Note: This post is an update of the post made following the initial release of the first quarter GDP numbers. The current numbers will be shown first, and the original numbers follow in parenthesis. When I have changed the commentary, it is in italics. This will allow you to assess exactly where in the economy growth has been slower than first estimated. The percentages of GDP figures did not change within the rounding to one decimal point and so are not changed.
In general I found the revision to be disappointing. In looking at the revisions to the February and March data in various reports as the April data was released, it appeared that the number would be revised upwards, not downwards. Further the composition of the growth deteriorated, with a much larger contribution from the change in inventories and less from fixed investment. In the short term the falling contribution (relative to the first cut at the numbers) is disappointing, but in the long term we need to grow other parts of the economy faster than we grow consumption. In particular, we need to reduce the drag from net exports and eventually turn that into a positive. Unfortunately every country in the world wants to run a trade surplus, and unless new trade routes open up with Mars, that is a mathematical impossibility. The core of our trade deficit problem is still our dependence on imported oil, and the disaster in the Gulf is not going to make it any easier to reduce that dependence through domestic drilling. Switching over as much as we can to Natural Gas, of which there is an abundant domestic supply would greatly help as a bridge, but eventually we need to have a far greater portion of our energy needs met by renewable sources. Investments in energy efficiency should pay large dividends as well. If the trade deficit could be reduced to zero, that alone would add 3.42% to GDP.
It is clear that the economic growth we have is not being driven by increased government spending. On balance, government spending was falling in the first quarter, and thus creating a net drag on the economy of 0.40 growth points. The Federal Government small net increase was more than offset by huge cutbacks in spending at the state and local levels. The GDP accounting uses a very different measure of government spending than most pundits use. All transfer payments are excluded, so we are just talking about things like salaries of employees and direct expenditures for things like fighter aircraft or fire engines. The transfer payments generally show up in the consumption figures.
In the first quarter the GDP grew at 3.0% (3.2%), which while slower than the 5.6% growth in the fourth quarter, is actually stronger once you look at the composition of the growth. In analyzing the GDP numbers, keep in mind that the various segments of GDP are of very different sizes and degrees of stability. Thus a small percentage change in a big segment, can have a much bigger impact than a huge percentage move in a small segment. However, it is usually the small but volatile sectors of the economy, such as residential investment, or business investment in equipment and software that make the difference between the economy booming and the economy busting. Thus in this analysis I will focus on the points to growth (totaling the 3.0% (3.2%) overall growth rate for the first quarter, or to the 5.6% total for the fourth quarter or the 2.2% total for the third quarter as the case may be) rather than on the percentage change in each sector of the economy. The percentage changes may be mentioned in passing, and will be identified with % signs after the number rather than being referred to as points. The structure of the report will follow the familiar C + I + G + (X – M) framework.
Consumer Adds More Than in 4Q
The consumer (C) is by far the biggest sector of the economy. Personal consumption expenditures (PCE) added 2.42 (2.55) points to growth, a substantial increase over the 1.16 point contribution in the fourth quarter and also above the 1.95 point addition in the third quarter. PCE has been on a secular increase as a share of GDP and now accounts for 71.0% of the total, up from 70.8% in the fourth quarter and 70.3% a year ago. Back in the 1960’s it was a far smaller share of GDP averaging only 61.8% in the decade, and as recently as the 1980’s it averaged 64.3%. While PCE is a more solid base for economic growth in the short term than a build up in inventories, one has to be very concerned about the long term implications of PCE being an ever rising share of the economy.
Goods Stronger Than First Read, Services Weaker
Consumers spend their money in a variety of ways, but basically they come down to goods and services, and what they spend on goods can be further broken down into durable goods like cars and furniture, and into non durable goods like food and gasoline. Services are by far the biggest part of PCE, but also tends to be the most stable. Non durable goods are more than twice the share of spending than durable goods, but due to their volatility, durable goods usually make up a big part of the difference between the economy doing well or being weak. Overall Goods added 1.47 (1.40) points to growth due to a 6.2% increase, up from a 0.66 point contribution in the 4Q but down from the 1.59 points in the third quarter. Durable goods were responsible for 0.85 (0.79) points up from just 0.03 in the 4Q but down from 1.36 points in the 3Q. The improvement from durable goods in the 3Q was largely due to the cash for clunkers program. The impact from durable goods is impressive considering that in the first quarter they comprised only 7.3% of the overall GDP. Consumption of non durable goods added 0.62 (0.61) points to growth in the 1Q after a 0.63% contribution in the 4Q and a 0.23 point contribution in the 3Q. Services, which in the 1Q were 67.2% of overall PCE and 47.7% of GDP added 0.96 (1.15) points to growth on top of contributions of 0.49 and 0.37 points in the 4Q and 3Q, respectively.
Fixed Investment: Structures Weak, Equipment Strong
Just as Consumption can be broken down into several key segments, so can Investment (I). The first breakdown is into fixed investment and into investment in inventories. Over all, Gross Private Domestic Investment added 1.66 (1.67) points to growth, which was a huge slowdown from the 4.39 contribution in the 4Q, but well above the 0.54 contribution in the 3Q. Fixed investment is the higher quality part of investment. It added just 0.01 (0.10) points to growth in the 1Q, down from a 0.61 contribution in the 4Q but above the 0.15 subtraction from growth it provided in the third quarter. Fixed investment is further broken down into residential investment and non residential investment.
Residential Investment a Drag Again
Residential investment is essentially construction of new homes, with a lesser contribution from home improvement spending. Residential investment has been the major thorn in the side of this economy for a long time. In the third quarter it actually added to the economy after subtracting from it for 14 straight quarters with a 0.43 point addition, That contribution fell to just 0.10 point in the fourth quarter. This quarter it again became a net subtraction of 0.28 (0.29) points from overall GDP growth. After spiking last fall in anticipation of the end of the homebuyer tax credit, which was later extended, new home sales plunged again in January and February, although they showed a nice gain in March they remain deeply depressed. Given the large upward revision to the March (and to a lesser extent February) numbers that was released yesterday, it is surprising that there was no significant improvement in this category from the original read. The tax credit is about to expire again, and this time there are not a lot of noises being made about extending it (it was effective, but extremely expensive and generally a very bad way to stimulate the economy). We will probably see another spike in new home sales in April, (we sure did, see: http://www.zacks.com/stock/news/34754/New+Home+Sales+-+WOW! ) followed by a hangover in May and June, so it is an open question as to if Residential investment will return to being a positive contributor to growth in the 2Q or will once again be a drag on the economy. The big jump in April adds to the odds that it will be a positive contributor, but the May numbers will be critical for determining how bad the hangover is. Historically residential investment has been one of the most important swing factors in the overall economy, despite being only 2.4% of the overall economy, which is a near record low. At the height of the housing bubble it was over 6.2% of the economy. The current low share will not remain there forever and will probably revert back to about 4% of the overall economy over the course of the next few years.
Business Invests in Equipment, Not Buildings
Non residential fixed investment is what people generally think of when they think of businesses investing for future growth. It added a total of 0.29 (0.38) points to growth in the 1Q, down from 0.51 points in the 4Q but up sharply from the 0.59 point subtraction in the 3Q. Business fixed investment is further broken down in to two parts, one of which is doing well, and the other is a large and persistent drag on the economy, and likely to remain so for several more quarters. The weak part of business investment is investment in structures such as new office buildings and strip malls. We already have far to many of them, as evidenced by high and rising vacancy rates in almost all types of commercial real estate in almost all areas of the country. Investment in structures subtracted 0.49 (0.44) points from growth in the fourth quarter, which is at least better than the 0.62 point subtraction in the 4Q and the 0.68 point drag in the 3Q.
The drag from lower business investment in buildings was offset by business buying of equipment and software, which added 0.78 (0.83) points in the 1Q on top of additions of 1.13 points in the 4Q and just a 0.10 point addition in the 3Q. Business investment in equipment and software is a relatively small part of the economy, at only 6.54%, but it also tends to be volatile and can have an outsized impact on overall economic growth. Seeing growth from this part of the economy is very encouraging. Over the long term, the country needs to see business investment, particularly investment in equipment and software, become a much, much bigger part of the economy, and consumption become a much smaller share.
Inventories: Bigger Part of the Story than in First Read
The really big swing factor though lately in economic growth is the non-fixed part of investment, otherwise known as the change in inventories. Inventories fell fast throughout 2009, but in the 4Q they fell at a much slower rate. That slowdown in the pace of inventory liquidation contributed 3.79 points of the 5.60 points of overall growth in the 4Q, or 2/3’s of the total growth. In the 3Q inventory liquidation had also slowed from the pace of the 2Q and resulted in a contribution of 0.69 points of the 2.20 total growth or 31.4% of total growth. In the first quarter, we actually saw inventories increase, rathe than just shrink at a slower pace. This resulted in inventory investment adding 1.65 (1.57) points to growth or 55% of the total growth. We will probably see at least one more quarter where inventory growth is a net addition to growth, but it will probably be a smaller contribution than in the 1Q. Generally inventory investment is seen as very low quality growth as big gains in one quarter tend to be reversed in subsequent quarters. This time around though the inventory liquidation was so extreme in late 2008 and early 2009 there is stll some room for inventory investment to be a net plus. However, if growth is just based on goods filling the store shelves, and nobody buys them, the growth is not going to last very long.
Government: State and Local Cuts Overwhelm Federal Contribution
For those of you who fear that the economic growth we are seeing is all a mirage due to higher government spending, your fears are not particularly justified by this report. Overall government spending was actually a net drag of 0.40 (0.37) points to growth coming on top of a net drag of 0.26 points in the 4Q. In the 3Q government spending added 0.55 points to growth, and it was just about the only thing keeping the economy afloat during the 2Q, adding 1.33 points that helped offset contractions elsewhere that lead to a 0.7% decline in overall GDP in the 2Q. Keep in mind the definition of government spending here is a bit different than what you are used to. It excludes all transfer payments like Social Security and Medicare. The spending on social security is registered as consumption spending as Grandma spends her check.
Federal government spending grew by 1.2% (1.4%) and as a result added 0.10 (0.11) points to the overall growth rate of GDP. Of that, 0.06 (0.07) points of growth came from Defense spending and (0.04) 0.04 came from non defense spending. Once one strips out transfer payments, the federal government is a far smaller share of GDP than most people think, particularly if one also excludes the Pentagon. In total it is just 8.1% of the economy, and 67.9% of that or 5.51% of GDP is spent on Defense. This means that everything else we think of as the Federal Government, from the salaries of members of Congress and of the Supreme Court, to the running of the federal prisons and the FBI to NASA and the State Department and the National Parks only makes up 2.6% of GDP.
The growth from Federal Government spending was more than offset by contractions at the state and local levels. State and local governments are not allowed to run deficits on an operating basis, and have been hit hard by falling tax revenues due to the recession. As a result they have been embarking on what amounts to massive anti stimulus programs by slashing spending. With the Federal stimulus finds that have been propping up the state and local government starting to tail off, look for these 50 little Hoovers to continue to be a drag on economic growth for at least several more quarters. In the first quarter falling S&L spending was a 0.49 (0.48) point drag on overall economic growth, up from being a 0.27 point drag in the 4Q and just a 0.80 point drag in the 3Q. In the 2Q, S&L spending actually contributed to growth by 0.48 points. Look for the drag from S&L spending to not only continue but probably accelerate in the next few quarters.
Net Exports: a Larger Drag than First Thought
Finally, international trade was once again a drag on our overall growth as the trade deficit expanded. Yes, increased exports added 0.82 (0.66) points to growth, but that was down from a 2.36 contribution in the 4Q and a 1.78 point addition in the 3Q. However, those gains were more than offset by increased imports that slashed 1.48 (1.28) points from growth in the 4Q. While the impact from increased imports was down from a 2.09 point reduction in the 4Q and a 2.59 point drag in the 3Q, imports more than offset exports. Net exports were a 0.66 (0.61) point drag on GDP in the 1Q rather than the 0.27 contribution in the 4Q, but better than the 0.81 point drag in the 2Q. The price of oil is really a key variable in the net export situation as petroleum makes up about half of our trade deficit. Increasing domestic production of oil might help, but that is not going to be easy to do since we have already depleted most of our on shore reserves, and the Deepwater Horizon disaster reminds us that it is not all that easy to increase our production offshore. A major part of the solution would be use more natural gas which is very abundant on shore as well as offshore (and if BP (BP) and Transocean (RIG) had been drilling for gas instead of oil when the disaster occurred, there would be no oil slick, just a lot of bubbles rising to the surface.
Overall: Solid but Not Spectacular
Overall this was a solid but not spectacular GDP report. In the short term it is good to see more of the growth coming from PCE, particularly from durable goods, and less from inventory investment. While we probably have a little more support from inventory investment left in the second quarter, it is likely to make a smaller contribution than it did in the first quarter, and will most likely be negligible by the third quarter. If growth is all due to inventory growth, it becomes extremely vulnerable to a double dip. The construction side of the economy is still being a major drag on overall growth, both residential and non-residential. We will probably start to see the residential side be a small but growing contributor to growth in the quarters ahead, while the non residential side will continue to be a drag on things. Normally residential investment is the main locomotive pulling the economy out of recessions, but it seems like it will be late to the party this time around, but when it does arrive it will be powerful force in keeping the recovery going.
The continued strong growth coming from investment in equipment and software is very encouraging. The is the sector of the economy that we really need to see grow at rapid rates for an extended period of time to put the economy on a longer term slid growth path. Consumption becoming an ever larger share of the economy is simply not sustainable, even if growth in PCE is very helpful right now. Over time we really need to see it fade back to something more like the level we saw in the 1980’s. However that will, due to very simple arithmetic, require that we see rapid growth in some combination of business investment, government spending, or a major improvement in the trade deficit, perhaps even turning it into a trade surplus. On the government spending side, 60% of that is done at the State and Local level, and they are in no position to grow, and will probably shrink substantially over the course of the next year. The recent rebound in the dollar (mostly due to the ongoing Greek Drama) is not going to be helpful in either increasing our exports or cutting back on our imports. With empty offices, hotels and boarded up strip malls all over the country, there dies not seem to be much of a reason to be investing in more commercial structures. Thus economic growth going forward is likely to rest on the shoulders of a rebound in residential investment, and further growth in business spending on equipment and software. To the extent that we invest in either alternative energy, or domestic natural gas, we will see a double impact from not only the investment, but a reduced drag on the net export side.Zacks Investment Research
