Those who think the economy
has managed to skirt a recession should consider that this private domestic
spending metric only embarked on such a losing streak in the past in 1960, 1974,
1980, 1990 and 2001 – all were classic recession years.
The headline GDP figure must be taken with a very large grain of salt because
there was no corroborating evidence from the other segments of the national
accounts data. It does not seem plausible to us that the broad economy
managed to expand at a 3.3% annual rate in the second quarter, and here is why:

Look at the income accounts
We see that wages and salaries, the organic part of personal income, were
revised down in the first half of the year by an additional $20 billion on top of a
previous revision of -$20 billion. We also see that national account corporate
profits declined at a 9.2% annual rate in the second quarter, the fourth
consecutive contraction (and down 7% year-over-year, which again, is completely
consistent with a recessionary macro backdrop and a bear market backdrop).
For domestic industries, profits are down 14.4% year-over-year. But in the profits
section of the report, we see that domestic non-financial profits were actually
down sharply at a 22% annual rate. The reason why the total earnings headline
was held to just a -9.2% pace was because, in Alice-in-Wonderland fashion,
profits in the financial sector were reported to have surged at (get this), a 27%
annual rate. Are you kidding me?

Look at the nonfarm nonfinancial corporate sector
Gross value in nominal terms added was a mere +0.1% annual rate in 2Q on top
of a -0.9% print in the first quarter (again, we only saw such a weak back-to-back
performance in 1960, 1982 and 2001). But in real terms, the headline growth rate
in corporate output was +3.8% at an annual rate. So what is the underlying
assumption here? That the nonfinancial corporate deflator deflated at a 3.8%
annual rate in the second quarter! This last happened in 1949 when the
consumer inflation rate was running at -2%. But we know that CPI inflation is now
running well in excess of 5% and the PPI by nearly 10%, so how can we possibly
have the most pronounced business sector deflation rate in six decades? It
makes no sense. The only way we can possibly get to a +3.3% headline GDP
reality is to buy into the assumption of a corporate deflation fantasy in the second
quarter data.

Gross domestic income pointing to a recession
Many focus myopically on the GDP data, even though 20% is centered in
government and for equity investors, what should matter most are corporate
profits and the trend is still deeply entrenched in negative terrain. Moreover, what
seems to get lost is GDI – Gross Domestic Income, which comprises corporate
income and personal income. Finance 101 tells us that investors are paying for
income, not spending. And, what is interesting from a behind-the-scenes look at
the data is that there is a visible mismatch between the spending and income
accounts in the national accounts database. In real terms, GDI was only up at a
1.9% annual rate in the second quarter, far below the 3.3% headline GDP result.
In fact, real GDI contracted at a 0.5% annual rate in 1Q (GDP was +0.9%) and
also shrank 0.8% in 4Q (when GDP was reported to have declined 0.2%). Note,
once again, that real GDI has only declined for two quarters or more when the
economy was in a technical recession. So again, beneath the veneer of GDP, this
is another nail in the coffin behind the (prolonged, in our view) recession call.
In each of the past six quarters, the growth rate in GDP has come in above that
for GDI – and by an average of 1.5 percentage points. That has no precedent
and the data cover a 60-year time frame. In other words, we have a statistical
discrepancy in the national accounts data that has never been as wide as it is
now, and our concern is that if it is headline GDP that the markets are currently
trading off of, it could well be an error of significant magnitude.


So let’s get the picture straight:
To believe in yesterday’s revised GDP data, we have to believe that …
1. We are seeing near-record deflation in the nonfarm nonfinancial corporate
sector.
2. We are seeing double-digit earnings growth in the financial arena.
3. Productivity growth is running at a near-3.5% pace and as such, “potential”
GDP growth is close to 5% (we’d like to believe that, but it can’t be true).
4. Unit labor costs in the nonfarm nonfinancial sector were actually declining at
a 2.2% annual rate in the second quarter (again, being bond bulls, nothing
would make us happier if this were all true),
5. Somehow, in a quarter which saw the CPI rise at a 5% annual rate and PPI
up by more than a 10% annual rate – both accelerating over the 1Q runup –
the GDP price deflator managed to decelerate from a 2.6% annual rate in 1Q
to a 1.2% annual rate in 2Q, the softest economy-wide inflation print in a
decade (and recall, the 2Q ends in June when the commodity bubble was
just about to reach its climax).
So, we have to say that we are non-believers
But if we are wrong, then the GDP data would certainly be suggesting that the
downturn in financials is over but the profit recession spreading to the industrial
sectors. And, if we are wrong, then the data are doubly-bullish for Treasuries
because of the implications for productivity, potential growth, unit labor costs and
inflation. After all, if you buy into yesterday’s GDP revision, then all you have to
know is that the chain deflator has slowed from 2.6% year-on-year in 4Q to 2.3%
in 1Q to now 2.0% in 2Q, which is the lowest economy-wide inflation rate since
the fourth quarter of 2002 when the funds rate was cut to 1.25% and the 10-year
note was on its way to testing the 3% threshold.