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V. Anantha Nageswaran

The US second quarter GDP growth, revised up to 3.1 per cent from 2.4 per cent, supposedly came from higher estimates for consumer spending, investments and a lower trade deficit. But the real news, says V. Anantha Nageswaran, is that without the defence spending contribution of 1.75 per cent, GDP growth would have been an anaemic 1.35 per cent.

THE second quarter GDP growth has been revised up to 3.1 per cent from a previously reported 2.4 per cent. The upward revision came mainly from higher estimates for consumer spending, investment spending and a lower trade deficit.

The real news does not lie in this but in the fact that defence spending contributed 1.75 per cent to GDP growth. That is, without such a big defence spending item, GDP growth would have been a rather anaemic 1.35 per cent.

Investment spending pick-up exaggerated by statistics

Investment spending has bottomed. However, here again, we need to understand the difference between real and nominal investment spending. Usually, nominal spending will be higher than real spending as inflation is usually positive.

For technology goods, it is the opposite. Real spending is more than nominal spending as prices of technology goods have been falling consistently over the years. We have deflation in the price of technology goods. However, America does not just stop here. It goes one step further. It adjusts for quality improvement of technology goods over time.

Just bear with me for a moment. A simple example would help. A desk-top personal computer cost $2000 ten years ago and is now available for $1000. That is a deflation rate of 50 per cent. However, the computer today is probably four times more powerful than the computer ten years ago. Hence, the quality-adjusted price, according to US statistical agencies, is even lower.

That is, we get a bigger bang for lesser bucks. In theory, it makes sense but it is hard to quantify such concepts and put a number to it. Nonetheless, that is what the US does. The difference between nominal investment spending growth and real investment spending growth is substantial. But human beings think in nominal terms and we spend nominal and not real dollars.

Personal consumption spend — how much more to go?

As has been the case throughout the last three years, personal consumption expenditure underpinned GDP growth in the second quarter too. Indeed, personal consumer spending growth accelerated in the second quarter over the first.

The reasons are not far to seek. Record low bond yields and mortgage yields spurred refinancing and enabled consumers to extract more equity out of their homes and contributed to their spending. Indeed, it was not a surprise to see personal savings rate drop to 3.3 per cent in the second quarter.

Of course, we have ourselves read the obituary of personal consumption spending many times in the past. American consumer's tenacity and ability to spend can never be underestimated. The Federal Reserve chairman, Mr Alan Greenspan, has continued to provide them one excuse or the other to continue to extract more equity out of their assets and thus add to their debt. Economists might not get the timing right but it is difficult to believe that this spending binge built on debt would be costless, particularly in the light of continued weak signals in the job market.

Not long if labour market weakness persists

Contrary to expectations, initial jobless claims have edged up in the last two months and the persistence of continuous claims at higher levels suggests that job seekers are not finding it easy to locate new jobs. Second, Conference Board's Help Wanted Index remained unchanged at 38 in July. It was 44 a year ago. Job offers are not plentiful. Also, couple of days ago, as part of the consumer confidence figure, the Conference Board indicated that the gap between jobs hard to find and jobs plentiful widened further from a nine-year high in July.

Pricing power for US cos? GDP data show deepening deflation

One of the reasons the bond market did not lose its composure on a day of upward revision to GDP growth was tame inflation news. Not only was the GDP deflator revised down to 0.9 per cent from the previously estimated 1.0 per cent, but also the personal consumption expenditure deflator excluding food and energy prices is edging down towards 1.0 per cent. This measure of inflation has been falling for the last four quarters (Graph 1). May be, just may be, the interest rate market is beginning to believe in the likelihood of deflation/disinflation and the prospect of short-rates staying low for an extended period, if the action in the futures pit is any indication.

The price of the December 2004 dollar three-month interest rate future. It was 96.98 as of the close of August 27 implying a market expectation of a 3.02 per cent rate on three-month dollar deposit in December 2004. On August 28, in New York trading, the price of this contract jumped 20 basis points. That is a big single day move. It means that the expected interest rate in December 2004 is 2.82 per cent now.

That this should happen on the day when the US government revised the second quarter GDP growth to 3.1 per cent from a previously reported 2.4 per cent is quite significant. If it is the beginning of a trend, then the dollar had peaked and the bond market had bottomed.

Is there real improvement in American corporate profits?

The answer to this question lies in the eye of the beholder. The standard measure of profits is corporate profits before tax. One could make some adjustment for the value of inventory depending on the fluctuations in the market price of unsold goods. The Bureau of Economic Analysis recommends this as the most reliable measure of corporate profits as this is closest to the profit returns submitted to the tax authorities by corporations.

However, the problem arises with depreciation.

Sometimes, governments confer the advantage of accelerated depreciation on companies to encourage investment spending in new technology, investment in rural and backward areas, etc. Businesses would be able to write off, for tax purposes, depreciation within a short time frame, say, a year or three or five. Such a higher rate of depreciation would naturally lower corporate profits and hence businesses would suffer lower taxes. In reality, the corporate cash-flow would be better as depreciation is a non-cash expenditure.

However, in profits reported to shareholders, companies would depreciate assets over their useful economic life which could be much longer and hence the depreciation charge would be lower in the accounting statements presented to shareholders.

This year, the Bush administration's tax-cut package has provided for precisely such an accelerated depreciation. According to Bureau of Economic Analysis, the Jobs and Growth Tax Relief Reconciliation Act of 2003 provided for an additional first-year bonus depreciation write-off, increasing the immediate depreciation write-off from 30 per cent (provided for in the Job Creation and Worker Assistance Act of 2002) to 50 per cent for property acquired after May 5, 2003, and placed in service before January 1, 2005.

To reconcile the discrepancy between depreciation expense claimed in tax returns and that charged to profits in accounts presented to shareholders, the Bureau of Economic Analysis had to add back $75 billion to the corporate profit figure and the Bureau calls this the Capital Consumption Adjustment (CCA). This seems a reasonable thing to do. Yet, the Bureau recommends that users refer to the Corporate Profit Before Tax with Inventory Valuation Adjustment (IVA). Why?

It is not possible to split the CCA between various industries to arrive at the `true' measure of profits that they had earned. This issue is more relevant for this quarter as the accelerated depreciation allowance was extended for property acquired after May 5, 2003. It is entirely possible that this measure of depreciation was concentrated in a few industries. Hence, adding it back to profits before tax might distort the overall profit measure.

Growth in Corporate Profit Before Tax as per national accounts is more modest than growth in Standard & Poor's 500 operating profits. Graph 2 shows that the gap between the two measures of profits is the widest since 1999-2000. Those of us who believed that accounting reforms have improved corporate disclosure in America should think again. Perhaps, this explains why corporate insider selling is at its highest level since January 2000.

It needs to be watched to see if corporations are up to their old tricks or is it explained by depreciation and other genuine differences between taxable and operating earnings. Indications are that it is more due to accounting sleight of hand than otherwise. We will explain.

Profits of non-financial corporations before tax declined in the second quarter ($357.2 billion compared to $364.4 billion in the first quarter). Based on figures reported by S&P 500 companies, excluding the financial and oil sector, corporate profit growth was negative. Both these measures are mutually supportive and lead us to the conclusion that the accelerated depreciation allowance did not distort the underlying profit story much.

Profits of financial corporations were slightly higher at $232.3 billion (versus $230.3 billion in the first quarter). These profits were earned due to vigorous consumer lending and proprietary trading in bonds.

With the steep increase in bond yields, how much of it is going to remain in coming quarters is an open question. Profits that American corporations earn from operating in the rest of the world were higher at $116.1 billion (versus $106.5 billion in the first quarter). This was made possible by a weaker dollar. Again, the absence of this stimulus in the third quarter leaves the door open for further disappointment on the profits front this quarter and next.

Mortgage refinancing has collapsed

In the light of the steep climb in long-term bond yields in the US since mid-June, the index of applications for mortgage refinancing has virtually collapsed. Just as consensus opinion (including ourselves) underestimated the power of low bond yields to propel cash extraction from home equity in the US, consensus could be equally blasé about the impact of higher yield in coming quarters.

As consensus is busy revising its forecasts for growth in the coming quarters, it is once again setting itself and equity investors for disappointment. We begin to sight the end of the irrationally exuberant rally that began in March when a war began and since the war had not ended, it is only logical that the rally that celebrated its commencement should end.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Singapore. The views are personal. Address feedback to anantha@nageswaran.com)

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