2Q 2014 GDP Numbers are in…

This morning the Bureau of Economic Analysis (BEA) announced the US economy grew at a 4.0% annual rate during the 2nd Quarter of 2014. This was better than expected. Further, it revised the 1st Quarter number to -2.1% from the previously announced -2.9%. Yet, the broad markets are largely in the red thus far today. Why is that?

First, the better than expected release has many people think the Federal Reserve will continue to curtail its bond purchases moving forward, perhaps more than expected. After all, do we really need to print money if the economy is really growing at a 4.0% clip? The easy answer to that is: probably not. However;

Second, the economy really isn’t growing at a 4.0% rate, just as it didn’t really shrink at a -2.1% clip during the first three months of the year. Let me explain.

The 1st Quarter number was largely skewed due to a decrease in the increase in private inventories during that time frame. Businesses only added something like $35.2 billion to their inventories (inflation adjusted) during the 1st Quarter, as opposed to growing them at a $81.8 billion rate during the 4th Quarter of 2013. As such, while companies were still growing inventories, they were growing them more slowly. Due to the way the BEA accounts for such things, the slowdown in inventory growth took 1.16% off the economy in 1Q. Therefore, growth = contraction in this calculation.

In the second quarter, companies added $93.4 billion to their inventories. Obviously, that is an improvement over the 1st Quarter (when they only added, again, $35.2 billion). As a result, this growth in inventories added a whopping 1.66% to the GDP equation.

Clearly, while building inventories is great, true economic growth comes from end user demand/consumption. Simply put, you can’t grow the economy in perpetuity by stocking the shelves and loading up boxes “in the back.” If the demand isn’t there, businesses will quit adding inventory until it is. As a result, the changes in inventories smooth out over time, ordinarily resulting in only modest growth….certainly not almost half of the equation (in either direction). In so many ways, the fluctuations in inventories is a by-product of end demand, and not the other way around.

Therefore, to measure true economic growth, sometimes you have to take the inventory swings out of the equation to get a truer understanding of what is really happening. So, what is?

Compared to the end of the year, the economy is growing at roughly a 1.8-1.9% clip. This is very much in keeping with most economic forecasts and the recent history of the US economy. In so many ways, the inclement weather the nation had, as a whole, during the 1st Quarter disrupted normal inventory building. As a result, it snapped back a little stronger than expected during the 2nd Quarter. This means we shouldn’t expect the same type of “tailwind” from inventories during the 3rd Quarter, and the remainder of the equation has to take up the slack. But another way, the BEA’s ‘seasonal adjusting’ didn’t work so well during this past, particularly harsh winter.

Currently, it seems Consumption is growing around 2-2.5%; Investment is growing 4-5%, and government spending is around 0-1%. Our trade deficit has deteriorated a little this year, but should probably stabilize between now and the end of the year. When you add the appropriate weights to the various components, the economy is poised to grow around 2%….which is what is currently doing, regardless of the wild fluctuations in inventories.