residential investment

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GDP and Unemployment

The release today of the revised second quarter GDP figures was a bit of a dud. Most of the other recent data has been suggesting we would see a slight revision upward of the preliminary figures. Instead there was no change: the economy shrank at an annual rate of 1.0% between March and June. That’s a considerable improvement over the first quarter disaster when GDP fell at an annual rate of a whopping 6.4%. So, clearly things are improving.

Well yes and no.

Here are the numbers [I have rounded them all off]:

  • Consumption -0.7%
  • Business Investment -1.1%
  • Residential Investment -0.7%
  • Inventories -1.4%
  • Trade [Exports minus Imports] +1.6%
  • Government Spending +1.3%
  • TOTAL GDP -1.0%

Ok what do we make of these numbers?

First: consumption was a disappointment. It’s contribution to the overall decline was a fall of 0.7%. This is after having been positive in the first quarter debacle. Clearly the economy will not spring to life if consumption -which accounts for two thirds of the total – languishes like this.

Second: private sector investment isn’t helping at all. Business investment is still shrinking, it has for seven straight quarters now, and residential investment also is declining. There is no surprise in these numbers: businesses are still retrenching and avoiding making any long term commitments to the future. With the enormous slack that now exists – idle factories, stores, and unemployed workers – there is no incentive for business to invest in anything new. I think it will be a while before this sector gets going. Likewise residential investment. There has been a little life recently in new home construction, but nowhere near enough to spark a recovery: even if construction perks up more over the summer I doubt that will last into the winter months as long as the unsold inventory of houses remains as high as it is. So I expect investment to sputter for a couple more quarters.

Inventories are another matter. Last quarter’s decline brings the ratio of sales and inventories to low levels. This is usually an indicator that businesses are about to increase production. I expect this ‘normal’ response to take place this quarter, and it is the reason that the third quarter GDp may well be positive – this is the ‘classic’ inventory driven recovery the media are all hyping.

Third: those trade figures are deceptive. The entire trade balance continues to shrink, not because of some extraordinary export successes but simply because our domestic consumption was heavily import based and since we are consuming less we are also importing less. The sharp drop in imports is also driven by changes in commodity prices – things like the drop in oil prices have a big impact – which do not necessarily represent an important indicator of future GDP growth. I expect that, as soon as the economy starts to grow again, our trade balance will shift back deeper into the red and therefore reduce GDP in future quarters. This imbalance is something that needs fixing over the medium and longer haul: look for the dollar to decline if it doesn’t.

Fourth: the only sector where the second quarter story gives us an indicator of the future is government spending. The entire private sector, excluding those specious trade figures, was negative still – it was government spending that kept the decline in overall GDP to a minimum.

So the picture is very mixed.

Yes things improved. But quite a bit of that improvement is more a quirk of the statistics than a concrete aspect of the economy. Clearly the government stimulus is having an impact, one that will increase as the various programs gather momentum. And inventories seem poised for rebound. Together these will probably pull us out of recession – they are as we speak. But the private sector generally still looks anemic. That should give us pause for reflection – this recovery still looks very weak and vulnerable to shocks.

I am yet to be convinced that next year will be much to write home about.

Today’s other news comes in the form of the weekly data for new claims for unemployment insurance – which gives us an idea of how the job market is doing. Here the news is decent: new claims fell last week by 10,000. Any time we see an improvement we should be happy, but the gain was small and the total remains stuck stubbornly high: it was 570,000 last week. That is just not very good.

Clearly the economy is still bleeding jobs. We cannot claim much advance in the economy while we are still losing over half a million jobs a month.

I have said repeatedly: this recovery has all the makings of being ‘jobless’. That is not something to cheer about.

So, talking all this together what do we have?

A weak recovery seems to be in the works. It will be driven by an inventory rebound and the government stimulus. These two will provide enough of a ‘kick’ that the private sector sputters back to life early next year. But I use the word ‘sputter’ purposefully – the huge slack in the economy hangs over the employment and investment markets and will dampen spending. Trade also could revers its gains if commodity prices start to rise as the worldwide recovery gains momentum – most of the world is now back to growth which drives up demand for things like oil and thus prices also.

We still have considerable risks to worry about that could ‘shock’ us back into recession.

The banks are very weak. Toxic assets still clutter up balance sheets and could explode at any moment. Commercial real estate is in the process of melting down and will produce big loan losses. Likewise continued high unemployment will accelerate the rise in personal loan losses – credit card and mortgage defaults will peak next year.

Debt remains high. Especially in the context of the loss of wealth implied by the combined stock market drop last year and the huge loss in [paper] value of houses. Households are still trying to ensure solvency let alone liquidity. That suggests a very low rate of recovery in consumption.

Above all else the job market is stuck in reverse. Until jobs become plentiful the economy will teeter on the edge. I realize this sounds like a tautology – which drives which? jobs or the economy? but experience indicates that households will remain cautious as long as the job market appears dismal. We need to reach an inflection point in consumer confidence before we can argue that the recovery is self-sustaining and that the government can take its foot off the gas.

Which brings me to one last thing: the stock market.

Stock prices have surged since earlier this year. that’s great for all those 401K plans you have. But I am a little skeptical about the underlying strength of the economy: I think the stock market has run ahead of the recovery somewhat and over-valued stocks in the short term. Exuberance is the norm on Wall Street – they all have a tendency to overshoot on both the up and down sides of a cycle. At the moment I think they are building in profits that are yet very uncertain: businesses have done very well to retrench and maintain some semblance of profit. But that came at the cost of a huge contraction in activity – hence the recession and all that slack I mentioned above – getting back onto a growth track is neither as easy, nor as certain, as the stock market seems to think it is. So don’t be surprised to see stock prices give way a bit over the next month or so.

It’s still a bumpy ride ahead.

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GDP Slide Continues

Surely no one was surprised by the release this morning of the first quarter GDP results. The sharp contraction that began lat the end of 2007 continued unabated with the economy shrinking at an annual rate of 6.1%. This was the first time in three decades that we have experienced back to back quarterly declines of over 5%, and, obviously, was a very poor performance.

Inside the numbers, however, are nuggets that can support everyone’s argument, pessimists and optimists alike. Usually this kind of split or ambiguous message is the first sign that the decline is beginning to moderate, so all eyes turn to the current quarter where most ‘experts’ are predicting a much slower rate of fall, possibly a drop of 2%, before we arrive at the third quarter which may well be flat or even a tiny uptick.

Let’s look at the details:

  • Trade. The difference between exports and imports, the balance of trade, played a major role in the first quarter. It added 2% to growth. Or rather, it prevented the decline from being 2% steeper. Under normal circumstances this would be cause for a little celebration: the US has run a considerable trade deficit for far too long. This time, however, our celebration should be severely muted. The reason the trade balance improved was simply due to a drastic cut in imports as American consumers stopped buying foreign goods. Imports fell at an annual rate of 34.1%, an extraordinary decline. Unfortunately exports also dropped like a stone, only not quite as much as imports: the drop was a ‘mere’ 30%. Taken together the trade gap shrank. But for all the wrong reasons. I see no joy in this. The global collapse of trade is an alarming feature of this recession and is an indicator of how difficult it will be to restore strong growth. There is no way any country can export their way out of the crisis. That’s a very big deal for export driven economies such as Germany and Japan, but it also removes one of our potential sources of recovery.
  • Consumption. The optimists will love the fact that consumer spending rose 2.2% in the first quarter. They will look at this number and immediately proclaim an end to our woes since our economy is driven in large part by consumer spending. I am a little more skeptical. Just this week consumer confidence improved dramatically: it jumped from a very low mid 20% to a high 30% range. But it remains really low. So, while I agree that there is an obvious improvement: consumption had fallen at annual rates of about 4% in each of the previous two quarters, I would not declare an end to the crisis on the back of this evidence. There is still a very long way to go, and the shadow cast by unemployment will linger well into next year. My position remains cautious: let’s see how the monthly data tracks over the coming months before getting too giddy. We are not cable TV hosts, so we can be realistic. Having said that it is equally evident that consumers stepped up more than expected in the first quarter. The combination of larger tax refunds and slashed prices had the desired effect. Let’s see if that effect carries over and sets a sustainable pace for the rest of the year.
  • Business Investment. Here’s the real rogue last quarter. Business investment plummeted: investment in buildings fell 44.2%, and investment in equipment and software fell 33.8% for an overall drop in business investment of 37.9% at annual rates. That’s ugly. Really ugly. Companies are slashing not just jobs but anything else they can lay their hands on in order to preserve cash flow. This is the biggest cut back since 1958 and has now reached a level that is probably unsustainable. Simultaneously businesses also kept on cutting back inventories: by some $103.7 billion in the quarter. At some point businesses will have eliminated all the expenses they can. When we arrive at that moment the only way is up and investment will increase again, no matter how small the increase is it will help end the recession. Of course being able to predict when the turning point has arrived is impossible, but with declines of that magnitude in the first quarter I have to believe we are very close to it. This is one major reason why I see the decline in GDP ending at the end of this year.
  • Investment in Housing. There can be no surprise here. Investment in housing continued its steep decline for the 13th straight quarter. It fell at an annual rate of 38%, the sharpest decline since 1980. Given the news earlier this week that home prices are still falling, I think it is fair to call the outlook for residential investment grim as far as the eye can see.
  • Government Spending. This data is weird. With all the fuss over deficit spending and stimulus plans you would think that government spending boomed in the first quarter. You’d be wrong. It fell at a 3.9% annual rate. State and Local government was one part of the cause: cut backs at those levels also were at a 3.9%, which is the sharpest drop since 1981. The surprise is that Federal spending fell at a 4% rate, with most of the decline coming from a 6.9% drop in defense spending, which is notoriously volatile and will therefore most likely jump back later this year. Clearly the stimulus has yet to kick in. When it does government spending will help lift the economy out of recession. Again this seems as another likely candidate to end the recession later this year.

So for those of you keeping count, we had a decline of 6.1% overall. When you adjust all the factors I just mentioned for their impact on the total economy here’s the scorecard: Consumer spending added 1.5% and trade added 2%. So on the positive side we had 3.7% gains in two sectors. The downside came from: business investment -4.7%; government spending – 0.8%; inventories -2.8%; and investment in housing -1.4%. Yes I know that only adds up to a drop of 6.0%, but that’s accounted for by sundry small stuff and rounding off the figures!

The message? The economy continues to tank. A 6.1% decline is awful in anyone’s book. But there are very slight signs the rate of decline will now start to moderate. We should even grow a little later this year.

None of this is controversial. The really big question remains: what is the shape of the eventual recovery? Will it be a sharp upturn? Or will it be a long slow slog?

The answer to that depends heavily on the health of our banks. But that’s probably not what you wanted to hear.

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