This week’s GDP report brought home the reality that the economy is on the downswing. The size of the deceleration caught me by surprise: from 2.5% Q4 2006 to 1.3% Q1 2007.
WHO CARES ABOUT THE GDP?
You do. It tells you where people are spending more or less money. That’s an important factor affecting where to invest (and, conversely, where not to invest).
You also care because it isn’t always the result of spending slowdowns but also the cause. People perceive a slowing economy and tend to accelerate it by hoarding their nuts for the winter.
SO WHERE IS MONEY GOING AND NOT GOING
Money is going to food, fuel, and medical services.
Money is flowing away from residential.
We want to talk about GDP excluding residential. Residential measures home sales and IMHO a home sale does not constitute value generation or consumption. Nothing was made and nothing was consumed.
And I want to look at the economy from the standpoint of actual growth.
Housing is being blamed for being a drag on the GDP and that is correct mathematically. As homes sales and prices drop, the residential figure drops. (I looked at GDP by quarter based in 2000 dollars.) In this case, between 1Q 2006 and 1Q 2007, Residential dropped $100B and that alone removed 1% from the GDP.
To give a sense of things, here’s what GDP would look like with and without residential.
Notice that for the first time in a few years, GDP grew faster without residential than it did with residential. In fact, the last 3 quarters of GDP net residential show accelerating growth. Also interesting, the variance of GDP with and without residential hsa typically been <0.4%,>
Now consider the absolute dollars (as measured by 2000 dollars).
The last 4 quarters are worth $230B less than the previous 4 quarters. Residential quarterly production hasn’t been this low since Q2 2003.
We have gone from $620B for 3 quarters in 2005/2006 to $515B and dropping. What took 7 quarters to go from $515B up to $620B, and now it’s taken 4 quarters to fall back down.
I am expecting a full blown retreat to $400B within 4 quarters. That’s another 1% drop in GDP and will mark the recession.
But that doesn't mean the rest of the economy freezes up - it just means that the technical measurements say that the economy is in retreat.
HOUSING PRICE LED GDP DROPS AND THE REST OF THE ECONOMY
Housing price drops are a mixed bag.
The losers are the real estate business sector, banking, and consumer durables. Some owners will be less prone to spend money.
But house price drops are also a big boon to others. For most people, rent equals ~30%+ of their after-tax salaries. So a 10% drop yields a 3% after-tax bump in discretionary spending.
I think blue collar jobs are at most risk. They are doubly exposed: job loss (manufaturing and home construction jobs will get wiped out) and bankruptcy (many of the most financially exposed homebuyers are blue collar workers). White collar spending will continue for the most part.
My main point here is that the end of housing is not the end of the rest of the economy. But that doesn’t mean a Goldilocks scenario.
Personal consumption has been on a decelerating trajectory for the previous 5 quarters. Consumption Increase
Q1 06 9079
Q2 06 9228 149
Q3 06 9347 119
Q4 06 9422 75
Q1 07 9590 168
This last quarter reversed the declerating trend significantly. Except that the bulk of the rise was food, gas, and medical spending.
What I would call discretionary spending is slowing down.
The challenge for the US economy is not the housing market but the fact that commodity prices won’t drop in sync with a US consumption slowdown. The global economy is flying on many engines now; US demand doesn’t dictate the rise and fall of commodity prices. In the past, the pain of a slowdown has been eased by falling prices. Not so this time. Manufacturers will be challenged to maintain margins in the face of falling sales and steady input prices. Raising prices during a recession is hard. The Fed is also limited in interest rate adjustments.
Meanwhile, a weakening dollar keeps commodity prices high.
INVESTING GOING FORWARD
Investments should have two flavors:
1. Food, medical, or energy
I haven't been able to find a good food growth stock, but we are deep in medical and energy. And we are global.
Also, be prepared for stock market jitters. One major jitter maker will be as the GDP edges closer to recession. Another will be unemployment figures. I strongly believe that the last jobs report was fudged: we know that lenders and home builders have been firing in the thousands.
A final element is interest rates. I don't think the conditions are right for an interest rate drop and that will upset people. A weakening dollar and rising commodity prices is inflationary and typically leads to interest rate hikes.