Oil Drives Weak GDP Growth
I would like to continue the discussion about oil’s impact on the Q1 GDP growth report. Q3 2016 had great growth which was surprising because economic growth has been tepid. It led to an extensive review of the report which led to the realization that it was temporarily boosted by soybean exports. The Q1 report showed only 0.7% growth. At face value, you’d think there weren’t any temporary factors boosting growth because the headline number was so bad. It’s why I focused on the weak PCE. When a report is bad, you try to understand why it’s bad and when it’s good, you try to figure out what drove growth. However, there is more detail in the Q1 report, namely that oil investment boosted growth significantly.
Oil investment accounted for 20% of nominal GDP growth even though its share in nominal GDP is 0.4%. It is 50 times over represented in GDP growth. As I showed in my last article, this overrepresentation has caused the annualized change in oil and gas investment to skyrocket. The annualized increase is over 400%. This has been caused by oil firms lowering their breakeven costs and oil rising to the low $50s until recently.
The chart below breaks down where GDP growth has come from in each quarter in the past 5 years. Most quarters have some drags, but the large green bar which is personal consumption has been consistently positive. The economy has relied on consumption to grow which is how it should be because it represents 2/3rds of the economy. As you can see, in the latest quarter personal consumption growth was very weak. Fixed investment helped growth more than usual. Much of the fixed investment is coming from the oil and gas drillers. Low interest rates are partially behind the growth in investment, but since interest rates have been low for years, it’s not the catalyst. Even though technological advancements lowering costs has been the catalyst, if interest rates rise, then they can be the catalyst to a decline in investment in the industry.
Fixed investment growth has been weak in this recovery. Weak fixed investment has been partially responsible for the low productivity growth. Obviously, an uptick in investment has a positive impact on near term GDP growth, but it remains to be seen if fixed investment growth can bolster productivity if the investment is mainly in one area. You would think investment in oil drilling which causes the price to decline would help productivity because firms have more free capital that doesn’t go to energy expenses, but oil prices were low in 2016 and there was only 0.2% productivity growth that year. As you can see from the chart below, Q1 and Q2 had negative fixed investment growth which could have pushed productivity growth down.
The chart below shows the free cash flow of U.S. independent shale producers. It gives you perspective on the sustainability of the boost in oil and gas investment. As you can see, the collective free cash flow of the 32 shale producers in the chart has been negative every quarter except Q2 2009. This picture shows us that the economy was reliant on oil investment to fund Q1 growth, but that growth is unsustainable because it relies on oil prices stabilizing above $50, interest rates to remain low, and firms which have negative free cash flow. The capital expenditures have started to rebound after oil prices rebounded following the OPEC production cuts. Cash flow from operations has also rebounded. The OPEC cuts are aimed at boosting prices, but the higher prices are helping American frackers which is a bad side effect since they compete with frackers for market share. If oil prices fall and frackers can’t raise more capital, capital expenditures will fall again and the positive impact on GDP will no longer be felt.
Apple Earnings
Apple reported earning on Tuesday. I feel it’s macroeconomic news as much as it is a company specific news because of how large Apple is. Apple falling after hours because of disappointing iPhone sales will push the Nasdaq down on Wednesday. iPhone unit sales were 50.8 million which missed expectations for 52 million unit sales according to Factset. Even with the disappointing iPhone sales, the quarter wasn’t a lost cause because of services revenue growth. The firm couldn’t come up with the next iPhone, so it decided to focus on monetizing the iPhone further with services.
Services revenue is a high margin business which is great for the company because hardware is less sustainable than software. With hardware, Apple must convince consumers to buy a new phone every time they shop for one. Software is easier because consumers will always buy products like music and movies on their devices. Apple does need to maintain market share to grow services, but it at least makes it more resilient to the inevitable decline in hardware prices. Services revenue grew faster than iPhone sales which is a good sign for the company. It grew 18% as it jumped to 12% of total revenue. It was driven by App Store revenue growth which was up 40% as the developer community grew by 20%.
As I said, Apple’s report tells us about the macro economy. Obviously, it can lose market share which makes it not perfectly reflective of the economy, but it’s still an important data point to look at. The chart below shows Apple’s revenue growth broken down by regions. Greater China is a large sore spot for Apple which isn’t completely different from the country’s economic growth. China grew at a 6.9% clip in 2016 and is expected to grow 6.5% in 2017. China is trying to go from a manufacturing driven economy to a services driven economy (ironically the same thing Apple is doing).
Conclusion
Oil investment boosted Q1 GDP growth, but that may be temporary if oil prices continue their fall. Consumer spending growth is going to have to rebound to get economic growth close to the 3% to 4% goal President Trump has set. The stock market is driven by Apple. iPhone sales are probably the most important product sold in the economy in terms of a percentage of total S&P 500 profits. This means the next iPhone release in the fall will be critical to S&P 500 profit growth.
Recent Comments