Senior strategist Dirk van Dijk, CFA has issued notes on this morning’s GDP numbers. These notes will be published in two separate blogs — Growth Rates and Contributions to Growth.
The recession is over!
In the third quarter, GDP grew by 3.5%, comfortably ahead of expectations for 3.0% growth. This is a huge improvement over the 0.7% decline in the second quarter and the 6.4% plunge in the first quarter.
The internals of the report were strong as well, although it appears that much of the growth came from things like the “Cash for Clunkers” (C4C) program and the extraordinary levels of support that are currently being given to the housing sector.
I will first go over the percentage growth rates for the main components of GDP, and then how much each part contributed (or subtracted from the 3.5% growth rate). This is probably the more important part since the size of the different parts of GDP are very different, and a small percentage change in a big component can have more impact than a large change in a small component.
Just as a reminder, GDP is equal to the sum of Consumer spending, Investment spending, Government spending and net exports, or Y = C + I + G + (X – M), and I will be using that framework for the discussion.
Growth Rates
The overall 3.5% growth of GDP was almost matched by its biggest component, Personal Consumption expenditures, or PCE, which grew 3.4% — a big improvement over the 0.7% decline in the second quarter and the 0.6% increase in the first three months of the year.
It is important to note that during the recession consumer spending declined far less than did overall GDP, especially in the first quarter, so the consumer was becoming a much bigger part of the overall economy. This is not healthy over the long run, but at this point I think people are happy to get some growth wherever we can find it.
Consumers spend on both Goods and Services, and Goods are broken down into Durable and Non-Durable goods. The big mover in the third quarter were Goods, which increased by 8.1% following a decline of 5.6% in the 2Q and an increase of 2.5% in the 1Q. Spending on Durable goods was the real driver, growing at an annualized rate of 22.3% in the 3Q, following a 5.6% decline in the 2q and a 3.9% increase in the 1Q.
Spending on Non-Durable goods tends to be much more stable than spending on Durable goods. Non-Durable goods spending rose by 2.0%, reversing a 1.9% decline in the 2Q, which was in turn a reversal of a 1.9% increase in the 1Q.
Spending on Services tends to be even more stable than spending on Non-Durable goods. Service spending grew at an annualized rate of 1.2% in the 2Q, up from a 0.2% increase in the 2Q and a 0.3% decline in the 1Q. Historically, spending on Durable goods has been one of the key drivers to get us out of a recession, just as not spending on Durable goods has been one of the key reasons for falling into recessions. It is the volatility in the sector that makes it important more than its absolute size.
Now, you might wonder — what caused the recession to be so nasty last winter when Consumer spending wasn’t really all that bad? The answer is that Investment really fell of a cliff. The good news is that it is starting to come back. Overall Gross Private Domestic investment grew at an 11.5% annualized rate in the 3Q, but it still has a lot of lost ground to make up from the earlier part of the year.
In the second quarter, overall Investment spending fell at a 23.7% annualized rate. Now here is the kicker; that was actually a dramatic improvement over the 1Q when investment spending absolutely collapsed — falling 50.5% — clearly the biggest collapse in investment spending since the Great Depression (and it came on the heels of a 24.2% decline in the 4Q of 2008). To anyone who understood what was going on, those were really terrifying times, and the turnaround from them is absolutely spectacular.
There are two basic types of Investment — Fixed and Inventory — and right now we are concerned with Fixed investment (I will cover Inventory later in the contributions to GDP part).
Fixed investment is broken into two parts, Non Residential or business investment, and Residential investment, which is mostly homebuilding. Overall Fixed investment rose by 2.3% following declines of 12.5% in the 2Q and 39.0% in the 1Q. Business investment, however, continued to decline, but at a much slower rate, falling 2.5% after 9.6% and 39.2% declines in the 2Q and 1Q, respectively.
With massive amounts of unused capacity, it is not surprising that businesses are cutting back on their capital spending still. Business investment comes in two flavors — spending on structures like building new factories, malls and office buildings and spending on equipment and software to go into them. Spending on structures continues to be very weak, falling at a 9.0% annualized rate in the 3Q, but that marks an improvement over the 17.3% decline in the 2Q and the 43.6% collapse in the 1Q.
With massive amounts of space sitting idle in offices and empty strip malls littering the landscape, look for new investment in commercial real estate to continue to decline in coming quarters. Moody’s (MCO) has estimated that the value of commercial real estate has plunged by 41% since the peak a little over a year ago, and that is hardly an inducement to build more. If a business needs the space, it’s far cheaper to just buy some that already exists.
Spending on Equipment and Software (E&S), on the other hand, is starting to come back, if only feebly — rising 1.1% after a 4.9% decline in the 2Q and a 36.4% plunge in the 1Q. Look for some stability in this line going forward as the new Microsoft (MSFT) operating system will probably generate a new PC cycle, but with capacity utilization still around 70% I would not expect a boom in orders for new factory equipment.
The real star of Fixed investment, though, came on the residential side, which rose 23.4%. This is the first increase in almost four years, and follows declines of 23.3% in the 2Q and 38.2% in the 1Q. The long string of declines had brought residential investment to a record low share of GDP. The extraordinary support of the housing sector by the government, including the first-time buyer tax credit — the Fed buying up $1.25 Trillion of Fannie Mae (FNM) and Freddie Mac (FRE)-backed paper to artificially suppress mortgage rates, and the FHA acting like the old New Century Financial or Washington Mutual on their worst days — have played a big role in the turnaround. I seriously question the sustainability of it after the support is removed, and I don’t think the support can continue indefinitely.
Government spending grew by 2.3% in the 3Q, a big slowdown from the 6.7% increase in the 2Q, but more than the 2.6% decline in the 1Q. It was all at the Federal level, where spending rose at an annual rate of 7.9% down from a 11.4% increase in the 2Q, but up from the 4.3% decline in the 1Q. Remember this measure of government spending does not include spending on transfer payments like Social Security and Medicare, which are largely captured in the Consumption numbers.
Defense spending was the big driver — remember we are still a nation fighting two wars. Defense grew at an annual rate of 8.4% down from a 14.0% rate of increase in the 2Q, but up from a 5.1% decline in the 1Q. Non-Defense spending rose at a 6.8% annual rate following a 6.1% increase in the 2Q and a 2.5% decline in the 1Q.
State and local spending, on the other hand, is constrained by balanced budget laws and falling tax revenues. It declined 1.1% in the 3Q following a 3.9% increase in the 2Q and a 1.5% decline in the 1Q. They were able to increase spending in the 2Q due to support for the Federal government as part of the stimulus package. Now that support looks like it is being overwhelmed by the plunge in property, income and sales taxes.
International trade has started to rebound, and we saw an increase in both imports and exports. Increasing exports are good for GDP and increases in Imports are bad for GDP, and unfortunately imports rose more than did exports. We were able to improve our overseas sales by 14.7% in the 3Q — a nice turnaround from the 4.1% decline in the 2Q and the 29.9% plunge in the 1Q.
Unfortunately, we also increase what we bought from overseas by 16.4%, a big turnaround from the 14.7% decline in the 2Q and the 36.4% plunge in the first three months of the year. Keep in mind that we import a lot more than we export, so not only was the percentage increase bigger for imports, it was coming off a higher base.
Look for the Contributions to Growth blog to be uploaded shortly.
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