With the release of the first cut at the 4Q GDP, it is worth taking a look at what the overall composition of GDP looks like, and how it has changed over time. GDP is equal to the sum of spending by the Consumer, business Investment, Government and Exports, minus Imports, or to put into the famous equation: GDP = C + I + G + (X – M).
It’s not enough to say the total GDP was running at an annual rate of $14,463.4 billion in the fourth quarter. The contributions from each of those segments matter as well, and they shift over time.
The graph below shows the evolution of the GDP composition since the end of WWII. In the fourth quarter, the consumer comprised 70.87% of GDP. While that was down from the record 71.15% of GDP in the third quarter, it remains far above its long-term average (since 1947) of 64.77%.
I see such a high percentage of GDP going to consumption as being fundamentally unhealthy. Consumption is a relatively stable part of GDP, but has been in a very long-term uptrend. That uptrend has coincided with the long-term decline in the savings rate.
The Investment Component
Investment is a far more volatile component of GDP, but over fairly long periods of time it tends to sort of average out and be not too different from decade to decade — though from quarter to quarter it can have very big changes. Because of this, Investment is generally the difference between the economy booming or being in a bust.
Notice just how squiggly the pink line is on the graph below. The Investment share of the economy rose to 11.64% of the economy in the fourth quarter, but it remains far below its 15.94% long-term average. The 10.93% in the third quarter was not only a record low, it was an off-the-charts record low. Prior to this downturn, the previous record low was 12.77% of GDP, and that was set all the way back in the second quarter of 1949. Indeed, since the start of 1947, the Investment share of the economy has only been below 13% in six quarters, and only been below 14% in 31 quarters (or 12.3% of the time).
Investment is what tends to drive future growth, particularly business investment (residential investment is also included in the Investment total). The business investment side is low, but not off-the-charts low. Non-residential fixed investment was low, but not shockingly low, at 9.39% of GDP versus a long-term average of 10.72%. Still, that was its lowest level since the first quarter of 1964.
Residential investment is still scraping along the bottom at 2.53% of GDP, versus its long-term average of 4.75% of GDP, although it is up off the record low of 2.44% in the first quarter. At the height of the housing bubble in the fourth quarter of 2005, residential investment was 6.38% of GDP.
Normally, residential investment is one of the key locomotives pulling the economy out of recessions, and if it were to return to its historical average share of the economy, we could have quite a boom. However, given the very high and rising delinquency rates, the high rental vacancy rate and several other factors, that does not seem likely to happen anytime soon. I would expect it to continue to increase though over coming quarters as a share of the economy, perhaps getting back up to about 3% by the end of the year.
The Government Share
The Government share of GDP was 20.53% in the fourth quarter, only slightly higher than its long-term average of 20.25% of GDP. That above average figure is not from huge growth in government spending, but rather because everything else was shrinking. The government figure includes both Federal and State and Local government spending, but it does not include transfer payments like Social Security — those tend to be picked up in the Consumer side of things.
Conventional wisdom is that Government spending is out of control, particularly Federal spending. However, the data does not support that assertion, at least if one strips out transfer payments, which are largely entitlements. Also, Federal government spending is just 39.4% of total government spending, with the rest being spent at the State and Local level. Within the Federal spending, 68.3% is for national defense.
Put another way, non-defense federal spending (again excluding those pesky transfer payments) is only 2.6% of GDP. Let me repeat that: non-defense federal spending (the part that is mostly discretionary, not entitlement transfer payments) is only 2.6% of GDP. Defense spending, at a time when we are involved in two wars, is 5.49% of GDP.
To put a little bit of context to that, the Federal Budget deficit (which includes those transfer payments) is projected to be about $1.3 Trillion in 2010, or about 9% of the fourth quarter run rate of GDP. Does anyone really think that the key to solving the budget deficit can be found just by cutting (or even less so by freezing) non-defense discretionary spending? It simply does not add up.
Net Exports Continue to Lag
Net Exports have been the real problem child of the economy. Over the long term, the average is a negative 0.96% of GDP, but that has been in a pretty steady decline; back in the 1950’s and 1960’s we tended to run trade surpluses, not trade deficits. Of course, it sure helped that in the 1950’s the industrial base of the rest of the world was just rebuilding from the ruins of WWII.
Recently there has ben a bit of an improvement, with Net Exports in the fourth quarter a negative 3.05% of GDP, down from the 2000’s average of -4.57% of GDP — but it sure is not healthy over the long run.
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.
