An Unpleasant Taste of Austerity

The Upshot

2/4/2013

A resilient Wall Street shrugged off last week’s poor GDP numbers, which reflected major defense-spending cuts leading up to the fiscal cliff. Still, it’s a reminder that belt-tightening can be painful, says Kristina Hooper.

Untitled Document Kristina Hooper, CFP^®, CIMA^®, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

The markets may have found reasons to overlook last week’s bad GDP numbers, but investors shouldn’t ignore how government-spending cuts could take a bite out of the ongoing economic recovery.

Last week’s strong stock-market performance marked the fifth consecutive week of stock-market gains. Driven by positive surprises in new economic data—including strong showings in manufacturing, durable-goods orders and construction spending—the Dow Jones Industrial Average finished over 14,000 and the S&P 500 Index stayed above 1500.

What’s remarkable, however, was the lack of concern about the preliminary reading of fourth-quarter 2012 gross domestic product (GDP)—which showed a dramatically disappointing annualized growth rate of -0.14% versus expectations of 1.2%. That’s right: The numbers show an economic contraction for the quarter.

Digging deeper into the GDP report, we can see several areas of quarter-over-quarter weakness—including a large drawdown in inventories, which is likely to rebound, and a large decrease in federal, state and local government spending:

Real federal government consumption expenditures fell 15% in the fourth quarter vs. a 9.5% third-quarter rise.

National defense was the biggest detractor; it fell 22.2% in the fourth quarter after jumping 12.9% in the third quarter.

Non-defense spending did increase 1.4%, although that was less than half of the third-quarter’s rise of 3.0%.

Real state and local government consumption expenditures and gross investment decreased 0.7% in the fourth quarter, compared with a third-quarter hike of 0.3%.

The GDP contraction was likely overlooked because it largely reflected defense-spending cuts that took effect as the nation approached the “fiscal cliff.” In fact, during the fourth quarter, military spending on everything but personnel reportedly fell at the sharpest rate since the end of the Vietnam War. Some of this enormous plunge could actually be due to a shift in defense spending from the fourth quarter to the third, when we saw an increase of 12.9%.

Still, overall, the fourth-quarter GDP decline is a cautionary tale about the risks of fiscal tightening—in particular, what a big decrease in government spending in the near future could mean for the economy.

Belt-Tightening Bar Graph

Government-spending cuts can take a toll on employment, too—as seen in the most recent jobs data. January non-farm payrolls showed a net creation of 157,000 jobs; 166,000 private-sector jobs were added in January but 9,000 public-sector jobs were lost.

This is actually the continuation of a near-four-year trend that has decreased only in severity: The average number of public-sector jobs lost per month in 2012 was 6,000 compared to 26,000 in 2011. Clearly, more private-sector jobs must be created to make up for public-sector losses—which is easier said than done. Although building a more fiscally sound government is a good thing, getting there can be painful.

At the same time, there is an overall positive economic picture that shouldn’t be overshadowed by the economy’s vulnerability to potential fiscal tightening. There was certainly some good news in the most recent GDP report; consumer spending was healthy, as was business investment in new equipment and software. What’s more, the employment report also contained some bright spots, including a substantial upward revision in total non-farm payroll employment for the previous two months. Last week’s robust ISM Manufacturing Index’s reading was also positively surprising. Clearly, the underlying dynamics of the US economy are much better than the GDP headline figure indicates.

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