GDP Awful, But Some Positives In Inventory Investment

In the first reading of the first quarter, GDP declined by 6.1%, which was almost as bad as the -6.3% decline in the fourth quarter. This is the first time we have booked back to back quarters of down 6% or more since the end of WWII. The number was also far worse than the consensus expectation of a 4.7% decline.

However, digging deeper into the numbers there is some reason for optimism going forward. In this analysis I will focus on the percentage contributions to GDP rather than the percentage change in the individual components. After all, a 30% decline in a component that makes up 1% of GDP is not as significant as a 5% decline in a component that makes up 20% of GDP.

Perhaps the biggest positive surprise in the report was that Personal Consumption Expenditures (PCE) actually contributed 1.50% to GDP, after subtracting 2.99% points of growth in the fourth quarter. Regular readers of this blog will recall that I forecast that PCE would be stronger than most expected. However, I thought we might just marginally break into the plus column on the biggest part of GDP.

A contribution of 1.50% is much higher than I was expecting. All three parts of PCE were up, with spending on Durable Goods adding 0.61 (vs. -1.67 in the 4Q), Non-Durable Goods kicking in 0.26 (vs. -1.97 in the 4Q) and Services adding 0.63 (vs. +0.66 in 4Q).

Going forward, there is a big question if this strong performance can continue in the face of rapidly rising unemployment. However, in the first quarter it is clear that consumers were taking advantage of post-Christmas sales.

Looking forward, perhaps the best part of the report was that inventory investment subtracted 2.79 points from growth (vs. -0.11 in 4Q). Large inventory draw-downs in one quarter have a tendency to be reversed in the next quarter. When the shelves are bare, people start to order more to restock them, causing output to rebound.

The drop off in inventories contributed to a horrific 8.83 point decline in Gross Private Domestic Investment (GPDI). This was more than twice as bad as the already ugly -3.47 point decline in the fourth quarter.

Essentially all investment in the real economy, both fixed and inventory, residential and non-residential, came to a screeching halt in the quarter. While ugly contributions from inventories are a good thing, the same cannot be said about fixed investments. There, bad is bad, and this was real bad.

Total fixed investment subtracted 6.04 growth points, or on a stand alone basis was responsible for the entire decline in GDP (everything else offset each other). This came on the heels of a 3.36 point drag in the 4Q. Of that 6.04 point decline, 4.68 points came from non-residential investment (vs. -2.56 in the 4Q). That in turn was split between a 2.13 point drag from non-residential structures (vs. -0.38 in 4Q) and a 2.55 point drag from spending on equipment and software (vs. -2.18 in the 4Q).

Businesses simply stopped investing in new productive capacity. It is not hard to see why, when over 30% of current capacity is sitting idle. Why buy that new machine tool when you have a dozen of them sitting around gathering dust? Why build a new office building when the place across the street is half empty and the tenant is laying off workers? Expect this part of the economy to remain weak for at least several more quarters.

This is particularly true on the structures side. I suspect that most of the spending we did see in the quarter was simply finishing off projects that were started in earlier quarters. The Commercial Real Estate (CRE) bust is just getting started and will last at least another year (see graph below, larger version available at http://www.calculatedriskblog.com/). Investment in structures (blue line) has only started to decline and was a major contributor to GDP up until the third quarter of last year.

The decline in equipment and software has been unusually steep, and it now represents the smallest share of the economy since the mid-1960’s. The decline will probably continue, but is may be at a slower rate in coming quarters.

Perhaps the most surprising number on the downside in fixed investment was the subtraction of 1.36 points from Residential Investment (RI). This was the 13th straight quarter that RI was a drag on GDP growth, and the biggest subtraction since a 1.40 point drag in the 3Q of 2006. RI is now only 2.7% of GDP, down from a peak of 6.3% in the 4Q of 2005.

At some point RI will have to stop being a big drag on GDP simply because it no longer exists. It is now at by far its lowest level relative to GDP since the end of WWII (see graph below, larger version available at http://www.calculatedriskblog.com/). Note that RI turning up is a classic signal that a recession is ending.

Normally the rebound is very sharp, but I have my doubts that it will be so this time around, given the huge inventory of unsold houses — both new and used — and the second wave of foreclosures that is starting to crash upon the shore.

Net exports helped prevent the quarter from being a total disaster, adding 1.99 points to growth, versus a subtraction of 0.11 points in the fourth quarter. This was, however, not due to a surge of exports, but rather a collapse of imports. Declining exports subtracted 4.06 points from growth in the first quarter, following a 3.44 point decline in the fourth quarter.

With the rest of the world in recession along with us, don’t look for a surge in exports to help out the GDP figures anytime soon. The decline in imports was stunning (imports are a subtraction from GDP so when they fall GDP goes up) and it contributed 6.05 points to growth. Put another way, if we had continued to import in the first quarter at the rate we had in the fourth quarter, then GDP would have crashed at an annualized rate of over 12% in the first quarter.

A good part of the decline in imports can be traced to lower oil prices, but even our non-energy imports have been declining fast. When inventories are drawn down, we buy less from China as well as less from domestic manufacturers. In case you have not noticed a lot of the stuff on the shelves of Wal-Mart (WMT) and Target (TGT) comes from overseas. If PCE can continue its surprising strength going forward, the decline in imports is unlikely to continue.

Finally, and probably surprising to many in view of the concerns about the budget deficits and federal spending, the government was overall a drag on GDP — subtracting 0.81 points after it had added 0.26 points in the fourth quarter. The Federal government was a drag of 0.32 points, more than reversing its 0.52 point addition to growth in the fourth quarter.

Defense spending swung from adding 0.18 points in the fourth quarter to subtracting 0.35 points in the first quarter. Non-defense spending added just 0.03 points vs. adding 0.34 points in the fourth quarter.

The stimulus bill had not kicked in the first quarter, and I would expect that Federal spending, particularly non-defense spending will be a much larger positive contributor to GDP in future quarters.

State and Local spending subtracted 0.49 points (vs. -0.25 in 4Q). With local tax revenues plunging and an inability to engage in deficit spending, S&L will be an increasing drag on the economy for the rest of the year. Yes, there was some support in the stimulus bill for S&L governments, but it is no where near enough to prevent them from being a big drag on the economy going forward.

Barring a negative revision in the figures, it now looks like the worst of the recession was in the fourth quarter. The second quarter will probably be very negative, but not nearly as bad as the first quarter. In turn, the third quarter will also be negative, but again less than the second quarter decline. The earliest we are likely to see a positive print for real GDP growth is the fourth quarter of this year.

If a negative revision does come for the first quarter, the most likely place to look would be in the surprisingly good PCE numbers. I would not be surprised to see inventory investment actually add to GDP in the second quarter. Even if it proves to be a zero, it would greatly help the overall GDP numbers.

On the other hand, I wonder if the PCE numbers are sustainable going forward. Non-residential investment is going to continue to be a drag on the economy for the foreseeable future, particularly in structures. Residential Investment will be less of a drag for the rest of the year.

We cannot count on net exports to continue to help as much as they did in the first quarter.  Federal spending will turn into an addition to GDP by the second quarter, and will continue to grow into next year. This will only be partially offset by S&L spending being more of a drag on the economy.

The longest recession since the Great Depression is not over by a long shot, but it will not last forever. We are past the steepest rate of decline, but are still going down. As the third graph shows, the worst damage done in this quarter came from the parts of the economy that tend to be coincident or lagging to the overall economy, not those that have historically been leading indicators of the economy (once again, larger version available at http://www.calculatedriskblog.com/).

There are still very substantial risks out there that could cause the rate of decline to accelerate again, most notably the prospect of long messy bankruptcies in Detroit, and the worst fears of the Flu epidemic coming true (almost impossible to tell at this point).

However, the seeds of recovery have been planted. Inventory will need to be restocked and eventually businesses will have to replace some of their equipment and will start to spend again. Then again, I would not expect a bumper crop from those seeds. The recovery, when it comes, is likely to be very anemic.

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