Causes of GDP Miss and Implications

The minority camp that expects a deep weakening of the U.S. economy may get a few new members today following the weak GDP report for the fourth quarter.

That said, for a variety of reasons, including some related to the details of today's report, few minds will be changed by today's data. At most, some will become a little more open to the possibility of a deeper slowdown than expected, but in the absence of factors that reinforce the thesis, they will stick with their current views and keep their positions as they are.

A key aspect of the GDP report that might lure some market participants into the bear camp (with respect to the economic outlook) was the weak pace of business spending. In particular, the 3.5% gain posted in spending on equipment and software was far below the double-digit gain seen over the past two years, a pace that was expected to have been repeated in the fourth quarter. Many are banking on a strong pace of business spending to offset expected weakening in consumer spending in 2006 to support their expectations for a relatively healthy pace of economic growth.

Government Spending Plunges

The 1.1% GDP gain was considerably weaker than the consensus for a gain of 2.8%.

There are a few reasons for the miss. For starters, government spending, including spending by federal, state, and local government, was much weaker than expected. It fell at a 2.4% annual pace, shaving a half-point from the headline gain. Expectations were for government spending to add as much as a half-point, meaning that there was a swing factor of a percentage point due to the unexpected decline in government spending, which was led by a 7% decline in federal spending, a decline that won't likely last. Federal spending will almost certainly rebound sharply in the current quarter.

The Treasury department has already announced plans to borrow a record amount of money during the quarter (via its issuance of Treasury securities), which will inevitably lead to more spending, a chunk of it is expected to be allocated toward the rebuilding effort in the hurricane-affected regions.

It's also an election year, and it is difficult to imagine a scenario in which Washington spends less than it has already appropriated for 2006.

Businesses Were Supposed to Pick Up the Slack

A second reason for the miss relates to business spending, which as noted earlier rose much less than expected. The weakness could reflect the business community's rapid response to the events of the fourth quarter, particularly the slowdown in consumer spending that resulted from the effects of the recent hurricanes. It is further evidence of Corporate America's desire to maintain growth in profits. In a way, this is good news for shareholders. On the other hand, if the weak spending is a harbinger of things to come, then it is worrisome. Especially given that business spending is expected to offset a slower pace of consumer spending.

More likely, business spending will snap back in the current and upcoming quarters. Cash levels are extraordinarily high, order backlogs have increased at a rapid pace, factory operating rates are above their long-term average, the global economy is stronger, and the rates of return on investing in capital equipment remain high.

There are already indications of a rebound apparent in recent data, particularly Thursday's durable goods report, which showed a 3.5% gain in orders for non-defense capital goods excluding aircraft. Moreover, with jobless claims at their lowest level in 5 1/2 years, businesses appear to remain confident in the economic outlook, confident enough to continue to increase capital spending.

Additional evidence is apparent in recent corporate borrowing trends. January saw very large issuance of corporate bonds and companies continued to expand their use of both commercial paper and commercial & industrial loans.

Inflation Accelerated, Lowering Real Growth

A third reason why GDP grew less than expected was because the inflation rate was higher than expected. The 1.1% gain, of course, reflects the growth in GDP after adjustment for inflation. The GDP deflator rose at a 3.0% pace, three-tenths of a percentage point higher than expected, thus accounting for three-tenths of the miss.

Importantly for the bond market, the deflator for personal consumption expenditures minus food and energy rose at a 2.2% pace. That's above the Federal Reserve's target range of 1.75% to 2.0%.

The 1.1% gain in GDP would have been much weaker if not for the contribution from inventory investment, which added 1.4 percentage points to GDP. Therefore, final sales, which measures GDP minus the inventory change, actually fell, by 0.3%. The inventory gain is not worrisome, however, given that inventories had contributed negatively to GDP in the two previous quarters and given that the inventory-to-sales ratio is now at a record low and below the secular trendline.

Service Spending Figure is Good For Job Growth

There are two final reasons why investors might dismiss today's data as aberrant.

First, the report should be put in the context of previous strength. GDP grew by 3.0% or more in 10 straight quarters, the longest such streak since 1984-1985.

Second, personal spending on services grew at a 3.2% pace, about the same as the past two years. Why is this important? Well, of the 134 million jobs in the U.S., 112 million are in the service-producing sector. The rest, of course, are in the durable goods sector, a sector that contributes very little to job growth, especially now given the problems in the automobile sector.

In other words, although consumer spending was weak, the composition of spending growth was favorable for continued job growth and hence the sustainability of the current expansion.

That said, today's data invite new believers into the notion of a deeper economic slowdown than is now currently expected. Nevertheless, in the absence of data that support a continuance of the fourth-quarter's weakness, and in light of some of the causes of the weakness, most views on the economic outlook probably haven't changed much. But the camp that is open to change probably has grown a bit. Not enough to change the course of the markets for now, however.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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