The stock market is adjusting to weaker 2011
economic and earnings growth. Business executives,
analysts and economists have yet to reduce their 2011
estimates, So the important question is how much of the lower
growth is already discounted. The consensus had been for
double digit earnings gains in 2011. But now it appears that
earnings growth will be less than nominal GDP growth —
the low single digits.
The revised first quarter GDP deflator of 1.9% appears to be
weaker than what other measures of inflation are reporting.
It is low. Within the report the deflators for both gross domestic purchases
and the personal consumption expenditures ( PCE) rose at a 3.8% rate.
The low GDP deflator stems from the way GDP is calculated.
GDP subtracts imports from final demand to indirectly estimate
production. When you buy an imported car it is reported in PCE.
But GDP measures production, not consumption. To go from
consumption to production that imported car has to be backed out
of the data by subtracting imports. So subtracting imports is the right way
to calculate GDP.
But when import prices surge — in the last quarter they rose at a 21.8% rate —
this methodology tends to distort the GDP deflator and causes it to understate
inflation. It happens every time oil prices spike.
So the reported low 1.9% inflation rate should be taken with a grain of salt
and viewed as a data distortion.
If the inflation rate is really 3.8%, not I.9 % it strongly implies that the dominant
cause of the economic and stock market weakness is higher inflation,
not supply chain disruptions.
This analysis strongly reinforces my belief that as long as wage gains are as
weak as they are, the economy can not sustain higher inflation. If and when
inflation accelerates it generates weaker economic growth, not a self reinforcing
Moreover, unit labor cost is now rising faster than the non-farm business deflator.
Last year strong productivity and falling labor cost meant that firms could absorb
higher commodity prices and still report strong earnings growth. That is no longer
true. Firms now need to try to pass these cost increases through and the revised first
quarter data implies that business executives, economists and analysts are still
too optimistic about firms ability to raise prices.