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What's Behind the GDP Surprise

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar. We got the first read on second-quarter GDP Wednesday. It showed that the U.S. economy grew by 1.7% in that second quarter. This was much higher than almost anyone expected, including Morningstar's Bob Johnson, our director of economic analysis. He's here to give his take on the report.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: The number was a lot better than you expected. You were actually really worried about this report, that it could even be negative. What's your take on this 1.7%?

Johnson: The 1.7% was a lot better than I hoped for. There were a few special factors in the number that made it come in better than I thought it would, but overall it was a better number.

Stipp: Two of the big things that varied from what you thought might happen in the second-quarter GDP was government, first of all. So government didn't help us, but it didn't hurt us nearly as badly as it did before?

Johnson: If you had to pick two things that I really blew in the forecast, certainly one was government, and I was a little worried. Defense spending is always very volatile and makes that number swing. Government took off 0.9% in the first quarter, only 0.4% in the second quarter, and almost all of that improvement was on the defense side, which is very volatile. I did see orders make an unusual spike in the last orders report, so I was a little worried about [my forecast], and indeed government was a big reason that we did better than I thought, and it was the federal government, [and specifically] defense spending. I don't think we're quite over the hill on that one yet.

And the other big thing was business investment spending that I really blew it on. There my methodology probably failed me a little bit. I looked at a lot of year-over-year data suggesting that the business investment spending on structures was off and had been on a four-month downtrend. However, sequentially we had bit of an accident, a bad number in the first quarter that really threw that number down. So that made the comparison very easy in the second quarter. So business investment spending actually didn't make a huge improvement. It was probably a 1% or so swing in that number between the first quarter and the second quarter, and that's one thing that I got wrong.

Stipp: One of the [components] where you were pretty close is the most important component, and that's consumer. You thought we would see about 1.5%; it came in at 1.8%. What's your sense of the consumer strength after you see that number?

Johnson: And that's quarter-to-quarter growth in numbers, not contribution. The contribution would have been in the 1.2% range. But the consumption number really came in about where we thought it would, and that's the key driver; its 70% of the economy. I would say services were probably just a little bit heftier than I thought. That would explain the small difference that we saw, but that number was certainly within the realm of what everybody had thought.

Stipp: Housing is, obviously, one area that everyone is talking about, but it doesn't necessarily have a huge impact on this report.

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Johnson: That's what I have been trying to drill into everybody's head, and I have to go through it because I haven't got the final numbers yet. But certainly the GDP is calculating the housing contribution a little bit differently than they used to. That tends to raise it a little bit. But nevertheless, I think even after the adjustments, [housing] is just over 3% of GDP. So even if it had a big move--which it actually did this quarter; it was up 13%--its contribution to GDP is only about 0.3%-0.4% after you do the multiplication. And while that's a nice growth rate and a nice contributor in a slow-growth economy, it really wasn't very much different than the first quarter. It was as I anticipated. That was one of the things that we got right.

Stipp: So a good number there, but unfortunately it's a smaller part of the total calculation.

Inventories were up, but not as much as they had been up earlier in the year.

Johnson: Based on the data that we had seen, [inventories were] just about where we thought they would be. Inventories were a much smaller contributor in the second than the first quarter, as expected. I'll count that one in the right category.

Stipp: What about the balance of trade, exports versus imports? We imported a lot more than we exported.

Johnson: This was a really bad quarter for imports and exports. Now, this number is subject to revision. They had to make an estimate for June. They only have data through May, and they need it through June, and May was a disaster, and I think they have to assume that it goes along the same trend. So it was really a pretty disastrous number.

[Trade has] been a 0.1%-0.2% detractor or adder to the GDP recently, and it was over 0.5% this time around. So it was a big nasty this time, as we had anticipated. So like I say, we got a lot of the parts right, but that big swing of investment spending just put us way behind the eight ball.

Stipp: Let's talk about some of the revisions that came along with this data. We got some revisions to prior quarters as well. What do the revisions mean for the numbers?

Johnson: Overall they made a number of changes. They can incorporate new data that they didn't have before into the datasets. This time they are changing the way they account for software and intellectual property. They're changing the way they account for pensions in here. And they are changing what category title insurance and so forth is going into; it now goes in housing investment. So, those were the big changes they made in methodology, and those tended to add to GDP, maybe over the course of time, about 3% or so, not per year, but in total. So, not a massive change, and they certainly didn't change the contour of the numbers. So, those were one set of revisions, the methodology.

Then they re-benchmarked for new data as well, and they benchmark to another year. So that stuff all happened. But when you get beneath it, … it raised the level of GDP a little. It didn't change which quarters were the strongest and weakest. It did amplify the volatility in quarters, and made some quarters look stronger and some quarters look weaker. How much exports and how much inventories and how much consumer contributed to GDP growth were remarkably unchanged since the recovery began. So the broad contours are the same, but details get funky. The biggest funky thing is that the first quarter went down so much.

Stipp: Let's talk about how some of the recent quarters look under this new methodology and some of these changes. It looks like we're seeing some acceleration now that we're looking at the revised data, right?

Johnson: It's a very different pattern than we saw before. Before we were seeing a pattern of continued slowing, and now we've changed the pattern that Hurricane Sandy set off a stream of downward sloping trends in the fourth quarter, which was revised down and then the first quarter, which was revised down. But now, we've had an improved growth rate in June. So, we've got something that looks like 0.1%, 1%, and 1.7% [GDP growth] for the last three quarters, so suddenly we've got the trend going in the right direction.

I'm not so sure that I fully believe the trend. The year-over-year data is still relatively flat at a low level of growth, and I still think that's the best way to look at the data. But some people are getting pretty excited about the sequential data indicating we might be seeing some real acceleration. I don't believe it for a minute.

Stipp: So, what are your expectations for the full year then?

Johnson: Well, here is another thing that complicated the data just a little bit. I'm still at 2% for the full year. But just as a reminder, I use fourth quarter to fourth quarter GDP. I compare what is the fourth quarter to the fourth quarter of the year ahead, and that's how I make my forecast, and right now I'm still at 2%. Some people take the average for all of 2012 and the average for all of 2013; because of this increased volatility, that number is quite a bit different. It's 1.5%.So, that's how those numbers come out.

And just to put it all on the table, those do imply quite an acceleration of growth in the second half. It implies 2.4% or 2.5% growth in the third quarter, and something pretty close to 3% for the fourth quarter. Keep in mind where we were here in the second quarter was 1.7%. So, we've got a fair amount of ground to make up to get to that number.

Stipp: You think that we will see improvement, though, in the back half of the year?

Johnson: I think we will see improvement, but I don't think it's going to be really dramatic, and it's not going to certainly be 4% or a real barnburner. If anything, I'm feeling a little more queasy about that number, especially the 3% in the fourth quarter.

Stipp: You mentioned a couple of times that when we look back at this data now, we have seen some volatility in the GDP number, which raises the issue of how useful is this GDP data now that we are seeing it jump around. What's the best way to look at this to really get a true sense of what it's measuring and how it's measuring? And given that we are seeing a jump around, what's the best way to use it?

Johnson: It used to be the best measure for, are things getting better or worse? Should I be investing more or less in terms of businesses? Giving you some idea if everybody is in some kind of agreement about where the economy is. This was a good way to do it. It was inflation-adjusted. It included all the categories.

But now it's beginning to be dominated by irrelevant things, like gold shipments and diamond shipments to India, which is swinging the export number all over the place. Some of the inventory numbers are doing funny things. While we are ramping down defense spending, there is a steady-state situation in the industry with the hiring and where the sales levels are, but one month there is a huge amount of sales when they happen to write the check, and in the next month there is none. That feast or famine is driving to make the GDP number just a little bit less relevant than it's ever been.

. … Consumption has still been relatively stable. I don't think they've taken that out of the equation, thank goodness, and I think we'll find that that drives the employment numbers more than anything else, because the disconnect between employment and GDP is massive right now. We've had three quarters of very good employment data and looking backward, now we can see the data including three-quarters of so-so GDP data, and the gap between the two is almost nonexistent. Employment always grows slower than GDP, and that's not the case right now. I'm a little fearful that some of the employment numbers or something will have to be adjusted, because they really are out of whack.

Stipp: A lot to digest in this GDP report. Thanks for walking us through all the data.

Johnson: Thank you.

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