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Why 3Q GDP Will Look Better the Second Time Around

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar.

We get the second read of third-quarter GDP on Thursday. The first read showed the economy grew by 2% in the third quarter; the second read is expected to show that the economy grew by 2.9%--a big jump.

Here to talk about what's behind that is Morningstar's director of economic analysis Bob Johnson.

Bob, thanks for being here.

Bob Johnson: Great to be here.

Stipp: So, before we get into the jump from the first to second read on third-quarter GDP, let's talk about why you care about this report. It's obviously given a lot of attention in the headlines. What do you look for in this report? Why is it important to you?

Johnson: I like the GDP report, because it does a few things for us. First of all, it's comprehensive. It puts all the little pieces together. We get retail sales over here, but if it turns out that all those retail sales are from stuff we're importing from a foreign country, well then it really doesn't do us here in the United States any good. So, this kind of puts those pieces together better than any other report.

Secondly, it's adjusted for inflation. So many of the reports we get, especially the retail sales report, is not adjusted for inflation. So we can't tell if people are actually buying more stuff or if they are just paying more for the same stuff that they've always been buying, so that makes it also a very relevant report.

Finally, it generally correlates with employment and how much people want to spend on capital goods, and it's the input to a ton of internal economic forecasting, things at businesses, so it's a widely used report. People will say, well the economy is growing at 2%, I should always will grow a little bit faster, so I should grew at 2.5%, or I should grow just a little bit under it. So, it kind of gives everybody a calibration methodology of where are we, how should I set by budgets? So, that's why this report is generally viewed as very positive.

Stipp: It's a widely used, very important report, but it also has some shortcomings and some problems. What are some of the things where it falls short of the benchmark for you?

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Johnson: One of the things that's in here is this whole concept that using natural resources is actually a help to our GDP. The more we mine, the more we dig up, the higher GDP is. And maybe it's a help, but on the other hand, we're depleting a resource, and it really doesn't quite capture that concept really well.

So, for example, the more coal we mine, the better the number looks, or the more oil and natural gas [we produce], the higher the number. And so, one can argue [that] it's not so good that we're using more; it's better if we conserve those assets just a little bit. [GDP] doesn't measure that concept at all.

Stipp: So it offers maybe … a shorter-term boost, the fact that we are having that activity, but longer-term there could be consequences from some of those activities.

Something else that you said, there are certainly intangibles that aren't captured in the GDP report. What do you mean by that?

Johnson: There are a lot of Europeans that want to look at GDP a different way--probably because the GDP numbers there aren't so good--but one of the things that they do rightfully point to is how much leisure time do you have now that you've done all this production? If you work 10 hours a day at a drudge job, is that really a decent measure of output--some people refer to it as psychic happiness or whatever. But clearly it doesn't measure some of those intangibles.

Stipp: So, essentially, we're saying that there could be some things that are driving GDP higher, but in the long run could actually be a negative or headwind against productivity or GDP in the future?

Johnson: Correct. And then the last thing would probably be looking at the data on a per capita basis.

A lot of people say, I remember when GDP used to be 3%; now it's 2%. Well, at least part of that is due to the fact that we have smaller population growth, and population growth is the number one contributor to the GDP. So, if you have lower GDP growth and lower population [growth], it isn't necessarily all bad.

Another interesting thing to think about per capita: Everybody keeps talking about the U.S. as the largest GDP in the world, then China is closing in quickly, at half of what the U.S. level is. But they've got a billion people, and we've got 300 million people. So, when you do it on a per-capita basis, there is still a very, very big gap in what you've got out there.

So, we all tend to look at the headline number, because that is what drives the employment, but on the other hand, you've going to say, what is the pro-capita data doing?

Stipp: Let's talk about the timing. So we're still talking about third-quarter GDP here. This is the second read on third-quarter GDP. Can you put that in some context: What the first read looked like, why the first read came in [where it did]. And this is a second read. And then we're going to get a third one as well, right?

Johnson: There are three. We have a GDP report every month, by the way. We either have a revision, or we have a new GDP number.

So this one is the second revision, which usually ends up being relatively close. The first set of data that we get it at the 30-day mark has got a lot of holes on it. The number one, always biggest hole is imports/exports. The import/export data for the last monthly report isn't available until 50 days after the quarter. You don't have the data, so they estimate it on the import/export data, and they just do what they have to do, which is usually some type of trend line. It's not based on … a few sample invoices or something. It just has to be trended.

Inventories is another one where the data is largely missing [in the first read of GDP]. There are a couple of pieces of manufacturing inventories that we have, but the retail, wholesale inventories, and a bunch of others are not available for the first read.

Stipp: So, what do we have by the second report, then, and what are we still waiting for?

Johnson: We have all the data, at least on a first-read, by the second GDP report. So this one usually turns out to be fairly accurate, and then what happens on the very last one is that you get a second read on the import/export data for late data, which tends to have some revisions in it, and usually the biggest swing in the last one is something with inventories. So, those are the big ones that are left out there.

Stipp: So, what were some of the contributing factors with the data that we did have on the first report being at 2.0%?

Johnson: Well, we had a relatively good consumer number, and we had a very good government number at 0.7%, and we had a decent housing number that contributed a couple of ticks, so that was also a big deal. We had a number of characteristics coming together on the 2% growth rate. But a lot of people would say, it was really 1.3% after you strip out the government effect, which was from an artificial boost in defense spending.

But on the other hand, those same people ignored the fact that auto production, according to that report, almost showed we were in a recession in terms of auto production, just because of some different timing and seasonal factors with the way the government calculates their seasonals on the auto industry and changing auto shutdowns in the summer. And so it made the auto production look like it fell off a cliff, and that number is going to come roaring back in the fourth quarter, but that hurt [in the third-quarter GDP data].

The other big hurt in the third-quarter first report was soybeans. We've had a little bit of a drought here, and we drew down some inventories, and drawing inventory down, as you recollect, is a hurt to GDP: Its goods not produced--it came out of inventories instead. So, that number really hurt in a big way.

I think people worry about the government number, and say "that's not replicable," and they're right; it's not. But I assure you that auto sales will be a big help instead of a hindrance in the fourth quarter, and I assure you that the soybeans situation will probably reverse itself.

Stipp: Well obviously, some things are going to look better in the second report of [third-quarter GDP], because we are expecting a big jump from 2.0% to 2.9%. What new data is behind that jump that we are seeing, because that's a pretty big jump from one revision to the next?

Johnson: It is. It's unusually large, and it's even more surprising that … the economists have caught on and put it in their models, but it's mainly the import/export report. The government had thought the trade deficit would get worse from the second month to the third month of the quarter--instead it got far better. It was a huge swing that nobody saw coming. And I think that's the biggest single factor about what the number is.

Then … the construction data came in a little better than people thought, so that will help, but not as much. There was revision to retail sales--again, kind of small--but it will also kick in to the report as well.

Now, you put those all together mathematically, and you do get somewhere around 2.8%, and I think people figure, well, if there is some [improvement] that I can see, there is [probably] more like it underneath, and that's why everybody has been racing to raise the number. But I caution people probably not to do that. The 2.8% is probably a decent starting point, even though the consensus is 2.9%.

Then the other thing is, it seems to be when there is an adjustment in the import/export data, there is usually at least a partially offsetting adjustment to inventories.

And I would say that maybe 2.5% looks like a very safe bet to me, maybe it does a little better. But let's not get carried away. Everybody is excited and tripping all over themselves to make a big name for themselves by saying how good the number is going to be on Thursday. I am comfortable with 2.5%; that's still a nice high amount and will look better to everybody.

Stipp: So, import and exports will help in that second revision. You said government was a big contributor even in the first look at the data. Are these things sustainable? Government seems unusually high at 0.7% contribution. So, are we going to see a drop down from that 2.5%-3% third quarter GDP in the fourth quarter, when we finally get that data?

Johnson: Well, the … consensus is that it will be about 1.3%. So whatever good news we get this quarter, some of it will be given back next quarter. I tend not to be as negative on that. I think that, yes, the government will be less, but I think auto production and soybean inventories will be positive effects in the fourth quarter that will enable us to come in at, I think, 2%. It will be a while before we know that.

Stipp: OK, Bob. We'll check in with you on Thursday when we do get that second read on third-quarter GDP, and get your take then and also your expectations adjusted potentially for the fourth quarter. Thanks for joining me today.

Johnson: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.