U.S. stocks shook off a weaker-than-expected (and completely one-sided) GDP report, but succumbed to geopolitical pressures as the Egyptian uprising accelerated on Friday. 

The S&P 500’s 1.8% decline and the NASDAQ’s 2.5% slide were the worst single-session declines since August.  Still, considering the former has rallied 23% and the latter 30% since late August, such downside moves could have occurred on lesser event risk.  Point is, the market hardly freaked out over what sure looks like a rolling unrest (first Tunisia, then Yemen, now Egypt...next possibly oil-rich Nigeria, Sudan or Jordan).  More on this morning’s market activity below.

All 10 major industry groups declined, led by consumer discretionary and tech shares.  Energy, consumer staples and utilities were the session’s outperformers. 

The Dollar Index rose for the first session in six due as just a little fear re-merged, this is about the only thing the greenback has going for it, at least until QE ends. 

The CRB Index rallied to a new post-crisis high, led by a 4% upshot in the price of crude – back to $89/barrel.   The uprising in Egypt was behind the move as the market worried about Suez Canal access (of which 2 million barrels of oil per day flows).  

On the GDP report, I came in Friday morning ready to talk about a relatively good report, thinking we’d see a 4% print.  While realizing big consumer spending in the final three months of the year would account for an outsized degree of GDP growth, I expected to see more help from business spending and less of a drag from inventories.  As a result of the one-sided nature of this report it’s tough to view it as something that suggests economic escape velocity.  It was all holiday shopping, which probably leads to a payback effect in 2011. Consumer spending will get additional short-term boosts from the 2% payroll tax reduction and refunds from the home-buyers tax credit that expired in April 2010.   Still, the durability of consumer activity is very much in question even with ongoing stimulus. 

Market Activity for January 28, 2011

Sector Activity for January 28, 2011

Fourth-Quarter GDP

The Commerce Department reported that the economy grew at a 3.2% real annual rate in the final quarter of 2010, which was below the 3.5% expected.   The figure withstood a huge drag from the inventory segment (I can’t say the inventory cycle is dead due to the near-record low inventory/sales ratio, but it certainly shows businesses remain extremely cautious) thanks to the huge degree of consumer spending – which had been telegraphed by the strong holiday-shopping  and car sales. 

For the year, GDP rose a real (inflation-adjusted) 2.8%, which is exceptionally below what it should be coming off of the worst contraction in the postwar era.  (Economic growth should have run above a 7% rate at this point in a recovery from deep contraction, using history as a guide.)   Nevertheless, we can now technically call this recovery an expansion as real GDP has finally eclipsed the peak hit in 2007.  It’s by a scant 0.1%, but technically we are talking expansion now.

So to the specifics:

Personal consumption, the largest segment of GDP, surged 4.4% as holiday shopping and auto financing was strong -- accounting for 95% of the quarter’s economic growth, which is so unsustainable it’s laughable; I’ll touch on this a bit more below. 

Net exports contributed a large 3.40 percentage points as import activity slid 13.6%, while exports rose 8.5% -- this was the first time net exports contributed in a year. 

Of course, when you get such a huge decline in imports you know what’s going to occur on the inventory front.  Inventories subtracted 3.70 percentage points from GDP, which follows six quarters in which the segment accounted for at least 50% of GDP growth. 

Fixed investment added 0.50 percentage point as commercial and residential building was essentially flat, while nonresidential investment (machinery) added 0.43 percentage point.  Business spending on equipment and software added 0.41 percentage point.  The segment rose 5.8% at an annual rate during the quarter, which is quite the slowdown after averaging 18.8% over the preceding four quarters – a topic we touched on in Friday’s letter.

Government spending subtracted 0.11 percentage point, which was only the second subtraction in 15 quarters.  The figure was dragged down by the reduction in state & local government spending.  Federal spending has been offsetting the decline in state & local spending for a couple of years now, but Washington’s ability to do so was of course temporary. 

Bottom line:

Fourth-quarter GDP was completely driven by personal consumption as the growth in business spending tailed off and inventories weighed heavily. 

A segment of GDP that we’ve talked about each quarter during this recovery exploded to the upside – real final sales.  This number is essentially the proxy for final demand as it is GDP minus inventories.  As we’ve been explaining, this figure had averaged just 1.1% at a real annual rate during this recovery (a number that should be growing at 4%-plus for this point in the cycle).  During the fourth-quarter, however, real final sales jumped to 7.1% -- a reading that has been hit only 5% of the time over the past 30 years. 

So the figure went from trending well below the average to jumping to a level that is rarely seen, and all while the jobless rate remains at heights rarely seen, the housing market, I think is safe to say, is in shambles and organic income growth is tepid.   Spending has clearly been goosed by a rising stock market (the affluent consumer accounts for close to 50% of spending), a record level of government transfer payments and to some extent defaulters able to live in their homes payment-free for 16 months on average.  The aforementioned realities do not suggest that GDP can depend on the consumer for 2011.  The next several quarters must see inventory rebuilding and business spending return to drive growth.  

It’s about the Tilt

This morning the market is shrugging off continued protests in Egypt and news of smaller uprising in Nigeria and Jordan.  Traders are taking a wait and see approach instead of dumping shares and running for safety just yet – despite Friday’s sell off, the market is seen as having too much momentum to run for cover. 

Taking a deeper look at this issue, there was an article in the WSJ yesterday comparing what we’re seeing in Egypt to the protests that occurred in Iran over the summer.  The author appeared to find it strange that the market paid no attention to the Iranian protests (even though Iran producers much more oil than Egypt), while focusing intently on the uprising in the Northern African country. 

But he’s missing the reason why Egypt is more important.  Iran is already controlled by Islamists, Egypt is not and therefore if it falls to the Muslim Brotherhood we’ve got quite a different Middle East on our hands.  (Israel is taking these developments very seriously for sure.)  While the Muburak regime is an autocracy (despite Vice President Biden’s claim that Muburak is not a dictator, he absolutely is), for the Middle East he was viewed as a stable autocrat -- much of his suppression had been focused on Egypt’s Muslim Brotherhood.  This is not simply about oil; it’s about the political tilt of the Middle East. 

Bright-Side Bias

It is reasonable to believe this thing could go either way.  The positive would obviously be a transition to democracy takes place; the negative, of course, being that ElBaradei is a puppet for the Muslim Brotherhood – he’s been a menace to the West since heading the IAEA.  ElBaradei has always defended the organization and it’s not a coincidence that he’s come out of nowhere to become the leader of the opposition. 

The consensus view seems to be moving in the direction that a positive result will emerge.  Then again, nothing new as the current market mentality has a proclivity toward the bright side even as risks abound.  Reason for this:  The dark side is really dark these days, thus it’s easier emotionally to take the bright side approach even when it offers poor odds. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900