If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.
Friedrich Hayek, The Pretence of Knowledge, Nobel Prize Lecture, 1974
The very weak initial estimate of first-quarter real GDP growth this year surprised many forecasters, in part because it was at odds with other fairly positive data, including solid employment gains over the past six months. We show that, although the BEA adjusts for seasonal movements at a disaggregated level, the published real GDP data still exhibit calendar-based fluctuations—that is, residual seasonality. After we apply a second round of seasonal adjustment directly to the published aggregate data, we estimate much faster real GDP growth in the first quarter of this year. We conclude that there is a good chance that underlying economic growth so far this year was substantially stronger than reported.
The Puzzle Of Weak First Quarter GDP Growth, FRB of San Francisco
Not only can economists never obtain sufficient knowledge to direct the future course of the economy, they can’t even collect and interpret sufficient data to describe the present state of the economy. They are reduced to applying ever more doubtful statistical adjustments to data which has already been subjected to statistical torture. All we can hope for, as Hayek said in his lecture, is to recognize the larger patterns of the economy. All we can really do is create an environment within which growth should thrive and then just leave things alone. Unfortunately, the debate over what that environment should look like is far from over and driven mainly by political agendas. So don’t expect economists to become more useful anytime soon.
I would also posit that the more clarity we try to obtain through our statistical aggregation and manipulation, the more likely it is that we will merely end up fooling ourselves into seeing a pattern that isn’t actually there. This debate over the quirk of weak 1st quarter economic growth may well be such a case. It is a desire of the Fed – and certainly the perpetually bullish denizens of Wall Street – that the economy be growing at a rate that can withstand higher interest rates. That is so, I think, primarily because the Fed desperately wants to get off the zero bound before the next recession arrives.
The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy appeared well positioned to help the economy withstand substantial adverse shocks.
And so, with the Fed really wanting the economy to be doing better right now, they have gone on a snipe hunt looking for evidence that it is actually doing what they want it to do, what they think it should be doing, rather than anything like the GDP data of the first quarter. Looking back and seeing that first quarter weakness is fairly common, the members of the FOMC dismiss the slowdown as transitory and Janet Yellen’s previous home finds statistical evidence to support the case. (No one seems to remember that the exact opposite conclusion was reached just recently by a different set of Fed researchers.) Investors and traders are no different, reacting similarly, assuming that this year is like last year, that this weakness, statistical or otherwise, too shall pass.
But what if this year’s slowdown is different than previous years? What if the economy really is that weak – or weaker? Might we – investors – dismiss this data only to find that it is more accurate than we thought? There is a simple way to avoid the seasonal adjustment issue. All one need do is look at the non seasonally adjusted data and look at the year over year change. If you do that – we actually do that a lot at Alhambra – you might find some things that you don’t see by looking at the month to month or quarter to quarter data. And in fact, this year, some data series such as retail sales, do look significantly weaker than last. That isn’t true across the board, with all data series, but it is true often enough to make me question the narrative that things are better than the GDP data indicates.
Perhaps the best method for observing the economy though is to forget the statistically massaged economic data and just look at it through the lens of the market. I am not a believer in a strong version of the efficient market hypothesis but there is a wisdom of crowds and markets are right a heck of a lot more often than economists (even a clowder of economists; apparently their performance doesn’t improve when their predictions are aggregated). And so, while I do find some uncomfortable year over year comparisons in some of the economic data, it is hard to square with what is happening in the currency, commodity, bond and stock markets.
The yield curve, despite some flattening since early 2014, is no where near flat or inverted, the condition we normally observe prior to recession. Credit spreads are elevated but not seriously so and are not at present moving wider. Curiously, as I pointed out in my bi-weekly economic review, credit spreads in investment grade bonds are actually acting more poorly than junk spreads. In currency markets, we see a dollar that has recently weakened but is substantially higher against other currencies than last year. And despite the currency market gyrations of the last year, gold prices have been very well behaved, an indication that the volatility of the dollar is actually more about the volatility of the Euro, the Yen and other currencies. Commodity markets have recently stabilized and come off their worst levels as the dollar peaked and corrected. In short, despite the problems I have with this economic expansion – and that is a pretty long list – there is nothing I can point to in markets that is consistent with the onset of recession.
Of course, the economic outlook isn’t the only thing that matters for investors. In fact, economic growth is not very highly correlated with stock market returns except at turning points. That, by the way, is really the only reason to monitor the macro-economic data – to figure out when the economy is entering or exiting recession. The last two recessions saw a 50% drop in the S&P 500 and I don’t think the next one will be different. But smaller downturns – corrections not bear markets – can happen for many reasons and can come at any time. We still have a market that is expensive by almost any measure, sentiment that is entirely too bullish (and confidently so) and momentum that has suddenly gone missing. And yes, I still think we’re likely to see a correction of 10 – 20% in the near future. Anything more than that, a true bear market, will probably require that the economic situation deteriorate further. I am confident the market will inform us of that deterioration when it happens no matter what the season.
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