Behind US GDP’s Q2 Dud: Quirky Categories and Oil

Friday, the US Bureau of Economic Analysis announced Q2 2016 GDP, and the figures showed growth ticked up slightly to 1.2% annualized from a downwardly revised 0.8% in Q1. While it is an acceleration, the magnitude of growth missed expectations pretty widely, even undershooting the Atlanta Fed's GDPNow gauge, which forecast 1.8% growth just a day earlier. In that sense, the media reaction to the report is rather glum, and we can see the point-the uptick was far less than most thought likely. However, for investors, we'd suggest considering growth is growth-there is very little connection between the magnitude of backward-looking GDP growth and stock returns. Moreover, this report wasn't as soundly disappointing as the headline figure suggests-some quirks and some oil were largely behind the weakness.

First, consider the basics: In Q2, consumer spending rose 4.2% annualized-the second-fastest growth in this expansion-adding 2.83 percentage points to the headline figure. Exports rose 1.4% while imports fell -0.4%. Since GDP's calculation considers net trade (exports minus imports), this resulted in a 0.23 contribution from trade. Government spending, led by state and local governments, fell slightly, detracting 0.16 percentage point from growth, continuing this expansion's longstanding trend.

Exhibit 1: Annualized Growth Rate, Real GDP and Real Personal Consumption

Source: US Bureau of Economic Analysis, as of 7/29/2016. Q3 2009 - Q2 2016.

For those scoring along, you'll see those contributions add up to 2.9% growth. So what accounts for the difference between that and the 1.2% headline GDP growth rate reported? Private investment generally, and inventory change and investment in mining structures more specifically.

Private investment as a whole fell at a -9.7% annualized rate in Q2, but the weakness was mostly centered in inventories-a quirky component subject to interpretation-and mining structures, influenced by the oil industry's well-known issues.

Inventory change is considered a positive when retail and wholesale firms add to stockpiles. If they reduce inventories, it detracts from growth. In Q2, the latter applied, when inventory change detracted a whopping 1.16 percentage points from growth. That's right, without this drag, headline GDP growth would have been 2.4%, entirely in line with the higher side of growth estimates. Now, you might say, "So what?!?!?!? That didn't happen!!!!" But here is what: Inventory change is open to interpretation. Firms may have cut inventories too much, requiring restocking that would flow through other categories of GDP looking forward. If firms build inventories when consumption is flagging, that would add to GDP now, but it could be a sign of trouble ahead. In this case, though, those inventory reductions come against a backdrop of strong consumption.

Now, this doesn't account for all of private investment's decline. Outside inventories, private fixed investment (business investment plus residential real estate) fell -3.2%, with business investment down -2.2% in the quarter-the third consecutive decline. However, as in prior quarters, the decline was heavily influenced by mining structures' -57.8% annualized drop, which accounted for nearly all of business investment's negative contribution. (Exhibit 2) This isn't to say all was rosy elsewhere, but the report is showing skew from weak oil prices.

Exhibit 2: Real Private Fixed Investment Detailed Category Breakdown

Source: US Bureau of Economic Analysis, as of 7/29/2016. Q2 annualized percentage change and contributions to Real Private Fixed Investment.

For investors, though, consider: GDP is a quirky, backward-looking effort to tabulate economic activity within one country's borders. Private firms aren't limited by national borders in many respects, so this is a disconnect right out of the gate. But also, GDP's methodology means it won't necessarily translate to what private firms are experiencing in the real world. The aforementioned issues with inventories are one. How GDP accounts for financial services and its use of net trade are two more. And, what isn't tabulated at all makes GDP more disconnected from reality: As Nobel laureate Simon Kuznets-the man who led the effort to build the US National Income Product Accounts underpinning GDP-acknowledged in the 1930s, any effort to tabulate growth would have inaccuracies. His primary evidence was that GDP didn't include the value added by stay-at-home parents was a major miss-and to anyone who pays for child care, Kuznets' point is strikingly obvious. For investors, the specific magnitude of headline GDP growth rates is less important than the trends it illustrates. And, in this case, that trend overall is continued growth.