This is effectively the same post as I put out when the first look at GDP in the first quarter was released last month. The numbers from the current release are in bold while those from the first release and for previous quarters are in normal font. This allows you to see exactly where the changes in the contributions to growth are coming from.
Overall, this is a disappointing report. Not only was the headline number disappointing, but the quality of the growth was lower relative to both the first release and relative to the fourth quarter. New commentary will also be in bold.
In the first quarter, the economy grew at an annual rate of 1.8% (unrevised), down from 3.1% in the fourth quarter, and from the 2.6% pace in the third quarter. The growth rate was below consensus expectations of 2.0%. The first graph (from this source) shows the history of GDP growth.
What Got Us Here?
So how did we get to the 1.8% 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. To do this 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.
Consumer 71.2% of Economy
The biggest part of the economy by far is the Consumer, or consumption — or to be more specific, Personal Consumption Expenditures (PCE). It represented 71.2% of the overall economy in the fourth quarter, and was the biggest growth driver. PCE contributed (1.53) 1.91 growth points, down from 2.79 points in the fourth quarter but up from 1.67 points in the third quarter.
The drop in contribution from PCE is exhibit A for how the quality of the growth deteriorated from the first data release to the current one. Over the long term, our economy is already weighted far to 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. This is high-quality growth, and is very welcome in the current environment.
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 those decisions have never looked into my closet.)
Services are by far the biggest part of consumption at 65.96% of PCE and 46.96% of overall GDP. It chipped in 0.69 (0.80) growth points, down slightly from contributing 0.70 points in the fourth quarter and from a net contribution of 0.74 points in the third quarter. This is still a solid contribution, but clearly 0.80 is better than 0.69.
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.
Durable vs. Non-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 purchase of durable goods 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 whether the economy is booming or slumping.
Durable goods consumption added 0.66 (0.78) points to growth, down sharply from an addition of 1.45 points in the fourth quarter but up from 0.54 points in the third quarter. While that contribution is not bad, the sharp slowdown is a bit disheartening, even moreso after the downward revision. The sector is only 10.88% of PCE and 7.75% of overall GDP, yet it contributed 43.33% of the overall GDP growth in the quarter. Early in recoveries it tends to have a bigger positive impact, but it also has a big negative impact when the economy falls into recession.
Non-durable goods are 23.15% of PCE and 16.48% of overall GDP. The sector’s contribution to growth fell to 0.17 (0.34) points in the first quarter from 0.65 points in the fourth quarter and 0.39 points in the third quarter. While one does not expect big flashy moves in this part of the economy’s contribution to growth, it is stall a major part of the overall economy. Its contribution being cut in half from an already mediocre level is not good news.
Overall, the Consumer is doing his and her part in getting the economy rolling again. The strong contribution from the consumer service sector was encouraging. The downward revisions to all three parts of consumer spending is a big disappointment. Yes, all three parts made contributions to growth, but much less so than in the fourth quarter, or from where we thought things stood after the first release of the first quarter data.
While over the long term we can worry that far too much of the overall U.S. economy is dedicated to consumption and not enough to investment and exports, for right now we want to see the Consumer alive and kicking. Without a doubt he was in the first quarter, but not kicking as hard as at the end of last year.
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 12.42% of the overall economy. Overall GDPI added 1.45 (1.01) growth points in the first quarter, a sharp reversal from subtracting 2.61 points in the fourth quarter but down from the 1.80 point contribution in the third quarter.
The increase in contribution from GDPI is encouraging, at least at first glance. But don’t break out the champagne yet — when one looks a bit deeper, the picture is much less encouraging.
Investment is the key to future growth, and as a share of the economy it is much lower than 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 for 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.
This is exactly the dynamic we are seeing in the first quarter numbers. 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 increase in inventories accounted for most than all the overall increase from GDPI. Inventory investment added 1.19 (0.93) points from growth in the fourth quarter. That is a sharp reversal from the fourth quarter, when lower inventories subtracted 3.42% from the overall growth.
In the third quarter, inventories added 1.61 points to growth. In other words, in the first quarter, 66.1% (1.19/1.8) (51.7% [0.93/1.8]) of the total growth came from adding goods to the shelves, not from people actually buying the stuff on the shelves.
This is very low quality growth, especially when it happens for several quarters in a row, and we had five of them where inventories were a big positive player in providing growth. Then again, those came after eight quarters in a row where inventories were a drag on overall growth.
Clearly inventories can have a big influence on overall growth, but it tends to be very low quality growth. There does, however, seem to be somewhat of an inverse correlation with net exports, which I discuss below. The contribution from inventories was large relative to overall growth, but not particularly big in absolute terms. In other words, not so big as it is likely to turn negative in the second quarter.
If inventories had just been a non-factor, the economy would have been crawling along at a 0.6% growth rate. Down from an awesome 6.5% growth rate in the fourth quarter. The pace of growth ex-inventories is slightly below what we were running in the third quarter (1.0%) and in the second quarter of last year (0.9%).
Residential vs. Non-Residential 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. That changed a bit in the fourth quarter, and we appear to be slowly forming a bottom in residential investment, it being up in two of the last three quarters.
In the fourth quarter, residential investment added just 0.07 points to growth, but that is a big swing from the 0.75 point drag in the third quarter. In the second quarter, fueled by the first time buyer tax credit, Residential Investment added 0.55 points to growth, but that was a big exception to the recent trend. The first quarter was back to more “normal” form subtracting 0.09 (0.07%) from overall growth.
Residential investment is now just 2.21% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble. "Normal" is about 4.4% of the economy. While the levels are still just plain awful, it has shrunk so much that it is hard for it to have that much of an effect on the overall rate of growth.
Residential investment has been a drag on GDP growth in 15 of the last 18 quarters. 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 1.6 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.
Still, starting from such a low level, it seems likely that Residential Investment is likely to be a positive contributor to growth in 2011. Not a very big one — that is more likely a 2012 story — but simply by not being a major drag on the economy will be a major turn for the better. 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.
We are now at an all-time low for residential investment as a share of the economy, as shown in the next graph (also from this source). Note how at the end of every previous recession, residential investment increased sharply as a share of GDP, in effect leading the economy out of the recession, but how it has persistently declined this time around. That is THE key reason that this recovery seems so sluggish.
(Part 2 of this report is available here.)
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KELLOGG CO (K): Free Stock Analysis Report
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