When it comes to measuring economic output, we all hear about gross domestic product (“GDP”). A better measure though may be gross domestic income (“GDI”). Yes, GDP should be equal GDI, given expenditures from the production of good and services should equal the income generated from the same production. A dollar spent by a consumer is after all a dollar earned by a producer.
However, they never come out to be exactly the same. GDP and GDI are measured differently. For example, GDP relies on estimates. This includes how much is spent on oil imports to the value of vehicles sitting at car dealerships. In contrast, GDI measures things like wages, profits and taxes, all of which the IRS follows closely. Lying to the taxman to has consequences, which makes GDI a potentially more accurate measure of economic output.
GDI at a Recessionary Level
The most recent data on real GDI (i.e. nominal GDI adjusted for inflation) shows its rate of growth in noticeable decline. You can see this on the right side of the graph below.
After reaching what may prove to be a peak of +4.0% in the final quarter (ending October) of 2014, real GDI growth has since decreased for six consecutive quarters. As of the second quarter (ending April) of 2016, real GDI growth has slowed to +1.1%. This is significant because this rate of growth has almost always led or coincided with recessions. In fact, real GDI growth slowed to a median of +2.1% at the beginning of the past 11 recessions.
To smooth out the data, I also crunched out the numbers for trailing 4-quarter average growth (black line). As you can see from the same graph above, the most recent data shows trailing 4-quarter average growth has slowed to +1.4%. This low level of growth has almost always coincided with recessions. In fact, trailing 4-quarter average growth slowed to a median of +2.7% at the onset of the past 11 recessions.
The One Exception
There is one exception to the +1.1% and +1.4% rules above: the year 2013. Real GDI growth slowed to +0.9% in first quarter (ending January) of 2013, and the trailing 4-quarter median growth slowed to +1.3% in the fourth quarter (ending October) 2013. In both cases, a recession did not follow. I would argue a recession was averted due to ultra-loose monetary policy.
As you may recall, the 3rd (and largest) quantitative easing (“QE3”) program enacted by the Federal Reserve started in September 2012. The Federal Reserve committed itself to buy $40 billion per month in mortgage-backed securities to inject cash into the financial system. When that proved insufficient in December 2012, the Federal Reserve more than doubled the program to $85 billion per month and expanded the program to also include treasury bills.
The Federal Reserve tapered and ended QE3 in late-2013 and late-2014, respectively. Monetary tightening began a year later when it increased its federal funds (interest) rate. The federal funds rate is also very likely to increase it again before the end of this year.
The CME Group 30-Day Fed Fund futures prices has long been used to express the market’s views on the likelihood of changes in U.S. monetary policy. Based on this, there is a ~91% chance the federal funds rate will increase by 25 to 50 basis points when the Federal Open Market Committee meets on November 2nd. For the current business cycle, it would appear the days of ultra-loose monetary policy are of the past.
Is GDI an Asset Bubble Indicator?
GDI includes capital gains, but it is not accounted for in GDP. Why? Though someone may profit from the sale of an existing asset, there is no change in production. For example, building a new house increases GDP, but selling an existing house at a profit has zero impact on GDP. If capital gains are significant enough, a recession could occur even if real GDI growth does not go negative. An example of this rare phenomenon occurred in the recession of 2001 near the end of the Tech Bubble. which is pointed out in the graph above.
During those years when asset prices (e.g. stocks, bonds, real estate) are booming, capital gains are easy to come by. GDI also exceeds GDP in those boom years. You see this in the graph below during the Tech and Subprime Mortgage Bubbles of the late-1990s/early-2000s and mid-2000s, respectively.
As illustrated above, GDI/GDP peaked in early-2000 (101.9%) and mid-2006 (101.8%). This not only predicted their accompanying recessions, but also the peak of their respective asset bubbles.
More recently in the fourth quarter (ending October) of 2014, GDI/GDP seemingly peaked at 101.8% and has since rolled over. October 2014 happened to have been the same month the Federal Reserve announced to end its QE programs. Coincidentally, capital gains in the stock (e.g. S&P 500) and housing (e.g. S&P/Case-Shiller 20-City Composite) markets have been harder to come by.
GDI may be a better measure of economic output given its relies on income, which relies less on estimates and more on figures reported to the IRS. It may also be a leading indicator of asset bubbles given GDI accounts for capital gains earned from the sale of assets.
The most recent data shows that real GDI growth is at a level very consistent with past 11 recessions. Moreover, GDI/GDP has reached virtually the same level observed in the past two asset bubbles. GDI/GDP also appears to have peaked and rolled over, suggesting this prospective asset bubble is near its end. Putting it all together, the economic expansion of the past 7+ years appears to be near the end its cycle.
Whether or not you find GDI as a better measure of economic output, please consult an investment fiduciary before making any investment decisions.