This is essentially the same report that I put out when the first revision of GDP was released last month. The new revised numbers are in bold, the first revision is in italics and the original estimates are in normal type and the prior numbers are in parenthesis right after them. Thus it will be easy to see where the changes in GDP came from, not just relative to prior quarters, but relative to the prior estimates. New commentary will be in bold.

In the fourth quarter, the economy grew at an annual rate of 3.1% (2.8%, 3.2%) up from 2.6% in the third quarter, and up from the 1.7% pace in the second three months of the year. The growth rate was somewhat above consensus expectations (2.9% for the expected revision). While most of the upward revisions came from relatively low quality sources, the overall quality of the growth in the fourth quarter is still very high.

Where the Growth Is (and Is Not)

So how did we get to the 3.1% (2.8%, 3.2%) overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag on growth? Since the different parts of the economy are of very different sizes, and some tend to be relatively stable, while others can be very volatile, I will focus on the contributions to growth.

In other words, growth points, not the percentage growth rates. After all, a small percentage change in a very big part of the economy can have more impact than a big percentage change in a small part of the economy. To do this I will follow the familiar Y = C + I + G + (X – M) framework, where Y = GDP, C= Consumption, I = Investment, G= Government, X = exports and M = imports.

C for Consumption

The biggest part of the economy by far is the Consumer, or consumption, or to be more specific, Personal Consumption Expenditures (PCE). It represented 70.8% of the overall economy in the fourth quarter, and was one of the biggest growth drivers. PCE contributed 2.79 (2.88, 3.04) growth points, up from 1.67 points in the third quarter and 1.54 points in the second quarter.

The increasing contribution to growth from C (relative to the third quarter) is generally a good thing, at least in the short term. Over the long term, our economy is already weighted far too much towards C, and that contribution has been rising over the years. Back in the 1960’s it represented more like 64% of the overall economy.

Our consumption share is also far higher than most other economies in the world. Still, we need consumers to be opening their wallets for the economy to grow at least in the short term. This is high quality growth, and is very welcome in the current environment. The lower contribution from PCE is a drop (relative to the earlier looks) in both magnitude and quality.

Consumption can be broken down into two main categories, goods and services. Goods can be further broken down into durable goods, which tend to be big ticket items that will last more than 3 years and Non-Durable goods, which tend to be consumed right away. (For some reason clothing is categorized as a non-durable good. Clearly the people making those decisions have never looked into my closet.)

Services are by far the biggest part of consumption at 66.43% of PCE and 47.02% of overall GDP. It chipped in 0.70 (0.68, 0.78) growth points. That is down slightly from contributing 0.74 points in the third quarter and from a net contribution of 0.75 points in the second quarter. This is still a pretty solid contribution. The upward revision was small and I would not read that much into it. Services tend to be “produced” domestically, not in China, and also tend to be more labor intensive than goods producing jobs. Normally demand for services is more stable than demand for goods, especially durable goods.

Durable vs. Non-Durable Goods

Within the consumption of goods, consumption of non-durable goods is about twice as large as the consumption of durable goods. However, since people can defer purchase of durable goods like an Auto from Ford (F) more easily than they can defer purchase of a box of Corn Flakes from Kellogg’s (K), durable goods demand is very volatile. As a result, durable goods tend to “punch above their weight” in determining is the economy is booming or slumping.

Durable goods consumption added 1.45 (1.44, 1.48) points to growth, up sharply from an addition of 0.54 points in the third quarter and 0.49 points in the second quarter. The high and accelerating contribution from durable goods is exactly what we want to see at this stage of the recovery (well actually it would have been nice to see it earlier, but I’ll take it now).

No reason to get excited about the very small upward revision, but it sure beats a downward revision. The sector is only 12.87% of PCE and 9.11% of overall GDP, yet it contributed 46.8% (51.43%, 46.25%) of the net overall GDP growth in the quarter. 

Non-durable goods are 22.78% of PCE and 16.12% of overall GDP. The sector’s contribution to growth rose to 0.65 (0.76, 0.78) points in the fourth quarter from 0.39 points in the third quarter and 0.31 points in the second quarter. For a “Steady Eddie” part of the economy, this is nice solid, and importantly, sustainable level of contribution to growth. The large downward revision is somewhat troubling, as this is a high quality part of growth.

Overall, the Consumer is doing his or her part in getting the economy rolling again. The strong contribution from the consumer service sector is encouraging. All three parts made solid contributions to growth. While over the long term we can worry that far too much of the overall U.S. economy is dedicated to consumption and not enough to investment and exports, for right now we want to see the Consumer alive and kicking. Without a doubt he was in the fourth quarter, but kicking less hard than we first thought.

Investment

Investment tends to be the most volatile part of the economy, and thus is the major reason why the economy either booms or busts, even though it is a relatively small part of the overall economic picture. Overall Gross Domestic Private Investment (GDPI) is just 12.08% of the overall economy. Overall GDPI subtracted 2.61 (3.13, 3.20) growth points in the fourth quarter, a sharp reversal from adding 1.80 points in the third quarter and 2.88 points in the second quarter.

The decline in contribution from GDPI is disconcerting, at least at first glance. Its shrinkage as a share of the economy was dramatic, in the third quarter it made up 12.93% of the overall economy. However when one looks a bit deeper, the picture is much more encouraging.

In fact, I would almost call it a reason for celebration, not despair. The operative word there is “almost.” From a growth quality point of view, there is good “investment” and bad “investment.” Relative to the third quarter, the swing from adding to growth to being a drag on growth all came from the “bad investment” side, namely the build-up of inventories. Unfortunately most of the diminished drag relative to the last estimate of the fourth quarter also came from the inventory side.

Investment is the key to future growth and as a share of the economy, it is much lower share of the overall economy than most other large and developed countries. However, not all investment is of the same quality. Fixed investment, particularly investment in equipment and software is investment that tends to have a positive return on investment and which then drives future growth.

But not all investment is fixed. If companies build up their inventories, that too is counted for as investment, and it tends to be of very low quality. If companies are simply adding to store shelves, and those goods just sit there, then the investment in inventories will be reversed in later quarters.

This is exactly the dynamic we are seeing in the fourth quarter numbers. The inventory cycle is a powerful driver of booms and busts (recessions from 1946 through the early 1980’s were mostly due to the inventory cycle, or at least had the inventory cycle as one of the major components). 

The drawdown in inventories accounted for more than all the overall drag from GDPI. Inventory investment subtracted 3.42 (3.70, 3.70) points from growth in the fourth quarter. This diminished drag from inventory drawdown accounts for almost the entire upward revision (on balance) in overall GDP. That is a sharp reversal from the third quarter, when higher inventories added 1.80 points to overall growth and from the second quarter when it added 0.82 points to growth.

In other words, in the third quarter, 69.2% (1.80, 2.6) of the total growth came from adding goods to the shelves, not from people actually buying the stuff on the shelves. This is very low-quality growth, especially when it happens for several quarters in a row, and we had five of them where inventories were a big positive player in providing growth. Then again, those came after eight quarters in a row where inventories were a drag on overall growth.

The big negative contribution from inventories this time around is actually good news and was the major reason that overall GDP growth came in lower than I (and most everyone else) was looking for. While as we have seen over the last few years, a negative contribution in one quarter does not guarantee a positive contribution to the next quarter, getting a bit of inventory correction out of the way now is a good thing. It potentially sets us up for strong growth in the first quarter.

After all, if inventories had just been a non-factor, the economy would have been booming at a 6.5% (6.5%, 6.9%) growth rate (then again the growth rate in the third quarter would have been only 1.0% and in the second quarter only 0.9%, so it can cut both ways).

Residential vs. Non-Residential Investment

Fixed investment can be broken down into Residential Investment (mostly homebuilding) and non-residential (or business) investment. Residential investment has been the major thorn in the side of the economy for a long time now. That changed a bit in the fourth quarter, and we appear to be slowly forming a bottom in residential investment, it being up in two of the last three quarters.

In the fourth quarter, residential investment added just 0.07 (0.06, 0.08) points to growth, but that is a big swing from the 0.75 point drag in the third quarter. In the second quarter, fueled by the first-time-buyer tax credit, Residential Investment added 0.55 points to growth, but that was a big exception to the recent trend. Residential investment is now just 2.27% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble.

Residential investment has been a drag on GDP growth in 14 of the last 17 quarters. We still have a massive overhang of existing homes for sale (including those in foreclosure, and those which are likely to be foreclosed on). Most estimates of the amount of excess housing available today put it at about 1.5 million housing units (including rentals). Given the absolutely dismal data on New Home Sales, Housing Starts and Building Permits so far this year, it looks pretty clear that once again Residential Investment will be a significant drag on growth again in the first quarter.

With that much excess supply, building more houses is at one level simply a massive misallocation of resources. On the other hand, residential investment has always been historically one of the most important locomotives pulling the economy out of recessions. That locomotive is derailed this time around.

Residential investment is extremely volatile, and as such tends to “punch far above its weight” when it comes to the overall growth rate of the economy. The lack of residential investment is one of the key reasons that the recovery so far has been so anemic. Eventually, population growth and new household formation will absorb the inventory overhang, and residential investment will pick up. That however, it not going to happen right away.

Still, starting from such a low level, it seems likely that Residential Investment is likely to be a positive contributor to growth in 2011, but probably not until the second half of the year. Simply not being a major drag on the economy is a major turn for the better. That bump is almost entirely a function of just how small residential investment has become as a share of the overall economy.

The overall bottoming process in residential investment is not over, and it will be a long time before it returns to its historical norm of about 4.4% of the overall economy. However, as it does, it will set off some very strong economic growth.

(Part 2 of this report can be found here.)

 
FORD MOTOR CO (F): Free Stock Analysis Report
 
KELLOGG CO (K): Free Stock Analysis Report
 
Zacks Investment Research