Goldman's Ed McKelvey is trying to salvage his team's reputation as the biggest gloom and doomer on Wall Street by explaining why facts and not noise will be responsible for a revised drop of Q2 GDP by not 50%... but 45% of something. What is more interesting are the reasons for the contraction: i) A significantly reduced pace of inventory accumulation; ii) An even wider trade deficit than was first estimated; and iii) A small shift in the composition of final sales to domestic purchasers. Yet those expecting this note to be a start of an optimistic shift, prepare to be disappointed. As McKevley says, "such a conclusion would be premature given the information currently available on the economy’s transition into the third quarter," and in looking at Q3 GDP, the firm gets even gloomier than ever: i) Growth in real consumer spending appears to have softened from an already sluggish pace; ii) Real residential investment has resumed falling at a double-digit pace, iii) Real business investment is roughly on track for our 10% annualized growth assumption, but with risks now tilting to the low side, iv) The trade deficit ended the second quarter in a deep hole, and the conclusion is :"Thus, the key components of private final demand suggest that our 1.7% estimate for annualized growth in real final sales this quarter is more likely to be too high than too low." A lot of words for not saying we are in a double dip.
From Ed McKelvey, "Fine-Tuning Q2 and Peering Into Q3"
Friday’s revision to second-quarter growth is apt to show a 1.2% annualized growth rate. While this is slightly better than the 1.1% rate we originally estimated, it still represents a significant downgrade from the 2.4% rate now on record.
About two-thirds of this revision should show up as a slower pace of inventory accumulation with the remainder as an even larger trade drag than the 2.8-point hit now on record. The composition of real final sales to domestic purchasers should show more business fixed investment in equipment and software and less in structures but otherwise no major changes.
Although the downward revision to last quarter’s inventory accumulation could, in principle, be reassuring for future growth, a quick tour of “tracking” calculations for key components reveals potentially considerable downside risks to our third-quarter estimate for 1.7% annualized growth in real final sales.
Today we nudged up our estimate of the revision to second quarter real GDP growth to 1.2% (annual rate) from 1.1%. This followed the release of the advance durable goods report for July, which included upward revisions to June figures for capital goods shipments and inventories. The GDP revision, which will be published on Friday, should still represent a significant downgrade from the preliminary 2.4% estimate that is now on record. In this comment, we summarize our expectations for the key aspects of this report and provide some (limited) perspective on how the economy is tracking into the third quarter.
The expected downgrade to second-quarter growth has three main features:
1. A significantly reduced pace of inventory accumulation. In its preliminary report on real GDP, the Commerce Department estimated that inventories rose $75.7 billion (bn) at an annual rate in the second quarter. The step-up from the first-quarter’s $44.1bn accumulation rate was worth nearly half (1.05 percentage point) of the 2.4% growth rate reported for real GDP. Since that estimate was published almost a month ago, most data on inventories have come in lower than Commerce officials had expected. As a result, we think they will knock out about $24bn in real inventory accumulation, about two-thirds of the 1.2-point downward revision we anticipate.
2. An even wider trade deficit than was first estimated. The Commerce Department’s initial estimate of last quarter’s trade drag shocked most economists for its size—a 2.78-point drag on real GDP growth from an $87.5bn widening in the annualized trade deficit. However, as noted in a recent daily comment, the drag now appears to have been even larger—just over $100bn by our reckoning, or more than 3 points. (See “What’s Behind that Huge Q2 Trade Drag?,” US Daily Comment, August 18, 2010.) This accounts for the remaining third of the downward revision we anticipate.
3. A small shift in the composition of final sales to domestic purchasers. On balance, we expect no significant change in this aggregate (the sum of consumer spending, business and residential fixed investment, and government spending), which is currently reported to have risen at a 4.1% annual rate. Within the total we expect an even larger increase in business outlays for equipment and software, implied by this morning’s durable goods data, to be offset by a downward revision to business outlays for structures, with little change in most other components.
If this were the end of the story, it would be a reasonably happy one. Inventories, which were originally reported to have risen at nearly a 4½% annual rate, now appear to have risen at only a 3% rate. This would still be well above the 1.3% (soon to be 0.9%) annualized increase in real final sales, but below the 4%-ish growth rate of domestic final sales. With US manufacturers already throttling industrial output, at least according to the surveys, it would appear that they have nipped a potential overshoot in inventory accumulation in the bud. Indeed, those same surveys indicate that suggest that inventories are under control, more or less. The inventory indexes of the Empire and Philadelphia Fed surveys fell from +6.35 to +2.86 and from +4.5 to -11.5, respectively, while the Richmond Fed survey gave mixed results (more accumulation of finished goods, less of raw materials).
However, such a conclusion would be premature given the information currently available on the economy’s transition into the third quarter. This information is based on “tracking” calculations relating data for June or July to the second-quarter averages. These calculations are admittedly quite tentative at this stage of the transition, but what they suggest is troubling, though probably not too surprising to a market already on edge regarding the potential for a double dip. In brief:
1. Growth in real consumer spending appears to have softened from an already sluggish pace. Our forecast currently shows a 1½% annualized increase in the third quarter, essentially the same as the 1.6% rate reported for the second quarter. However, the data for July suggest that this may be a bit high. Although auto sales rose 3.4% in July, retail sales of goods other than motor vehicles, building materials and gasoline edged down 0.1% in nominal terms. Based on these reports, we estimate that real consumer spending was roughly unchanged, with risks to the downside. A flat monthly reading for July would imply a growth rate for real spending of ½% to 1%.
2. Real residential investment has resumed falling at a double-digit pace. Here we have penciled in a 15% annualized decline for the third quarter. Data for private residential construction outlays in June point to a somewhat softer setback of about 12% (also annualized). However, the latest data for housing starts and sales of existing homes (which are important to GDP because of brokerage commissions) more than fill the gap. Starts are headed for an annualized decline of 15% to 40%, while sales will be down at more than a 50% rate even if they recover half of the setback reported for July.
3. Real business investment is roughly on track for our 10% annualized growth assumption, but with risks now tilting to the low side. Outlays for private nonresidential construction ended the second quarter on a weak note, pointing to about a 10% annualized drop in real outlays for structures versus our current assumption of no change. Although shipments of capital goods in July were a bit higher than implied by our +15% annualized growth assumption for real investment in equipment and software, the sharp fall-off in orders for such goods reported for July suggests that disappointments lie ahead in this area.
4. The trade deficit ended the second quarter in a deep hole. The $54.1bn real goods deficit reported for June was about $6bn larger than the average for the second quarter. As we noted in the August 18 comment cited above, our assumption of a 0.5-point contribution to third quarter growth from the trade balance requires a quick and substantial reversal of the deterioration reported for June. To illustrate, if the June balance held through the third quarter, the trade deficit would subtract more than 2 percentage points from this quarter’s growth rate.
Thus, the key components of private final demand suggest that our 1.7% estimate for annualized growth in real final sales this quarter is more likely to be too high than too low. If this is the case, then inventory accumulation could pile on as an additional risk, even at the reduced 3%-ish pace we now estimate for the second quarter.