By Dirk van Dijk
One of the first things you learn in Economics 101 is that GDP is equal to the sum of Consumption, Investment, Government and Net Exports. This remains one of the best frameworks for looking at how the economy has changed over time.
The graph below shows each as a percent of GDP since 1947. Two things leap off the graph at you -- the first is the rise in Consumption as a share of GDP, and the second is the fall of Net Exports.
Investment appears to be the most volatile part of GDP, but over longer stretches it is fairly stable. Investment will fall as a share of GDP during slowdowns and expand during expansions. It is interesting to note that Government (federal, state and local, but not including transfer payments like Social Security) has been quite stable, and during the 2000's has been running below its long-term average (see table).
In the first quarter of this year, Consumption accounted for 70.73% of GDP -- close to its all time record (set in 2Q08). Net Exports staged a dramatic recovery and were just -2.40%. They had been below -5.0% in 14 of 17 quarters from the second quarter of 2004 to the second quarter of 2008 (reaching -6.13% in 4Q05).
Government has been a remarkably stable part of GDP, particularly from the early 1950's on. The data shows that by far the biggest increase in Government during the post-war period came not from Johnson's Great Society, but from Truman (Korean War) -- from the third quarter of 1950 to the third quarter of 1952, government spending zoomed to 23.68% of GDP from just 15.20%.
In the first quarter of 2009, government spending was 20.44% of GDP, very close to the long term average. Thus, anyone who tells you that "government spending is out of control" either does not know what they are talking about, or must think that government spending has been out of control continuously since the country was debating if it would be a good idea to cross the Yalu River, although it is a bit above where it had been in the 1990's and earlier in the decade.
The number that stands out in the first quarter is Investment, which is at its lowest share of GDP on record, and by a wide margin, the next lowest was 12.77% back in 1949. The decline in investment was across all categories of investment in the quarter, but a big part of the decline in Investment as a share of GDP in the second quarter of 2007 has been the drop in residential investment (aka homebuilding).
The big questions are: Can Consumption continue at close to 70% or more of GDP, or does it have to fall back to the mid 60's? And if it does, what will replace it?
Personally, I do not see how it can stay up near 70%. The rise in Consumption has pretty much corresponded with the decline in the savings rate and the deterioration of net exports. The recent jump in net exports appears to have come out of the hide of Investment, not Consumption. Running a negative number on net exports means that we have to import capital from abroad. There is clearly a limit to how long we can do that, and it seems as if we are close to the limit.
If Consumption is going to decline as a share of the economy, clearly the Consumer Discretionary sector would take a bigger hit than the Consumer Staples sector. While some of the most discretionary type firms have seen big drop-offs in demand, many investors still seem to think that this is a normal recession and that demand will come back. I suspect that it will not for many industries. The sector sells for by far the highest P/E multiple (total market cap/total expected net income) of any in the S&P 500, even based on 2010 earnings (15.5x vs. 12.5x for the S&P 500 overall).
I would be particularly wary of any sector that seems to symbolize conspicuous consumption. Casino operators like Wynn Resorts (NASDAQ:WYNN) and Las Vegas Sands (NYSE:LVS) come to mind. Also, makers of high-priced toys like Harley Davidson (NYSE:HOG) and Winnebago (NYSE:WGO) will face very still long-term headwinds.
Ideally, the gap from declining Consumption share would be filled by a combination of further improvements in Net Exports and a rebound in Investment. However, in the face of weak consumer demand, it is hard to see Investment picking up any time soon. Residential investment might stop declining, but there is no reason to see it start to go up again.
Non-residential investment in structures is just starting to roll over, and could be weak for at least another year. Somehow I can't see equipment and software spending picking up as consumer demand falls.
That pretty much leaves Government to fill the void. Let's hope they can spend the money wisely.