It's The Economy, Stupid!

Today's subject: a bird's-eye view of the US economy (it's a big economy, so the bird sees a lot and the post is, necessarily, quite long).

• Comparing the pre-recession economy in 2006 with 2Q2009, the country's GDP is made up as follows (all numbers in current dollars):

Data: BEA

From this perspective, the major - in fact, the only - negative development in the economy is a plunge (-33%) in gross private investment, i.e. spending on plant, equipment and services by the country's businesses plus investment in residential property (i.e. homes). Personal consumption held up well, government spending rose significantly and net exports became a much smaller negative factor, as the trade deficit shrunk fast (but this is no cause for macro economists to celebrate since it came about due to (a) lower imported crude oil prices and (b) fewer imports of consumer goods).

• The next chart breaks down the economy in sectors, percentage-wise:

While personal consumption is still around 70% of GDP, private investment has been slashed and is now only 11% of GDP vs. 17.4% three years ago. Simply put, businesses and individuals are investing much less: in dollar terms, during the second quarter of 2009 they spent $800 billion fewer dollars than in 2006 (annualized figures). Government has taken up part of the slack, but the single biggest "positive" change between 2006 and 2009 has come from net exports, which are now a smaller negative by a whole 3.34 percentage points. Again, this is basically a "mirage" positive development and translates to no tangible gain for the day-to-day lives of working Americans, no matter what the macro GDP numbers may say.

Let's pause here.

From the above, we see that what has happened so far in this "crisis" is this: businesses and individuals slashed investment by an enormous amount, causing overall GDP to drop sharply and very fast. In round figures, a 33% decline in private investment - which made up 17% of GDP - produced a 6% decline in GDP. This was partially counterbalanced by government spending (Keynesian intervention) and by the large accounting entry of a shrinking trade deficit. Personal consumption, by far the largest component of GDP, was largely unaffected. That's where we are right now - the completion of Phase A, as it were.

But what is the future direction of the economy? In my view we are about to enter Phase B, one that will be shaped by the current rapid increase in unemployment and the resulting pull-back in personal consumption.

• U-6 is the measure of unemployment that includes those marginally attached to the economy, discouraged workers and those working part-time because they can't find full-time work. It has shot up to 17%, more than one in six Americans in the workforce. Notice how the difference between U-6 and U-3 (the commonly cited figure for unemployment) has widened out from 2.5% to 7.5%, meaning that actual conditions in the job market are much tougher than U-3 alone indicates and certainly tougher than during other recessions.

• This difficult situation is finally hitting personal spending: look at the chart of payrolls and personal consumption below. Spending has only turned negative in the beginning of 2009 but it is, understandably, well correlated with shrinking payrolls.
  

Personal Consumption Expenditures and Payrolls Are Tightly Correlated

Remember, personal consumption is the Holy Grail of the economy - it makes up 70% of GDP - so even a slight drop in personal spending translates into a large decline in headline GDP. Let's look closer at this Holy Grail..

• Personal consumption is made up of Services (68%), Non-Durable Goods (22%) and Durable Goods (10%), (see chart below, click to enlarge). Not surprisingly, durable goods have taken it on the chin: cars, furniture, appliances - but that's only 10% of overall spending. Non-durable goods, things like clothing and food, are also down but significantly less, whereas spending on services is still growing, albeit at a much slower pace.
  

PCE and It's Components

Such consumer services make up nearly 50% of the economy (68% of 70%) and this sector is still growing, at around 1% per year. It makes sense, if we consider how people react to economic difficulties: they immediately stop big purchases like cars and appliances (the credit crisis is at play here, too), then smaller ones like unneeded clothing, cosmetics, etc. and finally slow down on things like vacations, movies and dining out. Health care is, obviously, going to be cut last.

So, for Phase B this is the crux of the matter: what is going to happen to consumer services?

Again, we need to drill down on the data, where services are broken down into:

Housing services: 28%
Health services: 24%
Financial services: 12%
Food services: 9%
Recreation services: 9%
Transportation services: 4%
Other services: 14%

Housing and financial services (taken together, 40% of total services) are connected through the mortgage and home equity loan links. No great prospects there for the foreseeable future. Health services make up a massive 24%, a proportion that has more than doubled since 1960 (see chart below, click to enlarge). As I pointed out in previous posts, I see this sector as having reached a peak and likely to deteriorate as an engine of growth - the Obama plan is an obvious warning flag.

Breakdown Of The Consumer Services Sector

Thus, two thirds of the consumer services sector of the economy (remember, this is 50% of GDP) is going to be facing headwinds. Let's see what growth looks like in each of the service sectors (see chart below, click to enlarge).

Consumer Services Sectors, Y-O-Y Growth

There are only three service sectors that are, in fact, still growing, though at lower rates than previously: Health, Housing and Other. I can't predict anything about the catch-all "other", but health and housing are obvious targets for negative developments in the near future, as I already discussed.

Everything else that matters in the private sector of the economy is already in negative territory and all that remains is Health, Housing and Other services, together making up a massive 33% of GDP. And that's the rub, isn't it...? The economy is hanging by a very thin thread, indeed.

Can the other sectors of the economy make up for the present and upcoming decline in personal spending on goods and services? Let's see..

• Private investment: are businesses going to go on an investment spree soon? Highly unlikely - with unemployment rising and demand for all goods and services slackening businesses are going to be playing defence for a long time to come. And quite obviously individuals are not going to be buying new houses in great numbers, either.
  
• Exports: unless the dollar slides very, very substantially exports are not going to be a driver for the real economy. Yes, the trade deficit may shrink further due to a drop in imports and thus affect GDP accounting, but that doesn't change things.
  
• Government spending: This is the wild card- or joker, if you prefer. A massive Keynesian intervention is always a possibility, theoretically. But, in the real world... with what money? The government is already facing a $1+ trillion dollar budget deficit this year, having foolishly spent a boatload of money on ill-considered bailouts. Can it keep borrowing even more from the Chinese, et. al.? I don't think so..

Bottom line: We are now entering Phase B of the recession (it is better described as a depression, with a small "d"). We are likely to see sustainable declines in personal consumption for several quarters, since unemployment is high and still rising, crimping earned income. I very much doubt that banks will go on a lending spree to households to support spending - in fact, I believe they can't, given the atrocious shape of their balance sheets.

After the current transition period in GDP figures, which is characterized by a stabilization in business spending and inventories, I am looking for a series of quarters of -2% to -3% GDP declines, almost all of it from consecutive declines in consumer spending, particularly in services.

Once again, I note that all figures are nominal, i.e. not inflation adjusted.