Sunday, July 29, 2007

Based on the Q2 GDP Numbers from the BEA the Economy is Continues to Weaken

Examination of the GDP numbers from the US Dept. of Commerce Bureau of Economic Analysis (BEA) indicates that the economy is weakening and showing the early signs of going into a recession. The analysis used to determine this is different from that completed by the BEA and widely reported by the financial press. The specifics of the analysis used are as follows:

The data used is real, seasonally adjusted GDP.

Real GDP values are used to eliminate the effects of inflation in the analysis.

The BEA reports changes in GDP growth on a quarter over quarter basis (QOQ). I use year over year (YOY) analysis. This is done to reduce the noise in the analysis. Further, anyone familiar with sales or loan growth analysis will tell that YOY analysis is used because the Q4 is not comparable to Q1, Q1 is not comparable to Q2, etc. because the business dynamics in each quarter are different. For example, retail sales are strongest in Q4 for many industries and slowest in Q1. Therefore, the best comparison for Q4 data is Q4 data from the previous year. The YOY analysis tells you how good you did since last year. The same is true for the economy at large.

With all that said the YOY analysis of real, seasonally adjusted GDP values indicates a slowing economy:

Real GDP grew only 1.78% from the same period (Q2) last year. YOY economic growth has been falling for the last 4 quarters.

The Personal Consumption Expenditures (PCE) growth rate, the fancy term for consumer spending which makes up 71.6% of real GDP, fell again for the second straight quarter to 2.90%. The problem with this value is that it is below what many believe is the important 3% growth rate level required to sustain the economy. As an aside the weakest growth in the PCE is in non-durable goods.

The growth rate for Gross Private Domestic Investment (GPDI), which makes up 16% of GDP, dropped just over 6%. This is the 4th straight quarterly decline in GPDI and is due mostly to declines in fixed investment and residential construction (double click to enlarge the graph below).

Net export growth, the international trade component which is a relatively small portion of GDP, had a decline of just over 7%.

Government spending growth, which comprises 17.5% of GDP and is largely driven by state and local government spending, remains relatively constant at just under 2%.

When you add up all the numbers it spells out a relatively weak economy with a weakening consumer spending sector and a very weak private or industrial sector.

Admittedly, these numbers will be revised twice before the Q3 numbers come out at the end of October, but the ultimate picture will not change that much.

With a weaker consumer spending anticipated in the Q3 and a real estate market that continues to weaken it is difficult to be optimistic about the prognosis for the economy going forward. I would not be surprised if the economy continued to slide downward where negative GDP growth is reached in Q3. What happens next will depend on the reaction of consumers and businesses to the news. My guess is:

The real estate market will continue to contract as the home-owners with ARMs obtained in the last part of 2005 and 2006 continue to reset over the next 18 months.

The consumer will reduce spending further in response perceived and real loss of wealth due to declining housing and stock markets.

Businesses will react to weak consumer spending (demand) by restraining employment growth, which will further dampen consumer spending.

The net effect of all of this is a weaker economy over the next two or three quarters. Whether this causes a recession or not will depend largely on the ability of the consumer and businesses to keep spending. Let’s face it, when the consumer and business controls 87.6% of GDP, the economy goes they go.

An increase in energy prices, a crash of the stock market, or the bond market are unpredictable outside shocks to the system that will only exacerbate the problems of a loss in wealth of the consumer further weakening the economy

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