Is There a Danger in the GDP Report?

 

While a tad below expectations, this week’s news that the economy grew at a 2.6% rate in the second quarter was somewhat of a relief. After all, the economy grew at a paltry 1.2% pace in the first quarter of the year. Yet when taken together, the economy still only grew at a bit less than 2% for the first half of the year. That kind of growth is no cause for celebration, especially considering that it falls short of the 2.1% average growth rate since the recession ended. Where are we headed from here? Is there a chance we can break out of this malaise?

Before discussing growth rates, we should provide a little background about the composition of GDP. The US economy is heavily dependent on consumer spending, which the people at the Bureau of Economic Analysis refer to as “Personal Consumption Expenditures”, or PCE. PCE’s contribution to GDP had risen steadily for several decades, but it has hovered between 68% and 69% in the years since the recession ended – well above the post-WWII average of about 63%. Government spending, on the other hand, has diminished in significance over time, except for the spike in spending during and following the Financial Crisis. At its current contribution of about 17.5%, though, government’s contribution to GDP has again dropped to well below its post-WWII average of about 20.5%. The most volatile component of GDP is usually private investment, which is comprised of business investment in things like buildings, factories, equipment, software and inventories, as well as residential real estate construction. Despite a strong rebound from extremely low levels during the recession, private investment’s contribution to GDP has rebounded to just 16.4% – still below the long-term average of about 17%. And finally, the drag on GDP from net exports is well below levels prior to the recession. However, net exports are still subtracting about 3% from GDP in recent years – well above the 1% average drag since WWII. (As a reminder, exports add to GDP and imports subtract. Because the US imports more than it exports, net exports are a consistent drag on GDP.)

Source: Bureau of Economic Analysis

The chart below shows that PCE has been growing at a significantly faster pace than the overall economy for the past 11 quarters.  You can also tell from the chart that this is a fairly unusual pattern, at least over the past 15 years.  The steady, above-trend growth in consumer spending is both good news and bad news.  It’s quite positive that growth in consumer spending has been so steady and resilient given that consumer spending accounts for over two-thirds of the economy.  It is also encouraging that consumer spending has remained solid in the face of continued lackluster wage growth and some very loud political background noise.  But it’s also a bit of a concern that the PCE component of GDP is not getting much help from anywhere else.

Source: Bureau of Economic Analysis

As the chart below shows, the combined contribution to GDP growth from private investment, net exports and government spending (collectively “other”) has been well below the long-term average in recent quarters. In other words, the non-PCE categories of GDP typically contributed significantly more to overall economic growth than they have over the past three years. But could this be about to change?

 

Source: Bureau of Economic Analysis

Let’s take a look at the three lagging components of GDP individually. First, private investment has rebounded from very depressed levels in recent years, but it still has contributed less than the long-term average in every year since the recession ended. This is highly unusual. During typical recoveries from economic recessions, private investment would be expected to temporarily expand to well above longer-term averages. Indeed, corporate investment has been the major factor that has been glaringly absent during this recovery. Why? Well, companies have been deferring large capital investments for several reasons, but the most commonly cited are low visibility as to end demand, high uncertainty with regard to tax and regulatory policy (including health care), and a preference for stock buybacks and dividend increases. Unfortunately, the lack of business investment has also contributed to weak productivity growth in recent years. So, in a sense, increased private investment is our lowest-hanging fruit. Policies designed to support business investment could have dramatically positive effects on GDP growth over time.

Government spending as a percentage of GDP has dropped sharply from 21.4% in 2009 to 17.4% in the first half of 2017. This reduction reflects a drop in spending to support the economy during and after the recession. However, many feel that the government has been under-investing in areas like defense and infrastructure. Indeed, the Trump administration has earmarked these areas for major spending increases, even as it warns of “austerity” measures in other areas. Our view is that total spending by the government has nowhere to go but higher if spending on the military and infrastructure increases. Moreover, entitlement spending is set to surge as more and more baby boomers retire. So, government spending too could support economic growth. However, growth through this channel comes at the cost of higher deficits.

With regard to net exports, the drag on GDP in recent years has been exacerbated by a dramatic spike in the dollar from mid-2014 to early 2015. A stronger dollar makes US exports less competitive and foreign imports more competitive. More recently, the dollar has pulled back significantly from its highs in late 2016. Although we haven’t seen the effects yet, the roughly 10% pullback in the dollar (as measured by the DXY dollar index), should work to incrementally support exports and contain growth in imports. But there are many factors at work determining the trade balance, and relative currency values are just one of those factors.

So what’s our conclusion? In a nutshell, a lot is riding on our federal government. Comprehensive tax reform and more clarity with regard to tax, health care and regulatory policies could clearly stimulate business confidence and investment. A large infrastructure spending bill would likely increase government’s contribution to GDP. And action on any of these initiatives could improve the domestic growth outlook, which could lead to a virtuous cycle of consumption and investment. Our fear, though, is that the likelihood of Congress passing such sweeping initiatives has decreased, not increased. At the same time, it appears that the Trump administration is supporting some policies that could suppress economic growth rather than supporting it. And then there is always the risk that consumers don’t keep up the recent pace of spending.

What could work against the economy going forward? Restrictions on immigration (both legal and illegal) and protectionist trade policies, if pursued, represent policy initiatives that would likely suppress economic growth. There are only two ways to grow an economy – increased labor hours and improvements in productivity. If we restrict the growth of labor and impede our corporations’ access to foreign markets, the effects on GDP growth would not be good.