In the third quarter, the economy grew at an annual rate of 2.0%, up from 1.7% in the second quarter, but down from the 3.7% pace in the first three months of the year. The growth rate was in line with consensus expectations, and frankly a bit better than I was expecting.
So how did we get to the 2.0% 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. 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 70.4% of the overall economy in the third quarter, and was the biggest growth driver. PCE contributed 1.79 growth points, up from 1.54 points in the second quarter and 1.33 points in the first quarter.
The increasing contribution to growth from C is generally a good thing, at least in the short term. Over the long term, though, 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.
Goods vs. Services
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 these decisions have never looked into my closet.)
Services is by far the biggest part of consumption at 67.15% of PCE and 47.30% of overall GDP. It was the real star of the show this quarter, chipping in 1.15 growth points — up from just 0.75 points in the second quarter. In the first quarter, services were missing in action, adding just 0.03 growth points. This solid increase is very encouraging.
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.
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 the purchase of a durable good 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 0.44 points to growth, down from an addition of 0.49 points in the second quarter and 0.62 points in the first quarter. The downward trend in contributions from durable goods is a bit disconcerting, but is not too bad. The sector is only 10.45% of PCE and 7.36% of overall GDP, yet it contributed 22% of the overall GDP growth in the quarter.
Non-durable goods are 22.4% of PCE and 15.78% of overall GDP. The sectors contribution to growth fell to just 0.20 points in the third quarter from 0.31 points in the second quarter and 0.67 points in the first quarter. I suspect that its growth contribution will rebound a bit in the fourth quarter as demand for non-durable goods tends to be pretty steady and its contribution to growth this quarter was below its overall share of the economy.
Overall, the Consumer is doing his and her part in getting the economy rolling again. Unfortunately as we will see later, too much of that consumption is going to things that are made abroad, and not enough to things made here. The strong contribution from the consumer service sector is encouraging.
I for 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 12.87% of the overall economy. Overall, GDPI added 1.54 growth points in the third quarter, down from 2.88 points in the second quarter and 3.04 points in the first quarter.
The decline in contribution from GDPI is disconcerting, although the overall level is still OK. However, when one looks a bit deeper, the picture is a bit more disturbing.
Investment is the key to future growth, and as a share of the economy it is much lower than in most other economies. 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 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.
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 addition to inventories accounted for almost all the overall contribution from GDPI. Inventory investment added 1.44 points to growth up from 0.82 points in the second quarter and a whopping 2.64 points in the first quarter. This is very low quality growth, especially coming on several quarters where it has made a significant positive contribution to growth.
This is the fifth straight quarter where inventories have been adding to growth, but that comes after eight quarters in a row where inventories were a drag on overall growth. The big positive contribution from inventories this time around is both disconcerting and was the major reason that overall GDP growth came in higher than I was looking for. I would look for a much smaller contribution from inventory investment in the fourth quarter, and it would not shock me if it actually proved to be a drag on growth.
Residential vs. Non-Residential Fixed 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, and the third quarter was not an exception (the second quarter was).
In the third quarter, residential investment subtracted 0.80 points from growth. That is a huge swing from the 0.55 point addition it provided in the second quarter and is a bigger drag than the 0.32 headwind it provided in the first quarter. Residential investment is now just 2.22% 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 16 quarters. The increase in the second quarter was an anomaly that was mostly due to the homebuyer tax credit. 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 2 million housing units.
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.
Recent data on housing starts and new home sales suggest that we might get a positive contribution from residential investment in the fourth quarter, but if so it will be minor. Still, just not being a big drag will help overall growth. 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. That, however, is more likely to be a 2012 story than a 2011 story.
Business Investment: Structures vs. E&S
Non-residential, or business investment can also be broken into two major parts, investment in structures, such as new office buildings and strip malls, and investment in equipment and software (E&S). Investment in structures actually added 0.10 points to growth in the third quarter, after being a non-factor in the second quarter (a 0.01 drag to growth) and a 0.53 point drag in the first quarter.
This was a bit better than I expected. Vacancy rates are still extremely high in almost all areas of the country, and in almost all major types of non-residential real estate. We simply don’t need to be putting up a lot of new commercial buildings right now. I would expect it to revert to being a small drag on overall economic growth in the fourth quarter.
Investment in E&S is what we really want to see to power future growth, and there the news continues to be good, but not quite as good as earlier in the year. E&S investment added 0.80 points to growth, which is not a bad showing since it is only 7.11% of the overall economy. It is down, however, from a 1.52 point contribution in the second quarter and a 1.24 point contribution in the first quarter.
This is the sixth quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.43% of the overall economy. That increase is highly encouraging, but we need to see it continue it climb as a share of the overall economy. This is probably the highest quality form of growth out there, as it is growth that feeds future growth.
G for Government
Government spending added 0.71 points to growth in the third quarter, down from a 0.80 point contribution in the second quarter, but up from being a 0.32 point drag in the first quarter.
First, I should point out that in the GDP accounts it is only government consumption and investment that is counted as part of G. Transfer payments, such as Social Security, are not included. They tend to show up as part of PCE when Grandma spends her check.
What is counted is what the government pays in salaries to its employees (both civilian and military) and its spending on goods, from highways to fighter aircraft. All of the positive contribution came from the federal government, which added 0.71 point to growth, down ever-so-slightly from the 0.72 point contribution in the second quarter, but well above the 0.32 point drag in the first quarter.
Overall federal government spending, as defined in the national income statistics, was 8.37% of the economy in the third quarter. Of that, 67.32% was spent on Defense, and 32.68% was on non-defense spending. Defense spending contributed 0.46 points of growth, up from 0.40 points in the second quarter and just 0.02 points in the first quarter. The non-defense contribution was 0.25 points, down from a 0.32 in the second quarter but up from a positive contribution of 0.13 points in the first quarter.
I would point out that non-defense federal spending (excluding transfer payments) is just 2.74% of the overall economy, running at an annual rate of just $403.1 billion. Anyone who suggests that it is possible to cure the budget deficit by only cutting non-defense spending excluding transfer payments like Medicaid and Social Security is someone who quite simply should stay off of Jeff Foxworthy’s show, since they clearly are not smarter than a fifth grader.
State and local governments were a 0.03 point drag on the overall economy, down from a 0.08 contribution in the second quarter, but much better than the 0.48 point drag in the first quarter. Frankly, given the severe fiscal problems that most states are facing, and since they cannot borrow legally to cover operating deficits, the 0.03 point drag is a major positive surprise.
A big part of the ARRA has gone to helping state and local governments to avoid having to either cut spending drastically or raise taxes. The ARRA funding is starting to dry up. I would expect that S&L government spending will be a bigger drag in fourth quarter GDP than it was in the third quarter.
(X – M) = Net Exports
The biggest drag by far in the third quarter was net exports, subtracting 2.01 points from growth. In other words, if we had not had a deterioration in the trade deficit in the third quarter, the economy would have grown at a 4.0% rate rather than a 2.0% rate. That, however, is a substantial improvement over the 3.50 point drag in the second quarter (in other words, we would have grown at a 5.2% rate in the second quarter rather than at 1.7% if the trade deficit were unchanged in the second quarter), but is much worse than the 0.31 point drag in the first quarter.
The problem was all on the import side, as increasing imports subtracted 2.61 points from growth, down from being an incredible 4.58 point drag in the second quarter, but up from the 1.61 point drag in the first quarter. Of course, that assumes that the foreign goods we bought would have all been made up for by goods produced here in the good old U.S. of A. Since a big part of our trade deficit is due to our addiction to imported oil, that is not something that is going to happen.
However, if we can start to replace imported oil with domestically produced energy we could substantially boost the overall rate of economic growth. While ultimately we would want to do that with renewable sources, such as wind and solar, they mostly produce electricity, and oil is mostly used as a transportation fuel.
We do, however, have very abundant supplies of natural gas, and the technology for using natural gas as a transportation fuel is already very well established. We need to take steps NOW to transition to the use of more natural gas as a transportation fuel to replace oil. Ethanol really is not that good of an answer since the production of corn to be made into ethanol for fuel requires using a lot of oil. However if we can move to ethanol made from things like saw grass, or the corn stalks that are left over from the corn harvests, that would be a major step forward. Biofuels based on algae are also another promising area.
We are actually doing pretty well on the export front, and the recent weakness of the dollar should be a major help on that front going forward. It will also help on reducing imports as foreign goods become relatively more expensive and producers fill demand from domestic production. That does not happen overnight, however.
In the third quarter, increasing exports added 0.61 points to growth, down from an addition of 1.08 points in the second quarter and 1.30 points In the first quarter. I would expect a bigger positive contribution from exports in the fourth quarter and as we move into 2011, and a smaller drag from exports at the same time. The trade deficit is a far bigger economic problem than is the budget deficit, particularly over the short and intermediate term.
Report Card
Overall, this was an OK, but not great report. Growth accelerated from the second quarter, but the source of that growth can be traced to the lowest quality source of growth, namely more inventories building up on store shelves.
The increasing contribution from PCE is encouraging, at least in the short term. It is good that we are still seeing major contributions to growth from E&S investment, but the sharp decline in the contribution from the second quarter is not a good thing. The best thing we could see happen is for that to reaccelerate.
I would not be looking for much growth to be coming from building, either residential or non-residential, as we have a big oversupply of both types of buildings in this country. Eventually residential investment will pick up, and it is not going to fall all the way to zero, so we might see a little bit of a better performance in the fourth quarter on that front, but it is going to be a long time until we get back to seeing it at a normal share of the overall economy.
If the GOP gets control of one or both houses of Congress, look for federal government spending to become a drag on growth going forward, but that is probably more of a 2011 story than a fourth quarter story. I would also expect that S&L spending will be a bit more of a drag.
The real wild card for growth in the fourth quarter is going to be the net exports side of things. If we can restrain the trade deficit, we could have some very solid growth in the fourth quarter. That, however, is a very big IF.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
