Saturday, December 22, 2007

Q4 U.S. GDP Looks Stronger-But at the Expense of 2008

The probability of negative GDP growth during this quarter in America fell significantly today after the release on personal consumption expenditures in November. I had expected it to stay flat or even fall considering the decline in real income caused by the sharp increase in oil prices. Instead it rose significantly, 0.5%, and the September and October numbers were both upwardly revised. Although December consumption looks likely to fall for reasons which shall be discussed later, this still means that personal consumption will rise for the quarter. Indeed, assuming no revisions and a complete reversal of the November gain in December, that still implies 2.2% spending growth.

Although residential investments will continue to fall sharply, and business investments likely to fall too while inventories and trade looks likely to be negative, it is dubious whether it will really be enough to pull growth below zero. It seems unlikely on a volume basis and less likely than before even on a terms of trade adjusted basis, although that can still not be ruled out.

What was really remarkable about this 0.5% increase is that it happened at the same time as real disposable income fell 0.3%. And in October real consumption increased 0.1% even as real disposable income fell 0.1%. As a result, the household savings rate fell from 0.5% in September to -0.5% in November.

While this dramatic decline in savings will boost fourth quarter GDP, it represents a dramatic deterioration of the fundamentals of the economy. As long as asset prices rise, a negative savings rate may appear sustainable. But in reality it only is so if the rise in asset prices is due to high level of retained earnings as retained earnings represent a rise in the underlying value of the assets.

But to the extent higher asset prices simply reflect asset price inflation, it does not imply any addition in real wealth but only a reduction in the purchasing power of the dollar. And while retained earnings are still positive, they have decline dramatically in recent quarters due to a combination of falling profits and increase in both stock repurchases and dividends. And in any event, asset prices aren't rising that much anymore. Bond prices have soared, but stock prices have stalled after their previous gain (which still mean they are more overvalued as profits have fallen) and house prices have fallen.

In short, the negative savings rate simply isn't sustainable. That means that consumer spending will have to fall in the coming months. This in turn implies that while the probability of negative growth for the fourth quarter have fallen significantly, this makes negative growth in the first quarter of 2008 appear even more certain.

Most early indicators for December, including regional surveys from Chicago, New York, Philadelphia and Richmond, reports on retail sales and jobless claims indicate that the economy is indeed weakening already in December.


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