The Investor's Guide to the National Accounts

Much of the economic data produced and released by national statistical agencies around the world represent a labyrinth for investors to navigate through and interpret for the purposes of making informed decisions about the trajectory of asset prices.  Many market economists whose job is to decipher and communicate the key themes of macroeconomic data releases to investors and the broader community do themselves a disservice by assuming too much prior knowledge and confusing their audience with jargon laden observations.  In this post, Skeptikoi hopes to demystify some of the jargon surrounding the most complex of all data releases, the National Accounts.

What does it actually mean to say that Australia's gross domestic product (GDP) expanded by 0.8% in real or inflation adjusted terms in the December quarter to be 2.8% than a year earlier.  GDP is a measure of the flow of production that occurs in a particular period.  The ABS avoids double counting by deducting from the value of output the value of intermediate goods and services used up in the production process.  The term gross refers to the fact that the flow of production does not adjust for deprecation or wear and tear of fixed capital such as buildings and capital equipment that occurs in production processes.

GDP is measured three ways: production, income and expenditure.  Most of the higher frequency data produced by the Australian Bureau of Statistics (and other statistical agencies around the world) - including retail trade and building approvals releases - relates to the expenditure measure of GDP.  The production measure is based on surveys of business, while the income measure is based on the income earned by the household sector (employee compensation), business sector (profits) and governments (tax revenue).

The income measure clearly illustrates why profitability and stock market performance more generally are not necessarily related to a country's GDP growth.  The GDP or gross value add of the retail sector for instance, represents the sum of labour earnings earned, after tax profit generated and tax paid to governments.  A rise in wage rates for retail sector workers - without an offsetting reduction in the number of hours worked in the industry - could boost labour earnings in the sector but depress profitability. 

For investors, the distinction between nominal and real GDP is important but still poorly understood.  Nominal GDP is simply the dollar value of production, while the real estimate adjusts for inflation.  Statistical agencies that produce National Accounts and economists tend to focus on the headline GDP measure in real or inflation adjusted terms.  This is reasonable when comparing measures of production across time periods that have materially different rates of inflation.  But inflationary pressures have remained low in Australia and other developed economies for over two decades now.  Further, companies generate nominal revenues and earn nominal profits or cash flows.  Consequently, nominal GDP is more relevant than real GDP for understanding trends in aggregate sales revenues. 

Skeptikoi has been critical of the Reserve Bank of Australia (RBA) in the past because excessively tight monetary policy has contributed to a nominal 'recession'; average annual growth in nominal GDP of less than 4%.  The 1.6% quarterly growth in nominal GDP was a welcome development.  Nonetheless, by Skeptikoi's measure, the Australian economy remained in a nominal recession for the second consecutive calendar year; nominal GDP expanded by 3.5% in 2013 following 3.4% growth in 2012.  This represents the weakest two successive years of nominal GDP growth in over two decades and growth in 2013 remained well below the twenty year median of over 6%.  In an era where nominal GDP growth targeting is gaining some currency around the world, the persistent weakness in the nominal economy constitutes a fail for the RBA.

The weak environment for nominal GDP has undermined the ability of companies to achieve strong revenue expansion and instead they have resorted to margin expansion to boost profitability.  The profits of non-financial corporations in particular jumped by 4.7% in the December quarter to be 20% higher than the pre-financial crisis peak of 2008.  Profits of financial corporations posted modest quarterly growth of 0.5%, but are also around 20% higher than the pre-financial crisis peak.

Australian companies in aggregate have achieved strong margin expansion by aggressively managing operating expenses, reducing capital investment where feasible and boosting productivity.  The National Accounts confirm the cost discipline that has been evident at the company level in recent reporting seasons.  Nominal unit labour costs - which are productivity adjusted wages growth  - increased by a modest 0.3% in the December quarter and have been stagnant since March 2012, which has helped to support business sector profit margins.  Excluding the financial crisis, one has to go back to the late 1990s for the last extended period of stagnant unit labour costs.

The weakness in unit labour costs and margin expansion owes much to Australia's productivity renaissance in the past three years.  Gross value added per hour worked in the market sector expanded by a nominal 1.1% in the December quarter, the strongest quarterly outcome since March 2012.  Since March 2011, productivity has expanded at a compound annual rate of over 3%, well above compound annual growth of less than 1% in the five years to March 2011.  The last time it grew at or above 3% for a sustained period was over a decade ago.

Of course, the flipside of the productivity renaissance and corporate Australia's aggressive focus on cost containment, is continued weakness in labour market conditions.  Aggregate hours worked actually declined marginally in the December quarter and have remained little changed in the past two years, despite unusually strong population growth.  Consequently, the unemployment rate has increased to 6% from 5.2% in December 2011.

In summary, the National Accounts reveal a business sector that is prospering despite subdued environment for nominal GDP and revenue expansion in recent years.  The strong quarterly increase in nominal GDP is a welcome development but is unlikely to herald the start of a strong recovery if the interim reporting season is anything to go by.  Skeptikoi expects cost discipline to continue, as firms increasingly cater to the market's insatiable appetite for income by boosting free cash flows and lifting or maintaining already high dividend payout ratios.  Great news for investors; less so for workers and job-seekers.