Where the GDP Growth Came From - Analyst Blog
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 equal importance. Furthermore, some parts of GDP tend to be very stable, while others can swing wildly.
It is these 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 5.7% 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% and contributed 1.44 points to the 5.7% growth rate. Gross Private Domestic Investment grew by 39.3%, but since it was a much smaller part of the total economy, it only contributed 3.82 points to the total growth of 5.7%.
I will put out a separate post later that focuses on the growth rates; this one will focus on the contributions (i.e. the 1.44 and the 3.82). 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 (consult your standard Econ 101 texts for reference).
A Big Jump
Overall, GDP grew by 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 of 2009. The growth was significantly better than the 4.8% consensus expectation.
Personal Consumption Expenditures (PCE) contributed 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 70.9% of the total. In the 2Q, PCE subtracted 0.62 points from growth; 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 25.3% of total growth (1.44/5.7). Of that 1.44 PCE growth, 0.61 points came from Goods, and 0.83 came from Services.
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 actually subtracted 0.06 points from growth, after adding 1.36 points in the 3Q. Non-Durable goods, though, contributed 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 (67.3% 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 10.2% of total PCE in the 4Q, but it can really swing.
On the Investment Side
Gross Private Domestic Investment (GPDI) contributed 3.82 points to growth, or 67.0% of the total growth, even though it represented just 11.6% 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. I will put out a separate post on the shares of the economy, and how they have changed over time later today, or possibly it will be published on Monday.
GPDI is divided into Non-Residential and Residential, as well as Fixed and Inventory investment. Overall Fixed investment contributed 0.43 points to growth, up from a subtraction of 0.15 points in the 3Q.
Inventories were the big story, contributing 3.39 points to growth, up from just a 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.
Non-Residential Fixed investment, what we generally think of as "business investment," contributed 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 0.81 points to growth, while investment in structures subtracted 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 0.14 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 a record high share of the economy to a record low share.
Looking forward, 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. Residential investment is likely to be a small positive contributor, but only because it is coming from such a low base. Normally residential investment is the big driver of growth coming out of a recession, but that does not seem likely this time around.
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 0.43 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.
The G is for Government
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 0.02 points in the 4Q, after adding 0.55 points to growth in the 3Q.
A slight positive contribution from the Federal government of 0.02 points was offset by a slight drag of 0.04 points from state and local 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 count, 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 0.19 point drag on growth, after being a positive contributor of 0.45 points in the 3Q. Non-Defense spending added 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.
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 Package (ARRA). However, very big parts of the stimulus 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 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, air traffic control, the interstate highway system, etc. -- is only 2.6% of GDP. To put that in perspective, the expected bonuses (not total comp, but bonuses) of the big Wall Street Investment banks are expected to be close to 1.0% of GDP.
World Trade
Net Exports contributed 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. 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, 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. In the 4Q, Exports added 1.90 growth points, up from 1.78 points in the 3Q. Imports subtracted 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.
Good Numbers, but Expect Revisions
Overall, this is a much better than expected report. However, the numbers are very preliminary. In the 3Q, the first report came in very strong at 3.5%, and then was revised down twice to growth of just 2.2%. Before one gets too giddy about this report, remember that the numbers are subject to revision.
Most of the growth was low-quality inventory investment, which tends to be fleeting. Still, even if inventories are totally stripped out, this does represent an improvement to 2.31% growth from 1.51% growth in the 3Q and 0.72% growth in the 2Q.
The pickup in equipment and software investment by business is particularly welcome to see, as was the improvement in the Net Export line. To have a healthy economy in the long term, we need both of those areas to show strong and prolonged growth so they become a much larger share of the overall economy. PCE needs to fall towards its more historically normal share of the economy around 65%.
We need to be an economy that produces goods and services, not just consumes them. That has got to be a long-term process. At almost 71% of the overall economy, if PCE falls in absolute terms, it is almost impossible for the economy to grow. To move from 71% of the economy to 65% of the economy, it means that other parts of the economy -- most importantly business investment and net exports -- have to show very robust growth, and do so over a long time.
At least for the next few quarters, though, Non-Residential Investment in structures is going to be very weak. With empty strip malls and office buildings littering the landscape, there is not much reason to build more of them. Residential Investment is likely to improve in 2010, but at a far, far slower pace than normally happens coming out of a recession, particularly one that is as deep as this one was.
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
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