A Simple Growth Formula


As is the case with most truly classic dishes, the recipe for a strong economy is not complicated. Two key ingredients make this cake rise, and below we present a four-step recipe for economic growth.

Step 1: Start with a strong consumer.

Personal-consumption spending accounted for 71% of U.S. gross domestic product (GDP) in the 12 months ended September, the highest percentage in at least 60 years. Not surprisingly, the economy tends to perform best when consumers whip out their wallets. In the 247 quarters since the start of 1950, GDP has averaged an annualized increase of 3.3%. When consumption spending topped 2%, GDP rose an average of 4.6%. In contrast, GDP averaged just 1.5% growth when consumption spending rose less than 2% and a 1.4% decline when consumption fell.

The Blue Chip Economic Indicators consensus projects GDP growth of 2.2% in 2012. And if spending on consumption keeps rising at an annualized rate of 2% or higher, the GDP target could prove conservative.

Of course, consumption spending isn't the only metric for assessing the appetite of the consumer. As one of the nearby charts illustrates, the two most prominent measures of consumer sentiment jumped in November, though they remain below levels seen early in the year.

Step 2: Mix in businesses willing to invest.

More than 80% of personal income comes from individuals' salaries or profits from businesses they operate, with the remainder coming from dividends and interest. If consumers are the flour, businesses are the yeast that triggers the dough to expand.

The 432 S&P 500 Index components that reported capital-spending data for the most recent quarter combined to invest nearly $500 billion in capital projects in the last 12 months, up 27% from a year earlier.

While we don't see the robust hiring common after recessions, nonfarm payrolls have expanded by an average of 132,000 jobs in the last five months. Businesses are starting to invest in people as well as equipment.

Step 3: Heat up the oven.

The biggest risk to our economic cake stems from the baking conditions. On the home front, things look pretty good. The rise in commodity prices over the last year helped drive headline inflation near 4% in August and September. But core inflation excluding volatile food and energy prices hasn't topped 2.1% in any month so far this year. Interest rates remain at historically low levels, allowing many businesses to refinance their debt or cheaply borrow new money.

But overseas, trouble brews. Europe is taking uncomfortably small steps toward fixing big financial problems. The fate of the Continent's banking system — and several of its weaker economies — remains in doubt.

In addition, projections for global growth are on the decline. The International Monetary Fund expects the world's GDP to rise 4% in 2011 and 2012, well below growth of 5.1% in 2010. IMF projections could prove too optimistic, as they take into account neither a fiscal meltdown in the euro zone nor manufacturing slowdowns underway in China, Eastern Europe, and other key global markets. 

Step 4: Enjoy the economic expansion, and the stock-market gains it supports.

At the moment, we're cautiously optimistic. But we intend to keep a close eye on the cake, because the noise overseas could easily become loud enough to make it fall.

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