As of the end of January 2018, volatility is back. It seems that many investors have been suffering from what we call “recency bias”. This is to say that we have not – up until late January – witnessed any real volatility lately. Therefore, we have become biased to believe that volatility is abnormal. Any study of the data would reveal just the opposite. Volatility has always been a part of the equities markets. The reality is that 2017’s lack of volatility was the abnormality. However, because of our natural tendency towards recency bias, many are wondering if we are “due” for a recession. To this end, many point to the fact that we have not had a recession since 2008-2009. But is that perception? Or reality?
Since the 1940s, our nation has reported our economy’s health by way of the Gross Domestic Product calculation, or GDP. However, perhaps it’s time we question whether or not we should continue to rely on this measure as a primary indicator of the health of our nation’s economy.
GDP is calculated as consumer spending plus investment (business) spending plus government spending plus net exports or, GDP = C+I+G+NE. There are a couple of problems in this calculation. First of all, its focus is on consumption, not output. There is another calculation that we could be looking at called Gross Output, or GO. At the end of every quarter, publicly traded companies rush to publish their quarterly revenues and profit. So, every quarter they are releasing both the top line and the bottom line – at the same time. Yet, for the longest time, the nation only publishes GDP which represents only the bottom line.
So, the first problem with the GDP calculation is that it is only part of the picture. Why aren’t we reporting both the top line and the bottom line? To put it in layman’s terms, Company A sells aluminum to Car Manufacturer B and Car Manufacturer B sells you a car. GDP only counts your purchase of the car. But isn’t the Car Manufacturer’s purchase of the aluminum important?
According to the US Department of Commerce’s Bureau of Economic Analysis, if we had been looking at GO in addition to GDP, we would see that there was a two-consecutive quarter dip in GO in 4th Quarter 2015 and 1st Quarter 2016. So, perhaps our perception that the 2008-2009 recession as the most recent recession isn’t reality. If we study all the data, we see a different picture.
Another problem with the calculation is the net exports component. You’ve likely heard that we have a “trade deficit” with certain countries. Is this important? If you are solely focused on the nation’s GDP – which we now know only tells part of the economic story – then, yes, you want to eliminate any trade deficits as it impacts the net exports part of the calculation.
A trade deficit is simply imports minus exports. So, if we import $100 billion worth of goods from Country A, but only export $40 billion worth of goods to Country A, we have a $60 billion trade deficit with that Country. But does it really matter?
To answer this question, I usually ask my clients where they shop for groceries. They say Grocery Store A. “Well do you have a trade deficit with Grocery Store A?” Then, I follow up with another question, “Does Grocery Store A ever hire you for your computer programming skills?” (We work with a lot of software engineers.) Eventually, I will point out to them that they have likely never considered picketing Grocery Store A or advocating that they close this trade deficit because they likely believe the trade is fair. The client walks in with money and they walk out with produce. Both parties gained what they wanted in the transaction … yet, technically, there is a trade deficit as defined. So, does it matter?
Few care about the trade deficits they have with their grocery store, or their dry cleaners, or anyone else with whom they freely trade. So why do we care about trade deficits as a nation? Because it impacts the GDP calculation and GDP is how we’ve been measuring the economy since the 1940s.
But just because we’ve always done it that way doesn’t mean we always should. Perhaps, instead we should be looking at all of the data. The data are a gift.
The views expressed here reflect the views of C. Theodore Hicks II, CFP ® as of May 23, 2018. These views may change as market or other conditions change. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Past performance does not guarantee future results and no forecast should be considered a guarantee either.
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