Friday, April 27, 2007

Q1 2007 GDP: Investment and Recessions

by Bill McBride on 4/27/2007 10:16:00 AM

The good news in the Q1 2007 GDP report was that private non-residential investment rebounded slightly. As I noted yesterday, investment slumps correlate very well with recessions. The following graphs are an update to previous graphs and include Q1 2007 (note these are year-over-year changes, not quarter-by-quarter).

Click on graph for larger image

The first graph shows the change in real GDP and Private Fixed Investment over the preceding four quarters, shaded areas are recessions. (Source: BEA Table 1.1.1)

A couple of observations:

1) Since 1948, private fixed investment has fallen during every economic recession.

2) Private fixed investment has fallen 13 times since 1948 (14 including the current slump), with only 10 recessions.

So what happened during the periods around 1951, 1967 and 1986 to keep the economy out of recession? These are the periods when private investment fell, but the economy didn't slide into recession. The answer is generally the same for all three periods: a surge in defense spending. The defense spending in the early '50s was due to the Korean war, in the mid '60s the Vietnam war, and in the mid '80s a general defense build-up helped offset a small decline in private investment. The mid '80s also saw a surge in MEW (mortgage equity withdrawal) that also contributed to GDP growth.

The second graph shows the separation of private fixed investment into residential and nonresidential components.

This graphs shows something very interesting: in general, residential investment leads nonresidential investment. There are periods when this observation doesn't hold - like '95 when residential investment fell and the growth of nonresidential investment remained strong.

Another interesting period was 2001 when nonresidential investment fell significantly more than residential investment. Obviously the fall in nonresidential investment was related to the bursting of the stock market bubble.

However, the typical pattern is residential investment leads non-residential investment, so the current slowdown in non-residential investment is not unexpected.


The final graph is the YoY change in New Home Sales from the Census Bureau.

Note: the New Home Sales data is smoothed using a three month centered average before calculating the YoY change. The Census Bureau data starts in 1963.

Some observations:

1) When the YoY change in New Home Sales falls about 20%, usually a recession will follow. The one exception for this data series was the mid '60s when the Vietnam buildup kept the economy out of recession. Looking solely at this graph, one might expect the economy to already be in a recession - however these models are just guidelines, not perfect predictors. The pace of the current decline in new home sales hasn't been extremely high (only 20% YoY decline), and the slower the slump, the more the rest of the economy can absorb the impact.

2) It is also interesting to look at the '86/'87 and the mid '90s periods. New Home sales fell in both of these periods, although not quite 20%. As noted earlier, the mid '80s saw a surge in defense spending and MEW that more than offset the decline in New Home sales. In the mid '90s, nonresidential investment remained strong.

And that brings us back to this piece of good news in the Q1 GDP report: Non-residential investment rebounded.

Real nonresidential fixed investment increased 2.0 percent in the first quarter, in contrast to a decrease of 3.1 percent in the fourth. Nonresidential structures increased 2.2 percent, compared with an increase of 0.8 percent. Equipment and software increased 1.9 percent, in contrast to a decrease of 4.8 percent.
Perhaps non-residential investment will stay positive and help keep the economy out of recession. Later I'll review the typical lags between residential and non-residential investment.

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