Good Could Be Bad in Friday's GDP Report

Tomorrow's second-quarter gross domestic product release could be one of those "good is bad" reports.

The economy, save for consumer spending, was generally weak in the previous quarter, but a number of factors could end up making the report look better than the actual, underlying strength in the economy.

The consensus forecast among economists polled by Reuters was for a 0.9% increase in GDP in the second quarter, following a 1.2% increase in the first quarter. However, some believe GDP could end up around 1.5%, and even perhaps as high as 2%, because of the sharp decline in the trade deficit and a potential rise in inventories in the second quarter.

"We could wind up with a 2% figure for all the wrong reasons," said Joel Naroff, president of Naroff Economic Advisors. "It would give the absolute wrong picture about the economy. The details are going to be more important this month."

The underlying economic situation hasn't changed since the first quarter. Consumers continue to spend money, housing is strong and businesses aren't spending at all. The reason this quarter, overall, should be considered a weaker one is because consumers spent money at a less rapid rate, and businesses, which already cut back spending in the first quarter, retrenched further in the second quarter.

Business Spending Plummets Monthly Durable Goods Orders

Source: Commerce Department

The GDP report is made up of several components. Consumer spending is by far the most important, making up a bit more than two-thirds of the country's GDP. John Lonski, senior economist at Moody's, expects the rate of consumer spending grew about 2.5% in the second quarter, down from 3.4% in the first quarter. Overall, that's not bad. In the first quarter, consumer spending accounted for 2.3 GDP percentage points, with the rest of the components combining to subtract 1.1.

Business investment, meanwhile, fell off a cliff in the second quarter. That's evident from today's durable goods report, which showed orders of nondefense capital goods were down 23.5% in June on a year-over-year rate. On a quarterly basis, the year-over-year rate of decline is 25%.

Investment rose 1.9% in the first quarter, largely because of ongoing investment in structures, but "business investment spending could more closely reflect orders for nondefense capital goods," said Lonski. "This thing could be pretty ugly when it comes out." Lonski said he expects a 10.6% decline in business spending in the quarter.

Rock and Roll, Hootchie Coo

The data that could make this report look better than expected is the trade deficit. When the trade deficit is growing, it subtracts from GDP growth, as the country imports more than it exports. The U.S. trade deficit has been growing for years, but it surprisingly dropped in April and May. However, the reason it dropped isn't heartening -- exports probably fell slightly, and imports fell dramatically. Falling imports may narrow the trade deficit, but it doesn't mean there's economic strength -- it means businesses have less demand for goods.

The other problematic area is the inventory situation. Inventories fell strikingly in the first quarter, and economists trumpeted this as a sign of the power of our free-market economy, as companies adjusted dramatically for the slowing in growth. This quarter may prove that thinking doesn't amount to a hill of beans when there's still no demand.

Inventories may rise slightly, which would add to growth, but the demand hasn't returned from businesses. Lonski believes inventories could decline outright again, which would be the first time that inventories have fallen for two consecutive quarters since 1991. Lonski's looking for 1.2% growth in the second quarter, same as the first quarter.

"If you take away consumer spending, you have a recession," he said.