GDP Better than Expected, Market Tanks

Gross Domestic Product (GDP) is the most widely-used indicator for the health of an economy. So, when the fourth quarter GDP number was released prior to the market open and was almost two percent better than expected, you would think that stocks would get a lift from the better-than-expected news. Not so! After a brief rally, the market continued the decline begun yesterday as investors began fully digesting the nuts and bolts of the economy’s quarterly progress report.

In its broadest sense, GDP is the measure of all goods and services produced in a country during the quarter, which is expressed on an annualized basis. The basic formula is: GDP = consumption (consumer spending) + government spending + investment (which is basically business spending) + net exports. For the quarter, GDP fell at a 3.8% annual rate, which is the worst quarter in 26 years but was not as bad as the 5.5% drop that many had forecast. Overall for the year, GDP is down .2% from the prior year.

Quarter after quarter, the largest component of GDP is consumer spending. With the Conference Board’s consumer sentiment indicators reaching new lows (the index began in 1967), it is no surprise that consumer spending has slowed considerably. Consumer’s spent 3.5% less in the final three months of 2008 than at the same time in 2007, which is actually slightly better than the 3.8% decline in fourth quarter GDP. Consumption sank as a percentage of GDP from 71% in the third quarter to 63% in the quarter just ended. Final sales, which is often a proxy for consumer demand fell by 5.1%. Meanwhile, as aggregate demand faltered, inventories grew (adding 1.32% to GDP) which could spell trouble in future quarters as orders for these goods slacken.

Government spending rose in the quarter by 5.8%, which did serve to boost overall GDP, but is hardly the component that we would like to see growing. With the Administration’s stimulus plan in the works and the possibility of TARP II or the creation of a “Bad-Bank” also looking more likely, this number will surely continue to grow in the future.

Perhaps most distressing was the falling investment component, as business curtailed spending by 19.1% in the quarter–the worst such performance in 34 years. Businesses are clearly very hesitant to overextend themselves in this environment and keeping costs down is key as evidenced by rising unemployment. Investment in structures fell by 1.8%, while investment in IT and software was hit very hard, dropping 27.8%. Clearly any business-to-business sales have been hit especially hard in this downturn.

Net exports ended up yielding a small gain for overall GDP in the quarter, as trade slowed considerably. Exports fell by 19.7% in the quarter as a stronger dollar and decreased global demand worked against U.S. producers. Imports dropped by nearly 16% in the quarter as well.

So, even though the preliminary fourth quarter GDP number was better than most had feared it would be, a 3.8% drop offers plenty to be concerned about going forward. One such concern is the $6.2 billion increase in inventories, which could further depress future production as businesses are forced adjust their output in the next few months. Further compounding this problem is the 5.1% drop in aggregate demand during the quarter. However, one potential bright spot is the fact that inflation is not a concern presently. In the calculation of GDP, prices fell .1% during the quarter (the first decline in more than 50 years), compared to a drop in the Consumer Price Index (CPI) of 9.2% in the quarter mostly due to plunging energy prices. One could argue that CPI is a better measure of price levels in the calculation of GDP and that it is being under-stated in the current release.

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