The GDP Math Doesn’t Work

President Trump has made much of his administration’s success in jump-starting economic growth. He has even gone so far as to suggest that his economic policies could eventually produce 4%-5% economic growth, which would be double the average growth rate since the end of the Great Recession. Given the optimistic rhetoric, last week’s release of the fourth-quarter numbers was highly anticipated.

Unfortunately, at least on the surface, the quarter was a disappointment. The economy grew just 2.6% in the fourth quarter – moderately below the 3.1% and 3.2% rates for the second and third quarters, respectively. For the full year, GDP grew at just a 2.3% rate – well above the 1.5% pace in 2016 but only modestly better than the 2.1%-2.2% average rate since the end of the Great Recession. So is the economy doing better or not? Did the disappointing growth in the 4Q represent a reversion to the post-recession average, or is the headline figure missing something?

 

Source: Bureau of Economic Analysis

GDP growth can be calculated as the sum of 1) Personal Consumption, which is simply consumer spending; 2) Private Investment; 3) Government spending; and 4) Net Exports.  (Because we consistently import more than we export, the contribution to GDP from Net Exports is negative.)  In the fourth quarter, the largest component of GDP by far, Personal Consumption, grew at a very robust rate of 3.8%.  Given its heavy weighting (typically comprises 68%-69% of total GDP), Personal Consumption alone contributed 2.58% of growth to overall GDP in the quarter.  This means that the other three GDP components combined were a wash in the quarter.  The table below shows that the large drags on growth in the quarter were Net Exports and Change in Inventories (a sub-component of Private Investment), which together subtracted 1.8% from overall GDP growth in the quarter.
Source: Bureau of Economic Analysis

Inventories are a highly volatile component of GDP. The trouble with this line item is that inventories add to GDP when they are produced, not when they are actually sold to end users. Therefore, if demand is actually improving – a sign of economic vitality – the effect may not be captured in the GDP figures in any given period. For example, if distributors or wholesalers are experiencing rapid sales growth but they decline to replenish their dwindling inventories, this improvement in economic activity will not show up in GDP. Alternatively, if end demand is actually weakening but distributors or wholesalers are slow to react by cutting orders, inventories could build up and mask the deterioration in economic activity. Due to this timing issue, many economist like to track growth in “Real Final Sales”, which is simply GDP growth after eliminating the effects of inventory builds or drawdowns. In the chart below you can see that growth in Real Final Sales actually improved sequentially in the 4Q to its best level since the second quarter of 2015.

 

Source: Bureau of Economic Analysis

The second drag on GDP growth in the 4Q was Net Exports.  Exports surged in the fourth quarter (+6.9% annual rate vs. the 3Q), but imports surged even more (+13.9%).  The strength in each was a sign of robust global demand.  As noted above, though, imports subtract from GDP growth while exports add to GDP growth.  So in order to better gauge domestic demand (and therefore domestic economic strength), economists also look at a metric called “Real Final Sales to Domestic Purchasers”, which makes adjustments for both changes in inventories and net exports.  In the chart below, you can see why some economists are getting excited.  Real Final Sales to Domestic Purchasers grew at a 4.3% rate in the fourth quarter – well above anything we’ve seen since the third quarter of 2014.

Source: Bureau of Economic Analysis

No matter which calculation is used, the economy is growing.  Fundamentals continue to support an economic expansion. The effects of lower taxes, fewer regulations, and (we hope) higher wages should argue for higher prices as well.  As always our investment decisions will be driven by our investment discipline and dogged research.

Next week we’ll discuss the sustainability of the recent strength in the most important component of the economy – consumer spending.  As a teaser, I will say that, notwithstanding the tax cuts, there are some large obstacles to sustaining the consumer’s recent spending spree.  Tune in next week!