Revised Q2 GDP Figures: Much Worse Than the Headline…Beware of the Spin Doctors
Nouriel Roubini | Aug 30, 2006

The revised Q2 figures are out and the headline figure – 2.9% growth – is better than the initial advance estimate of 2.5%. Right after the publication of these revised figures today the spin doctors have been in a frenzy to use this number to prove that the economy is fine. First in the line among these spin doctors is “Eighth Inning” Dallas Fed President Richard Fisher – yes the same Fisher who firmly predicted in June 2005 that we were at the “eighth inning” of the Fed tightening cycle and then went on voting another nine times for a Fed Funds raise. An hour after the release of the new Q2 figures he stated in a speech:

"We are slowing down, but this number may help us keep it in perspective,'' Federal Reserve Bank of Dallas President Richard Fisher said today after a speech in Dallas. ``We could not have kept growing at the rate we were growing in the first quarter.'' He called the figures today ``pretty healthy,''

This is also the same Fisher who – in a previous speech – called me and other realists who are worried about housing and the economy an Eeyore.

Beware of these spin doctors. Behind the headline figure, the numbers in the revised Q2 figures are much worse than the initial estimate. Essentially, almost all of the upward revision to the figures comes from a much larger increase in inventories of unsold goods, an ominous signal for future growth as firms saddled with unsold goods will soon start cutting production (as it is happening, for example in the auto sector). Indeed, if you exclude inventories and look at final sales, the figures are much worse: in Q2 final sales of domestic product grew only 2.3%.

The GDP growth improvement is also due in part to slightly better net exports but beware of this. The fact that now net exports are not anymore a drag on growth is also bad news, not good news: as the economy sharply slows down imports of consumption and investment goods are slowing down. Thus, the news from net exports is also lousy as it signals the coming recession: net exports improve when an economy slows down and worsen when the economy grows fast. Indeed, the figures about a fall in imports - a -0.1% in Q2 – are a clear indication that, as the economy is sharply slowing imports are falling.

The sharp increase in inventories is particularly worrisome since, as in any inventory cycle, an increase in such supply of unsold goods, is a leading indicators that firms will tend to reduce production when faced with slowing demand and rising inventories. So, higher GDP figures for Q2 via higher inventories means that – all equal – Q3 and Q4 figures for GDP growth will be worse than otherwise as a sharp inventory adjustment will occur; indeed, the Ford decision to cut production by over 20% in Q4 is a typical – if extreme - canary in the mine in terms of signaling how corporates will react to a sharp unexpected increase in inventories.

The new data also confirm that the bust in the housing market is even greater than initially estimated: real residential investment fell in Q2 at an annualized rate of -9.8%, much worse than the initial estimate of -6.3%. Given these revised figures I now expect that real residential investment will fall closer to a 20% annualized rate for the next few quarters. As I discussed in a number of recent writings (here and here and here) this housing bust will be a crucial driver – both directly and indirectly of the coming economy-wide recession that I am predicting.

The revised data also confirmed that corporate investment - in software and equipment – was falling already in Q2 at annualized rate of 1.6%, even worse than the 1.0% reported in the first estimate of Q2 GDP; so much for the view that corporates will invest more as housing and consumption falter. Indeed, corporates may be full of profits and cash now but they do not see any good real investment opportunity as other components of demand are slowing sharply and inventories of unsold goods surging; thus, there is an unprecedented share buybacks bonanza, the largest in U.S. history, a signal of no god real investment options out there for corporate America.

And beware also of the rhetoric on profits and earnings. Based on the revised data, corporate profits in Q3 increase a mediocre 3.2%, down from 12.6% in Q1. Indeed the Q2 figures now show a sharp and worrisome increase in unit labor costs as Q1 employee compensation growth was revised much higher and Q2 was also revised higher. So, you can expect profit growth to become sharply negative once the economy slows down even more in H2 and enters into a recession in 2007. I will separately blog soon on the relation between recessions and the stock market and on what is happening to earnings; the perma-bull spin that earnings growth is still rapid is non-sense once you carefully dissect the data; the reality is that earnings growth is sharply decelerating now with ominous implications for the coming bear market in equities.

So, in summary the details of the new Q2 GDP figures are simply ugly and uglier than the initial estimate: much bigger inventories of unsold goods implying slower production and GDP growth in the second half of 2006; very slow growth of final sales that is down to 2.3%; actual falling investment in software and equipment; a modest trade improvement that is reflecting an economic slowdown; profit growth sharply down, sharp productivity growth slowdown and unit labor costs sharply up; anemic consumption growth and flat consumption of durables (and a worsening of consumer confidence based on current July-August data); negative growth of Federal consumption spending.
So let “Eighth-Inning” Spin-Doctor-In-Chief Fisher eat crow – as he did after he raised rates nine more times after his “eighth inning” speech – again once the actual real economy figures about the coming sharp slowdown and eventual recession will prove him soundly wrong again. Beware of perma-bull spin doctors with rose-tinted glasses who are totally blind to the extent of the current economic slowdown and are still talking about a soft landing of housing and an orderly economic slowdown. Soon enough the only thing orderly about the comatose housing market will be the undertaker carrying the coffin...and the rest of the economy will enter into a coma right after...