Priming the Pump

The GDP component most responsible for our lackluster economic recovery from the Great Recession has been Gross Private Domestic Investment (GPDI).  GPDI includes business investment in plants, equipment, software, intellectual property, and inventories, as well as fixed investments in residential property.  It’s not that GPDI hasn’t been growing during the recovery.  In fact, GPDI has grown at an inflation-adjusted rate of over 6% since the end of the Great Recession (June, 2009) compared to only about 2% for the economy as a whole.  Rather, the problem is that GPDI plummeted much more sharply and has been recovering much more slowly compared to previous recessions.  GPDI dropped by a massive 34% (or roughly $900 billion) from the first quarter of 2006 to the third quarter of 2009.  Over that time frame, GPDI as a percentage of GDP fell from 19.8% to 12.4%.  In the chart below we show that we have only recovered about half of the drop in that ratio.  Following every other recession over the past 36 years (represented by the gray bars below), GDPI has recovered in a much more dramatic fashion and has generally rebounded to about 20% of GDP.  This time around, we didn’t even make it back to the long-term average of 17.5% before the ratio started declining again to the current level of 16.2%.


*Source: Bureau of Economic Analysis

GDP = Consumer Spending (68%) +  Gross Private Domestic Investment (17%) + Government Expenditures (18%) + Net Exports (-3%)

So what drives GPDI?  Why hasn’t it recovered in the same way it did from prior recessions?  And what can be done about it?  Well, the first reason is rather obvious.  We were in a housing bubble prior to the Great Recession, and investment in residential property doubled from an annual pace of about $460 billion (or 4.6% of GDP) in the second quarter of 1999 to an annual pace of almost $900 billion (6.6% of GDP) in the first quarter of 2006, when it topped out.  It was inevitable that spending on housing would fall from the lofty levels of 2006, and indeed the drop in spending on residential real estate accounted for over half of the decline in GPDI by the end of the Great Recession.  Since that time, ultra-low interest rates have revived spending on residential real estate.  However, the $700 billion annual pace reported for the third quarter of 2016 remains well below that peak of around $900 billion in late 2005 and early 2006.

From a policy standpoint, it is highly unlikely that the Trump administration will implement the kinds of policies that will get us back to that peak level of spending on residential real estate that we saw prior to the financial crisis.  This would likely require significantly lower mortgage rates as well as dramatic easing in lending standards – the same conditions that led to the housing crisis.  We don’t believe we are going back to the days of no-document loans and option adjustable-rate mortgages.  By all accounts, that would be lunacy.

An area of greater opportunity for the Trump administration is business investment, which accounts for a much larger share of GPDI.  It is widely believed that a lack of business confidence, along with tighter lending standards and a lack of demand, have inhibited business investment during the recovery.  Rather than making capital investments in future growth, many if not most large corporations have been using cash to buy back stock, increase dividends, and make acquisitions.  To his credit, President Trump has clearly identified the problem of a lack of confidence, and he has already taken steps to improve the backdrop for investment.  Trump has promised lower tax rates, a simpler tax code, less regulation, a provision to allow repatriation of cash trapped outside the US, infrastructure investments, and the replacement of the Affordable Care Act with a more affordable and less complicated alternative.  As policy visibility and transparency improves, business confidence is likely to improve as well.  And as confidence improves, so will business investment and GPDI.

We’ve discussed in previous Market Commentaries that weak growth in labor productivity has been a major factor impeding our economic growth potential.  Remember that a simple equation for GDP growth is: GDP growth = Productivity growth + Labor Force growth.  One way to improve productivity is for businesses to increase investment in things like plants, equipment, software, and intellectual property.  This makes complete sense.  If workers are given more efficient tools they will be able to produce more in the same amount of time.  Another way to increase productivity growth is through improvements to our infrastructure.  It appears that our new President is well on his way to structuring an infrastructure package that should help on this front as well.  A third way to improve productivity is investing in education and training, which we think could be an area of greater focus due to the fact that US educational achievement has been lagging for quite some time in the US.  In any case, two out of three for starters isn’t bad.

But while initial steps toward economic revitalization look promising, not all of the new administration’s proposed policies can be considered “pro-growth”.  Efforts to limit immigration may impede growth in the labor force, which could also be a drag on economic growth.  As well, it is hard to envision how the president’s efforts to restrict free-trade policies, which have brought the US so much prosperity over the past several decades, will be a positive influence on the pace of economic growth in the future.  Over time, we are hopeful that the new administration will strike the right balance between policies designed to grow the economy and those designed to bring relief to suffering segments of the population.