Dodging the Dip

On Sequester’s Eve, US Q4 2012 GDP growth was revised up from -0.1% q/q to +0.1% q/q, confirming economic growth for 14 consecutive quarters. To us, the GDP revision should give reason to question fears about the sequester’s impact on the economy. Q4 growth, albeit meager, underscored that the economy’s primary growth engine—the private sector—continues to be strong. That’s something the small, overall government spending increase under the sequester should little change.*

Government spending—the biggest drag on growth—fell 6.9% annualized. Diving further into the government components, defense spending was the biggest component detractor, falling 22% annualized and detracting -1.3% from headline GDP. But note, overall government spending has detracted from headline GDP for most of the current expansion. Total government spending actually fell $42.6 billion in 2012, but GDP for the full year still clocked in at +2.2%, roughly in line with the still just-OK pace of the recovery. And even if sequestration happens as projected, total government spending should still rise $15 billion in 2013. (As we’ve noted, sequestration doesn’t actually mean aggregate cuts, rather cuts to projected budget increases in certain categories of spending.)

Similarly, for those fretting giant sea-monsters or an invasion by the Royal Canadian Mounted Police, overall US defense spending last year was still higher than in 2008. Even defense spending under the sequester will still be right around where it was in 2006—~$600 billion—and higher than peak-Cold War spending of $580 billion. All told, the US accounted for approximately 48% of the world’s military spending in 2012. Should our share fall to 44% or 45% of the world’s total in 2013, no single country or combination of rivals (including China) would still come anywhere close to the figure.

What’s more important than the impact of the sequester on the government is the private sector continues to be strong—a fact confirmed by Thursday’s revision. Consumption (70% of GDP) marked its 12^th consecutive quarter of growth (2.1% annualized), with durable goods accounting for nearly two-thirds of the impact at a 13.8% annualized pace. Likewise, other components are beginning to pick up steam. Residential investment’s gone from being just an incremental tailwind to a full gust—positively contributing to the headline figure for the seventh consecutive quarter—overall adding +0.4% to GDP while growing at a 17.5% annualized pace last year.

One last note. None of the prior is to say the economy necessarily accelerates off its historically-less-than-robust recovery pace. It may. It certainly may not. And there might be some wiggles and volatility there too. But for investors, that doesn’t mean stocks can’t keep rising. GDP is an economic flow aimed at measuring output. It does not measure economic health—recall, things like government spending contribute to GDP while imports detract. And though total trade is a better measure of economic health, imports detract from headline GDP growth. Stocks, however, are a piece of firm ownership, the price of which tend to reflect future earnings expectations over time. Broadly, company’s earnings have little correlation to wiggles in headline GDP as firms find ways to grow revenues and earnings over time in a way quite detached from the minutia of the GDP calculation. And right now, corporate America has rarely been this strong. Corporate profits continue to be healthy and are above the pre-recession peak. Firms still have near record cash on balance sheets, which they are deploying on growth-oriented capital expenditures and share buybacks. Also, total loan growth is expanding, with commercial loan growth up briskly. None of which you’d see if the outlook for corporate earnings ahead were dimming.

* Source: The Congressional Budget Office, “The Budget and Economic Outlook: Fiscal Years 2013 to 2023. Government spending was previously projected to fall by -$9 billion, but the latest update projects a $15 billion increase.