Final Q4 GDP Revised Down to 5.6% - Analyst Blog

Where the Growth Came From

This is essentially the same report as was posted when the first and second cuts at the 4th Quarter GDP numbers came out, but with the revised contributions to growth shown, the numbers from the first two releases are in parentheses, with the second revisions numbers first and in italics. The final numbers are outside the parentheses and are in bold. This will allow you to quickly assess what has changed in this report relative to the first and second iterations, and also assess how the fourth quarter was different from the earlier quarters of 2009.

When looking at the GDP report and trying to look at what is driving growth, it is important to keep in mind that now all parts of GDP are of equal size, and thus importance. Furthermore, some parts of GDP tend to be very stable, while others can swing wildly.

It is those volatile parts of GDP that generally make the difference between boom and bust. Thus in this post I will look at how much each part of the economy contributed to the overall 5.6% (5.9, 5.7) growth rate. The discussion will be framed in point contributions.

For example, the biggest part of the economy, the consumer, also known as Personal Consumption Expenditures or PCE, increased by 2.0%, that contributed 1.16 (1.23, 1.44) points to the 5.6% (5.9, 5.7) growth rate, while Gross Private Domestic Investment is a much smaller and more volatile part of the economy. It grew by 39.3%, but since it was a much smaller part of the total economy, it only contributed 4.39 (4.63, 3.82) points to the total growth of 5.6% (5.9, 5.7).

Each major component has several sub-components that I will discuss and compare to previous quarters. I will follow the familiar GDP = C + I + G + (X – M) framework.

Overall Growth 5.6%, Not 5.9%

Overall GDP grew by 5.6% (5.9, 5.7) in the fourth quarter, a major acceleration from the 2.2% growth rate in the third quarter, which in turn was far better than the 0.7% decline in the second quarter and the 6.4% implosion that was the disastrous first quarter.

The expectation was that the numbers in this revision would be unchanged from the second cut, so this is a minor negative surprise. Personal Consumption Expenditures (PCE) contributed 1.16 (1.23, 1.44) points to growth, down from 1.96% in the 3Q when the Cash for Clunkers program was in full swing.

PCE is far and away the biggest part of the economy, accounting for 70.8% of the total. In the 2Q, PCE subtracted 0.62 points from growth, or in other words, it was responsible for 88.5% (0.62, 0.70) of the total decline in GDP in that quarter, while in the 4Q PCE was responsible for 20.7% of total growth (1.16, 5.6). Of that 1.16 (1.23, 1.44) PCE growth, 0.63 (0.66, 0.61) points came from Goods, and 0.49 (0.57, 0.83) came from Services.

In Goods, Non-Durables Were Good

In the 3Q, Goods contributed 1.59 points to growth while Services only contributed 0.37 points. Within Goods, there was a huge negative swing in durable goods, which added just 0.03 (0.02, -0.06) points to growth, after adding 1.36 points in the 3Q.

Non-durable goods, though, contributed 0.63 (0.64, 0.67) points -- up sharply from the 0.37 point contribution in the 3Q. Looking further back, Goods PCE pretty much explained the entire decline in the 2Q, with a 0.71 point subtraction from growth (everything else cancelled each other out).

In the first quarter, Goods PCE actually was a net positive contribution of 0.56 points, partially mitigating the absolute collapse of the rest of the economy. Non-durable goods manufacturing subtracted 0.29 points in the 2Q after adding 0.29 points in the 1Q, while durable goods subtracted 0.41 points in the 2Q but added 0.28 points in the 1Q.

Services added 0.09 points in the 2Q and subtracted 0.13 points in the 1Q. Of the three components of PCE, Services is by far the largest (67.4% of total PCE), but it also tends to be the most stable. Durable goods, on the other hand, is a relatively small part of the total, just 10.3% of total PCE in the 4Q, but it can really swing.

Inventory Investment Biggest Contributor

Gross Private Domestic Investment (GPDI) contributed 4.39 (4.63, 3.82) points to growth, or 78.4% of the total growth, even though it represented just 11.8% of the total economy in the 4Q. In what I consider very good news, that is up from 10.9% of the economy in the 3Q.

The bad news is that historically, GPDI has run about 14 to 15% of the economy. We really need to get GPDI back up to its historical share of investment if the economy is going to be truly healthy over the long haul.

GPDI is divided into non-residential and residential, as well as fixed and inventory investment. Overall fixed investment contributed 0.61 (0.75, 0.43) points to growth, up from a subtraction of 0.15 points in the 3Q. Inventories were the big story, contributing 3.79 (3.98, 3.39) points to growth, up from just 0.69 points in the 3Q.

Inventory investment is the lowest “quality" form of growth, since a big increase in one quarter is generally followed by declines in subsequent quarters. However, in absolute terms, inventories are still declining, just at a much slower rate than earlier in the year. It is the change in the rate of decline that added to the GDP growth.

In the fourth quarter, inventories still fell by $23.6 billion, but that was down from a decline of $156.5 billion in the third quarter. Inventories are not going to continue to decline in absolute terms forever, and Macy’s (M) in New York is not going to start to resemble the G.U.M. department store in Moscow under Brezhnev. Thus there could still be some growth coming from inventories in the first quarter, and perhaps into the second, but probably not as much of a contribution, and it will most likely peter out after that.

Crumbling Structures

Non-residential fixed investment, what we generally think of as "business investment," contributed 0.51 (0.62, 0.29) points to growth, up from subtracting 0.59 points in the 3Q. That segment, though, really was a tale of two cities. Business investment in equipment and software was strong, contributing 1.13 (1.09, 0.81) points to growth, while investment in structures subtracted 0.62 (0.47, 0.52) points.

In the 3Q, equipment and software investment subtracted 0.68 growth points, so it really was a major swing factor. The drag from investment in structures, however, was less than the 0.68 growth point drag in the 3Q.

Residential investment posted its second straight positive contribution to growth, adding 0.10 (0.13, 0.14) points, but that was down from a 0.43 point positive contribution in the 3Q. Prior to that, it had been a drag on growth for 15 straight quarters. Those declines brought Residential investment from record high share of the economy to a record low share.

Given the data so far in the first quarter on housing starts and new home sales, look for residential investment to be a big drag on first-quarter growth. Also, with high and rising vacancy rates in almost every part of commercial real estate, look for non-residential investment in structures to continue to be a drag on growth for the next few quarters.

Normally, residential investment is the big driver of growth coming out of a recession, but that does not seem likely this time around. Given the very low base, one does not have to make very heroic assumptions about the level of new home sales to have a very large percentage growth in residential investment, but for residential investment to really get going, we need to see the rate of household formation increase. And for that to happen, we need jobs. Unfortunately, construction is a big swing factor in job creation. Yesterday I discussed the longer-term implications of a housing rebound here: So When Will Housing Come Back?

Investment (the “I" in the equation) is always going to be the most volatile part of GDP. It is what makes the difference between booms and busts. While the overall 0.61 (0.75, 0.43) contribution from fixed investment was not huge in the 4Q, it is important to keep in mind where it was coming from:

In the 2Q, it subtracted 1.68 growth points and in the 1Q it absolutely collapsed, subtracting 6.62 growth points. Non-residential fixed investment subtracted 1.01 points in the 2Q and 5.29 points in the 1Q. That, from a sector of the economy that only made up 9.4% of the whole economy in the 4Q. In the 2Q, inventory investment (or the lack there of) subtracted 1.42 points from growth, and that was an improvement over the 2.36 point subtraction in the 1Q.

“Government" Not a Major Factor

Government consumption and net investment was essentially a non-factor in the growth of the economy in the 4Q. It had a net drag of just 0.26 (0.23, 0.02) points in the 4Q, after adding 0.55 points to growth in the 3Q. A slight positive contribution from the federal government of 0.01 (0.02, 0.02) points was offset by a slight drag of 0.27 (0.25, 0.04) points from state and local (S&L) governments.

In the 3Q, federal spending contributed 0.62 points to growth (0.45 from defense, 0.17 from non-defense) while state and local governments were a slight 0.08 drag on economic growth. On both counts, though, Government was essentially a rounding error as far as overall growth was concerned in the 4Q.

However, in the national income accounting, transfer payments like Social Security are counted as part of PCE, not Government. Within the federal spending, expenditures on national defense were a 0.20 (0.19, 0.19) point drag on growth, after being a positive contributor of 0.45 points in the 3Q. Non-defense spending added 0.21 (0.21, 0.21) points to growth, up from a 0.17 point contribution in the 3Q. In other words, government spending on the military, and for the stuff it buys for Lockheed Martin (LMT) and General Dynamics (GD) fell a bit relative to what it was spending in the 3Q, but that was offset by increases in spending for things like highway infrastructure and civilian government salaries.

On the surface, those sorts of numbers do not support the claim that all the growth is just a “sugar high" from direct government spending and the stimulus program. However, very big parts of the stimulus package were actually tax cuts and entitlement spending (for example, the extended unemployment benefits show up in PCE as the people getting the checks spend them).

Another big part of the ARRA (aka Stimulus Act) was help for S&L governments. In the absence of that aid, S&L spending would have been a far bigger drag on growth. Since states and municipalities are generally not allowed to run operating deficits, they would have been forced to slash spending and raise taxes even more than they already have been.

Looking further back, overall government added 0.85 points to growth in the 2Q after being a 0.52 point drag in the 1Q. Of that, in the 2Q, the federal government contributed 0.85 points (0.70 Defense, 0.15 non-defense) while S&L governments added 0.28 points. In the 1Q, federal spending was a net drag of 0.33 points (-0.27 Defense, -0.06 non-defense) while S&L government spending was a 0.19 point drag.

Contrary to popular belief, overall Government spending (again excluding transfer payments, which are largely entitlements) is not a particularly huge part of the overall economy, just 20.5%. Federal government spending is just 8.1% of the total, and 67.8% of that is spending on National Defense. Non-defense spending, the running of Justice system, the national parks, the collecting of these economic statistics, the air traffic control system, the interstate highway system, etc. is only 2.6% of GDP combined. To put that in perspective, the expected bonuses (not total comp, but bonuses) of the big Wall Street investment banks were close to 1.0% of GDP.

Imports and Exports Both Rise, Net Small Positive

Net exports contributed 0.27 (0.30, 0.50) points to growth, a very nice turnaround from the 0.81 point drag in the 3Q. In the accounting, an increase in exports increases GDP and an increase in imports subtracts from GDP. As a general rule, we want to see both imports and exports growing. We saw that in the fourth quarter, and even more than in the first look at the numbers. If they are not, it means that world trade is contracting, and that is a very bad thing.

What we want to see though is imports growing faster than exports. In the State of the Union Speech, President Obama called for doubling our exports over the next five years. That would be great if we can do it, but "how" is a very big question. Also, if we double our exports but also double our imports, we will not really have accomplished much. In the 4Q, exports added 2.36 (2.23, 1.90) growth points, up from 1.78 points in the 3Q. Imports subtracted 2.09 (2.02, 1.41) points from growth, but that was a much smaller drag than the 2.59 subtraction from growth in the 3Q. 

Looking further back, in the 2Q, falling exports subtracted 0.45 points from growth, while falling imports added 2.09 growth points. So net exports were a huge offset of 1.65 positive growth points, to the overall contraction of 0.7 points in GDP in the 2Q.

As trade collapsed in the 1Q, the offset was even more extreme. Falling exports subtracted 3.95 points from growth but a collapse in imports added 6.58 points to growth, so net exports actually offset 2.64 points of contraction in the domestic economy. In other words, if imports had not fallen in the 1Q, overall GDP would have fallen by more than 13%! This illustrates the point that falling world trade is a bad thing overall, even if declining imports contribute positively to the GDP accounting.

Looking Forward

This report pretty much confirmed what was in the first two reports on the numbers. Mostly the growth is coming from inventories, which is low-quality growth. However, it is not uncommon for most of the growth very early in an expansion to come from inventories -- they are sort of like the batteries and the starter motor in a car. The big unanswered question is if the engine will turnover and start running on its own after the key is no longer being turned.

The consumer is not yet a major factor in the expansion. The consumer is trying to rebuild his or her balance sheet by paying down debt and adding to savings, not taking the incremental dollar and spending it. Over the long term this is very much needed, but without the consumer, the six cylinder engine that is the US economy will be running with just two spark plugs working.

The most promising bright spot is the higher contribution from business spending on equipment and software. The other side of business investment, building commercial real estate, is likely to remain a drag on growth for the rest of the year, but it is not a huge part of the economy.

The expansion of trade shown by the increasing absolute contributions of both imports and exports is a good thing, but on the import side is very sensitive to oil prices. Unless we can cut our dependence on foreign oil, it will continue to be a thorn in the side of the economy. Moving to more use of natural gas, which we have very plentiful domestic supplies of (thanks to the new shale plays), would go a long ways in that regard. Longer-term renewable sources like wind and solar will be even more important. Nukes might also play an important role, particularly if we can solve the problem of what to do with the waste. 

Residential investment is normally the biggest locomotive pulling the economy out of recessions, and while it is no longer pulling the economy down (at least in the 4Q), it is not contributing very much. The renewed downturn we have seen in recent months in new home sales is a very troubling development in terms of near term economic growth. With the just plain awful new home sales numbers in January, which got even worse in February and the weak data on housing starts, residential investment will go back to being a drag in the first quarter.

Eventually a bigger population is going to need more housing, but household formation is at extraordinarily low levels. When it picks up, that will drive the demand for housing which will absorb the current inventory overhang (including the big shadow inventory of soon to be foreclosed homes).

However, to see household formation pick up, we need to see actual job growth. How we get that with no real contribution from residential investment is a major conundrum. When the residential investment tide finally turns for good it has the potential to be a huge economic driver, as getting back to the population adjusted normal level of new home sales would imply a near tripling from current levels. That will of course not happen over night, and it really does not look like the process has even started.

A rise in employment will lead to a rise in household formation, which will lead to higher demand for housing, which in turn will lead to more construction jobs, which will lead to higher household formation. Lather, Rinse, Repeat.

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.

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