Recent 3rd Q GDP, Construction Spending, and ISM Report Point to Continued Economic Slowing
By Chris Puplava, November 1, 2006
The advanced estimate for third quarter GDP report was released last Friday which showed further deceleration in the economy after the 5.6% annualized growth rate in the first quarter, and the 2.6% annualized growth rate of the second quarter. The main culprit was residential fixed investment and stronger imports which hurt net exports of goods and services. The components of GDP are given below with the quarter-over-quarter percent change and annualized growth rates as well as their respective contributions to the percent change in real GDP below.
Table 1. 3rd Quarter GDP Report
The greatest improvements in the quarter came from non-residential fixed investment and durable goods, which rose at an annualized growth rate of 8.4% and 8.1% respectively, with the change in private inventories and residential fixed investment showing the greatest weakness over the second quarter, with -22.3% and -18.7% annualized growth rates. Looking at component affects on overall GDP, the greatest support to GDP in the third quarter came from personal consumption expenditures and non residential fixed investment, which contributed 2.15% and 0.96% respectively. The greatest drags on GDP in the third quarter came from residential fixed investment and net exports, which reduced GDP by 0.98% and 0.55% respectively.
What the report shows is that consumer spending remains healthy, coming in at a 3% annualized growth rate and represented 71% of total GDP, and residential fixed investment has now contributed negatively to GDP for four straight quarters, and represents 5% of GDP. Even though consumer spending makes up 71% of total GDP, its growth has slowed from the peak in 2003 and can be seen from the figure below to be following a decelerating trend with third quarter year-over-year (YOY) percent change coming in at the lowest reading since the second quarter of 2003.
Source: Paul Kasriel, The Northern Trust Company
The deceleration in personal consumption expenditures is likely the result of the wealth affect of housing; with housing prices falling, consumers are slowing their spending habits as they previously increased spending as housing prices rose. What is also important to understand is that residential fixed investment leads overall GDP with housing being a leading indicator. A housing downturn first shows up with reduced residential investment followed by falling housing prices. Notice in the figure below that when the annual rate of change in the market value of household real estate drops sharply, a recession (grey bars) typically follows. Reduced market values for household real estate leads to higher debt levels as the ratio of home mortgages to net worth rises. (For a great source of charts I highly recommend The Chart Store, with charts on the financial markets, commodity markets, economics, business cycles and more.)
Source: The Chart Store (http://www.thechartstore.com)
Falling housing prices and the affect of rising interest rates then cuts into consumer spending, which then reduces the personal consumption expenditure component of GDP. Thus, residential investment falls first followed by overall GDP. This relationship is seen in the following figure.
Source: Paul Kasriel, The Northern Trust Company
With residential private investment turning down sharply, real GDP ex-residential investment is likely to head lower in the coming quarters. Another contributing factor to decreased overall GDP is not only slowing in the growth rate of consumer expenditures, but also in business expenditures. Private non-residential investment in equipment and software has slowed from the peak of 9.3% in the third quarter of 2005 to 5.7% in the third quarter of this year.
Source: Paul Kasriel, The Northern Trust Company
I commented in my last observation, "Housing & Energy Economic Review" that last month several economic reports came out that showed a slight breather from a falling housing trend. I was amazed to hear articles and the financial media already calling for the bottom as homebuilder stocks were rebounding. I wasn't the only one with this reaction as Brian Pretti from Contrary Investor.com provided the following commentary.
It never fails to amaze us that when bubble like price moves in any asset class peak and begin their inevitable descent, bottom callers seem to literally come out of the woodwork as they view virtually any sign of industry related sunshine as THE bottom for the asset class in question. If the tech bubble and eventual pop didn't teach us this little lesson about human nature, then we just don't know what will. Well, get prepared because it's already starting in terms of the bottom calling for residential real estate.
The bottom in housing is still a ways off, as I pointed out in a previous observation, " Recent Housing and Inflation Data Support Fed Pause", that housing starts typically have bottomed near a negative 40% YOY rate and at 893 units.
Not only did I hear of a bottom in housing, but also that it wasn't having an affect on the U.S. consumer and spreading into other areas of the economy. I can’thelp but notice Paul Kasriel's annoyance of this assertation as the charts he created above show otherwise. The title for the daily global commentary was "Housing Recession Isn't Spreading?" with Mr. Kasriel having the following to say.
This is the nonsense that many of the talking heads are spewing. But that's what it is - nonsense in sum, it is not just the housing component of real GDP that is slowing, but the consumer and business capital goods sectors as well. Moreover, you probably "ain't seen nothing yet" compared to what lies ahead for a slowdown in the rest of the economy because housing leads.
Proof that housing leads can be seen with the relationship of existing home sales and nonfarm employment as I showed several weeks ago, where existing homes sales turn south well in advance of nonfarm employment, is shown below.
Besides residential investment and non-residential investment in equipment and software slowing down, other areas of the economy are showing weakness due to the housing downturn and the reduced consumer spending growth rate. This can be seen with falling retail employment which leads total employment.
Bottom line, the housing downturn has a ways to go, and don't be fooled into thinking that now is the time for bottom fishing or that the housing slowdown isn't affecting the rest of the economy.
Stocks were down today after the release of several economic reports showing weakness in the economy. The Institute for Supply Management (ISM) released their October report which showed the ISM Purchasing Manager's Index (PMI) falling to 51.2, the lowest reading since June 2003. Weighing the index down was production falling from 56.1 in September to 51.9 last month, with new orders and order backlogs falling and inventories rising, all of which point to a slowing economy. With inventories rising, manufacturers are likely to further cut production to prevent an inventory overhang. On the bright side, prices paid fell sharply to 47.0 last month from September's 61.0 and employment rose slightly, up to 50.8 from September's 49.4 reading.
The ISM PMI points to an expanding economy as the level is still above 50. Sharp declines below 50 often mark recessions as seen by the charts below, with mid-cycle slow downs associated with slight dips below 50.
Figure 8. 1950-1976
Figure 9. 1975-2006
Source: Chris Puplava, FSO, Data: Institute for Supply Management
Also released today was construction spending, which decreased 0.3% in September. Confirming last week's GDP release, the biggest drag on construction spending was private residential spending, which was down 1.1% last month and down 6.9% from last year's levels. The decline marked the sixth consecutive monthly decline. In contrast to private residential construction, private non-residential construction spending was up slightly, rising 0.1% last month and 19.2% above last year's levels, marking the seventh consecutive monthly advance.
Figure 10. Total Construction YOY % Change
Also released today was the Mortgage Bankers Association of America's (MBA) mortgage applications survey, which showed a decline in their refinance index and purchasing index, down 4.5% and 1.8% respectively. The report showed mortgage demand decreased 3% last week and is 12% below last year's level. The decrease in mortgage demand came as purchase applications declined to their lowest level of the current downturn.
The Energy Information Agency (EIA) released their weekly petroleum report today, which showed crude oil inventories rising 2 million barrels last week, below the expectation for a 2.7 million build, with distillate inventories falling 2.7 million barrels and gasoline stocks falling 2.8 million barrels, both in line with expectations.
Last week I looked at the trends in crude oil, gasoline, and distillates and wanted to add below the commentary by the EIA which provided some trend analysis in this week's report.
Of course, many in the oil analytical community may continue to look at daily changes in prices and concentrate on weekly changes in U.S. oil data. But sometimes it is important to step back from the trees to see the whole forest, which is why it is often best to closely scrutinize the four-week averages, rather than just focusing on the latest weekly data.
One observation appears to be that demand growth for key oil products in the United States has recently accelerated. Looking at the three main light product categories (gasoline, distillate fuel, and jet fuel) in combination, demand for the four weeks ending October 27, 2006 averaged over 15.5 million barrels per day. Comparing this to the four weeks ending October 29, 2004, provides an annual average growth rate of 2.2 percent, which is somewhat higher than a typical annual growth rate of about 1.5 to 2.0 percent.
These growth rates were observed despite higher crude oil prices. The spot price in October 2006 averaged just under $59 per barrel, whereas the WTI spot price in October 2004 averaged around $53 per barrel, and the average price in October 2003 was around $30 per barrel. Even as recently released economic data indicated that U.S. economic growth continued to slow, with a preliminary estimate of 1.6 percent growth in Gross Domestic Product (GDP) in the third quarter of this year, overall economic activity appears to be solid enough to sustain demand growth for gasoline, distillate, and jet fuel.
Another trend relates to crude oil imports. Since domestic production has declined in each of the last three years, but demand generally increases every year, the expected trend would be significantly higher crude oil imports now than seen in 2003 or 2004. Yet crude oil imports the last four weeks are roughly equivalent to those seen 2 and 3 years ago (again, last year's data is ignored for analytical purposes due to the effects from Hurricanes Katrina and Rita). It appears that increased product imports over the years, among other factors, have helped to keep the market in balance.
All of the broad market indices were down on the day, with the DJIA posting a loss of 49.71 points to close at 12031.02. The S&P 500 was down 10.13 points to close at 1367.81, and the NASDAQ was also down, falling 32.36 points to close at 2334.35. The 10-year Treasury note yield fell to 4.561%, and the dollar index posted a gain on the day, rising 0.13 points to close at 85.45. Advancing issues represented 34% and 26% for the NYSE and NASDAQ respectively, with up volume representing 22% and 18% of total volume on the NYSE and NASDAQ.
Energy commodities were mixed on the day, with uranium spot prices advancing past $60 a pound for the first time ever, rising more than 7%. Precious metals rose today with gold continuing to advance above $600/oz while base metals were mostly down.
Overseas markets were mixed with Brazil's Bolsa Index and France's CAC-40 Index posting the greatest gains, up 1.70% and 0.41% respectively, with Japan's Nikkei 225 and Mexico's Bolsa Index posting the greatest losses, down 0.15% and 0.02%.
The decline in the markets was broad based as all but one S&P 500 sector declined, with utilities putting in the only positive performance, up 0.73% on the day. The technology sector, financials, and consumer discretionary posted the greatest losses, down 0.90%, 0.88% and 0.82% respectively.
Have a pleasant weekend,
© 2006 Chris Puplava