Dissecting 3rd Q GDP

By Chris Puplava, October 31, 2007

The Bureau of Economic Analysis (BEA) released the first look at third quarter GDP, which showed the economy expanded at a 3.9% annualized rate in real GDP. This was above the consensus expectations of 3.0% growth and slightly larger than the 3.82% second quarter growth rate in real GDP.

Figure 1

Source: Moody's Economy.com

What is not widely reported in the financial press regarding the GDP report was the implicit price deflator. The implicit price deflator used to subtract inflation from nominal GDP to obtain real GDP was 4.23% in the first quarter, 2.63% in the second quarter, and 0.75% in the third quarter. Nominal GDP came in this quarter at 4.67% and subtracting the implicit price deflator gives real GDP of 3.90%.

Figure 2

Source: Moody's Economy.com

What is incredibly hard to believe is that inflation grew an annualized 0.75% in the third quarter despite oil pushing over $90/barrel, surging food prices where the food & beverage CPI is running at an accelerated 4.4% YOY rate, core CPI running at a 2.14% YOY rate, and the ultimate inflation barometer, gold, pushing through $800/oz intraday and approaching an all-time high.

Figure 3

Source: Moody's Economy.com

Figure 4

Source: Moody's Economy.com

What is interesting is that the implicit price deflator was directionally correlated with West Texas Intermediate crude oil prices in 2006, where both trended lower. However, they decoupled this year with the deflator falling since the first quarter while crude has been trending up the whole year as has food inflation. In the GDP revisions to come down the road, expect the growth rate to be adjusted downward as the implicit price deflator is likely grossly understated, which in turn overstates GDP.

Moving on to other details of the report, the areas of weakness and strength came as no surprise as housing continued to be the economy's Achilles heel while exports rose sharply on the falling dollar. Fixed residential investment fell at an annualized 20.12%, nearly double the 11.77% decline seen in the second quarter indicating that the housing recession may be picking up steam as homebuilders are reacting to falling demand and rising supply from foreclosures.

The sharp decline in residential fixed investment (red line below) pulled down total fixed investment (blue line below), which fell an annualized 1.48% despite positive annualized growth of 7.92% in nonresidential fixed investment (green line below).

Figure 5

Source: Moody's Economy.com

Even though nonresidential fixed investment put in a strong showing with an annualized 7.92% growth rate, the year-over-year (YOY) rate was 4.8%, down from the peak of 9.1% seen in 2005. The deceleration in nonresidential fixed investment is coming from weakness in equipment and software, which currently make up 77.6% of total nonresidential fixed investment, and has fallen to a 1.4% YOY growth rate. Though equipment and software spending has decelerated, spending on structures (commercial real estate) is experiencing a boom, growing at a 12.8% YOY growth rate, though making up only 22.3% of total nonresidential fixed investment.

Figure 6

Source: Moody's Economy.com

So the fixed investment component to GDP was a drag with an annualized growth rate of -1.48%, while consumption grew at an annualized 2.99%, adding 2.11% overall to GDP growth in the quarter. Consumers continue to spend despite a severe housing recession and falling home prices, though at a decelerated pace.

Figure 7

Source: Moody's Economy.com

The real big story for the report was the surge in exports due to a weaker dollar that saw exports rise an annualized 16.18% in the quarter compared to imports which rose 5.22%. The subsequent contribution of net exports to GDP was 0.93% for the quarter.

However, the surge in exports is not all that encouraging. For example, when the economy begins to overheat the Fed raises short term interest rates to slow consumption which also leads to a flattening yield curve. As the economy slows from decelerating consumption, the dollar often begins to weaken with the anticipation of Fed easing that lowers the demand for our government debt securities. A falling dollar makes our export sector more competitive globally as our goods become cheaper to the rest of the world, and thus exports rise.

As seen in the figure below, the ratio of imports (a proxy for consumption) to exports falls heading into a recession. However, the 2001 example was the one exception as the last recession was not a consumer led recession but a business led recession, and so consumption remained strong and held above a 2% YOY rate. As seen in the figure below, the ratio peaked in the fourth quarter of 2004 and its rate of decent has accelerated recently, which often preceeds a recession. Thus, sharply rising exports with weakening imports is not completely encouraging.

Figure 8

Source: Moody's Economy.com

And the last component of GDP, government spending, rose an annualized 3.72% in the third quarter, and contributed 0.73% to overall third quarter real GDP. So overall real GDP grew in the third quarter at an annualized 3.90%, but that is looking at the economy in the rear view mirror as the report covered July through September, and what is most important is the economy's future.

The YOY growth rate in real GDP has a strong correlation to the consumer confidence expectations index and the sharp drop in the Conference Board index yesterday does not bode well for GDP going forward. The expectations index has fallen over 10% since August and any further weakness will show up in consumer spending.

Figure 9

Source: Moody's Economy.com

The reason GDP growth correlates closely with the consumer confidence index is that consumer spending makes up 70% of GDP and consumer consumption trends follow confidence levels closely.

Falling confidence levels translates directly into falling consumption . Thus, falling consumer expectations poses a threat to the consumption side of GDP.

Figure 10

Source: Moody's Economy.com

What is likely to bring down consumer expectations further is the ongoing decline in housing. Also released yesterday was the S&P/Case-Shiller monthly home price index. The 10-metro house price index fell 5% YOY and was the worst reading since April 1991. What is very troubling is that the monthly declines are accelerating, not improving, as the housing market is worsening instead of bottoming due to tighter lending standards. Home prices in Miami declined 21.1% in August compared to July, with declines of 15.6% and 14.3% in Los Angeles and San Diego! That is a huge decline over only one month.

Figure 11

Source: Moody's Economy.com, DismalScientist

Commentary from DismalScientist is provided below:

The S&P/Case-Shiller house price indexes reflect the weakness that is pervading throughout the nation's housing markets. The 10-metro average house price is declining at its fastest pace in over 16 years. Moreover, the decline is broad-based regionally, with prices falling in almost every market covered by the indices. The September price data just begin to reflect the near freeze-up of mortgage markets that occurred at the end of August. The lack of credit is exacerbating already weak drivers of housing demand and sending market prices down�

The S&P/Case-Shiller price should continue to descend in coming months as the impact of the August credit crunch will have its full impact on the index. Longer term, any rebound in the housing market will be delayed by the rising number of mortgage payment delinquencies and defaults, which renders it difficult to work off the already high levels of inventory. Expect declines in house prices to last well into 2009.

The loss in household real estate is significant as the negative wealth affect of a housing downturn often leads to a recession. As seen in the figure below, there are few exceptions of a recession not resulting whenever the annualized percent change in household real estate asset growth falls below 3%, a mark we are fast approaching.

Figure 12

Source: Moody's Economy.com

Whenever the largest household investment falls (real estate), so does consumer confidence. The consumer confidence expectations index follows the trend in household real estate closely and the sharp loss in household real estate assets is certainly likely to talk hold of consumer psyches.

Figure 13

Source: Moody's Economy.com

So, despite a strong GDP report (strong only if you take the BEA�s implicit price deflator at face value) there are significant risks to economic growth going forward, housing being in the forefront as well as peak ARM resets that will weigh on consumer spending that has remained resilient up to September. However, with consumer confidence falling, this may not be the case going forward.

If consumer trends fall going forward, the stock market will realize the fabled �Goldilocks� economy is dead, and the divergence below may be resolved. Either the market or the consumer has it wrong -- time will tell.

Figure 14

Source: Moody's Economy.com

Today's Market

The markets moved northward today on expectations of a Fed rate cut. The markets sold off after the Fed announcement to lower both the federal funds rate and discount rate by 25 basis points to 4.5% and 5.0% respectively, but later rallied strongly into the close.

The Dow Jones Industrial Average rose 137.54 points to close at 13930.01 (+1.00%), the S&P 500 rose 18.36 points to close at 1549.38 (+1.20%), and the NASDAQ gained 42.41 points to close at 2859.12 (+1.51%).

Treasuries fell with the yield on the 10-year note rising 9.2 basis points to close at 4.475%. The dollar index was down on the day, falling 0.23 points to close at a new low of 76.54. Advancing issues represented 72% and 64% for the NYSE and NASDAQ respectively, reflecting a fairly broad advance.

The best performing sectors were the reflation sensitive sectors with materials (+2.48%) and energy (+1.88%) putting in the strongest showing, while consumer discretionary (+0.63%) and consumer staples (+0.64%) were the sectors putting in the weakest performance on the day.

Chris Puplava

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Christopher M. Puplava
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