Parsing 3Q GDP

Includes: DIA, QQQ, SPY
by: Elliott Gue

The big economic news this week was the release of the advance data on US gross domestic product (GDP). US Commerce Dept data show the economy grew by 3.5 percent in the third quarter, the first positive showing for GDP since the second quarter of 2008 and the largest jump since the third quarter of 2007.

This is more evidence the recession that began in December 2007 likely ended over the summer. This should come as little surprise to regular readers of PF Weekly as I’ve been predicting the recession would end over the summer since last spring.

Indicators such as the Conference Boards’ Leading Economic Index (LEI) have been flagging this recovery for months.

The chart below depicts quarterly GDP data going back to the late 1960s.

Source: Bureau of Economic Analysis

I’ve heard a parade of pundits in the financial media state that the recent recession is the worst since the Great Depression. There are certainly some similarities between the ’30s and the current period, and I see some severe long-term headwinds for the US economy. But for the most part such talk is mindless sensationalism designed to boost ratings.

Naturally, some politicians are using similar language as a way of justifying government spending and economic intervention at a level unprecedented in the post-war era.

But as the chart above shows, the recent downturn bears significant resemblance to the nasty recessions of the early ’80s and the mid-’70s. The real aberrations on this chart were the downturns of the early ’90s and 2001; these recessions were unusually mild by historic norms and make the more recent downturn seem all the more vicious by comparison.

This lends further credence to my long-held view that the secular bull market that began in 1982 ended earlier this decade. The current period is similar to the 1968-to-1982 era: Economic cycles will be more extreme, and the market is likely to see some wild swings in both directions.

Investors who cut their teeth in the great bull market now face a different market and will need to adjust their strategy. As I pointed out last week this will require a greater willingness to play cyclical moves as well as a tighter focus on long-term growth themes such as energy and emerging markets.

For now, however, the cycle is in the market’s favor. The recent growth in quarterly GDP is similar to the initial pops we witnessed after the downturns of the early ’80s and mid-’70s.

Going forward, the question will be one of sustainability. Let’s dig a bit further inside third quarter GDP and look at the major upside and downside contributors to the number.

Source: Bureau of Economic Analysis

This table highlights some of the categories that contributed to third quarter growth in GDP both on the upside and downside. There are three basic components of GDP: personal consumption expenditures (PCE), investment, and government spending.

The real driver of third quarter GDP was a 2.36 percent contribution from personal consumption expenditures, compared to a -0.62 percent contribution in the second quarter and over -2 percent at the end of 2008.

The biggest component of PCE in the third quarter was Motor Vehicles and Parts, up 1.01 percent. This should come as no surprise, as we already knew that several auto manufacturers restarted capacity in the quarter that had been idled in response to an up-tick in demand. We also heard from the railroad companies that they saw an increase in auto-related freight in the quarter.

The problem with this number is that it’s likely not sustainable because it’s primarily the result of the “cash for clunkers” program over the summer. In fact, the Bureau of Economic Analysis (BEA) admits as much in the text of its release:

Motor vehicle output added 1.66 percentage points to the third quarter change in real GDP after adding 0.19 percentage points to the second-quarter change…

The third-quarter increase largely reflected motor vehicle purchases under the Consumer Assistance to Recycle and Save Act of 2009 (popularly called, "Cash for Clunkers" Program).

BEA stated that taken together the jump in activity related to motor vehicles added 1.66 percent to third quarter GDP. That means that when we take all factors into account--including the 1.01 percent contribution from motor vehicles to PCE--motor vehicles accounted for close to half the third quarter jump in GDP.

It appears that there were signs of life in motor vehicles spending before the cash for clunkers program hit over the summer; the same category was a positive in the second quarter as well. But the program clearly juiced sales, likely borrowing demand from future quarters. It’s unlikely we’ll see quite the same positive contribution from this sector going forward.

Federal government spending added about 0.62 percent to GDP. But contrary to popular belief, about three-quarters of that was from defense spending. This is less than the 0.85 contribution in the second quarter.

Another major contributor to the GDP number was inventories, which added nearly 1 percent to GDP. As the economy entered the maelstrom late in 2008, companies liquidated inventories at an unprecedented pace.

The change in private inventories subtracted 1.42 percent from second quarter GDP and a whopping 2.36 percent in the first, so this represented a large and significant positive swing factor.

Source: Bureau of Economic Analysis

This chart shows the actual change in private inventories in terms of billions of dollars. As you can see, the recent liquidation of inventories was dramatic and accelerated sharply into early 2009.

But just because the inventory number contributed to GDP growth doesn’t mean that companies actually added to their inventories. In fact, inventories continued to fall at the second-fastest quarterly pace in history.

The reason that inventories added to GDP is that they shrank less quickly than in the second quarter. The second quarter represented the fastest liquidation in history.

There’s much more upside in this data. It’s unlikely companies will keep slashing inventories at this pace because those inventories are starting to look lean across many industries. I see this inventory restocking cycle adding to GDP generally over the next few quarters.

A couple of additional points are worth noting. One is that residential housing investment added to GDP for the first time since the fourth quarter of 2005; housing added 0.54 percent to GDP. This, coupled with evidence of a turn in pricing from Case-Schiller data, suggests that the hangover from the housing bubble is finally abating.

However, it will be interesting to see how housing reacts to the expiration of first-time buyer credits and other government housing stimulus measures in coming months.

In the non-residential investment category, it was interesting to see that spending on information processing equipment and software added 0.31 percent to GDP after adding 0.19 percent in the second quarter. This is further evidence that spending on technology is recovering; it’s another reason to overweight the tech sector. Technology has been a perennial favorite in my subscription-based newsletter, Personal Finance.

Finally, looking at PCE on non-durable goods is instructive. These are goods that last less than a year. The biggest winner: food and beverages purchased for off-site consumption, which added 0.27 percent to GDP.

This is the largest contribution since the fourth quarter of 2006. Spending on this category suggests that a more frugal US consumer is spending more on meals prepared at home. This bodes well for another favorite sector favored in PF, consumer staples.

There were a number of artificial boosts to third quarter GDP data, including cash for clunkers and the first-time homebuyers’ tax credit. As this stimulus fades, GDP growth will face additional headwinds. However, there’s enough slack in inventory data and additional stimulus in the pipeline to keep the economy growing for the next few quarters.

The data is broadly consistent with the types of shorter cyclical rebounds we saw in the ’70s. Just as with those cycles, the market rally off the March lows has been dramatic and, corrections aside, is likely to continue through the first part of 2010.

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