The second quarter GDP release was as expected, but we examine the factors behind the Q2 expansion and direct your attention to which of those drivers could disappear in the quarters ahead. With their absence, the economy should stall, and could very well slip back into recession.
The first news of second quarter GDP arrived in the "Advance Report" last week. This highly anticipated proof-to-the-pudding type of release produced the anticipated decline in the pace of economic expansion, to +2.4%. However, that slower pace came against a revised higher first quarter growth rate of +3.7% (revised a point higher after two previous revisions lower to 2.7%). This looks about as shady as it possibly could, but it's misleading in its graying.
A change to first quarter economic activity was not so much to blame as were benchmark revisions to 2007, 2008 and 2009 economic activity. The percent change from the preceding year in real GDP was revised down for all 3 years: from 2.1 percent to 1.9 percent for 2007, from an increase of 0.4 percent to 0.0 percent for 2008, and from a decrease of 2.4 percent to a decrease of 2.6 percent for 2009. The initial legs of economic recover were tempered significantly, bringing down levels of activity to an even more concerning point. Because of these revisions, Q1 only seems stronger than when it was initially reported. Q2 looks about in line, versus the Q1 level of activity.
What troubled investors was that last year's final two quarters, now old news and long forgotten (perhaps the gov't thinks so), have been revised to lower levels that reflect more moderate growth. Likewise, the first quarter of 2009's economic contraction was revised to a more moderate mark.
The "benchmark revisions" are what drove Q1 to look stronger than it initially did. Q1 was hardly changed in fact, but is now being compared to a significantly lower fourth quarter of 2009.
Q2 GDP Detail
The details of the report and anecdotal evidence reinforce our concerns about the second half of 2010. Q2 GDP growth was impacted by factors we see disappearing in the quarters ahead. Firstly, Q2 received a +0.59 percentage point benefit from residential housing, greatly due to the closings of First-Time Homebuyer Tax Credit assisted purchases. The impact of residential fixed investment on the first quarter was -0.32 percentage points. We expect this housing factor will at least offer a net zero impact to Q3, if not negative.
Government spending added 0.88 of a percentage point to Q2 GDP. Political pressure is building against the Administration with regard to its fiscal imprudence. Future spending must be funded by law now. Stimulus is running out, and is being allowed to expire instead of renewed. States are already cash-strapped, as evidenced by highly public troubles in California and New Jersey. Government help is going away, so this positive driver should see further limitation in the quarters ahead.
One positive of the GDP report was apparent business investment, especially in the IT sector. Equipment & Software spending by non-residential investors contributed 1.36 percentage points to quarterly GDP in Q2. This followed a 1.24 point impact in Q1. We continue to view pent-up demand as the key catalyst here; more so than organic growth on economic revival. Therefore, it cannot last for long without economic revival. However, we suspect it can last a bit longer and may still provide support to Q3, though perhaps less of it.
The impact of the change in nonfarm private inventories contributed +0.97 points to Q2, after a 2.57 point contribution to Q1. Inventory restocking looks to therefore be complete, and this driver should be a less significant factor in Q3 (nearing zero perhaps).
The important driver of the economy is Personal Consumption Expenditures, as this is the natural driver behind all things. Without it, we feel comfortable saying, little or nothing else could occur. PCE added 1.15 points to Q2, after a 1.33 contribution to Q1, +0.69 to Q4 09, +1.41 to Q3 09 and -1.12 to Q2 09. Spending is slowing folks, and as long as businesses are not hiring full timers, banks are not lending, and the global market place offers little outside support, this factor looks to moderate further.
Now, exports jumped in Q2, contributing 1.22 to GDP. This follows +1.3 and +2.56 contributions to the preceding two quarters. So, even while Europe struggles, Asian and other demand is holding up. We expect exports to continue to contribute, but we see a real tug of war between European weakness and Asian strength continuing.
Over the last few months, individual data points in key economic segments have offered this columnist enough anecdotal reason to raise alarm, and we continue to see the economic fundamentals pointing toward a double-dip, or at least stagnant state of economic development through the second half of the year. The greatest factor weighing against the prospect of double dip recession (and it's significant), especially now that the aggregate level of activity has been adjusted lower, is mathematics. Each quarter is compared against the previous, and so we would need to drop pretty hard to get back to those panic level lows of activity. That said, anchored unemployment, still conservative corporate spending (for the most part), and a highly uncertain geopolitical and political atmosphere offer a confusing environment for a confounded consumer. Look for the pace of GDP through the second half to at least moderate toward a stagnant state, and renewed recession is certainly possible under these conditions.
The worst case scenario remains highly possible as well. War with Iran could drive oil prices and the cost of energy into noose-tightening heights. Potential terrorism threats would also result here at home and in Europe, perhaps burrowing the consumer deeper into his hole. There is certainly enough reason to give weight to caution in investment decision making.
Disclosure: No Positions