Economic growth decelerated sharply from the 4.91% annualized growth rate seen in the Q3 2007 to 0.64% in Q4, nearly coming in at only half of the 1.2% consensus growth rate reported by Thomson Financial. The deceleration in growth came from a fall in inventories and weaker growth in federal spending, consumption, and exports.
Figure 1
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Source: Moody’s Economy.com
Breaking down the GDP report by components, consumption grew 1.97%, fixed investment fell 2.58%, exports rose 3.89%, imports rose 0.32%, and government expenditures rose 2.6%. In terms of contributions to percent change in real GDP, positive growth came from personal consumption expenditures, net exports of goods and services, and government expenditures, which added 1.37%, 0.41%, and 0.50% respectively. Subtracting from growth was gross private domestic investment, which subtracted 1.64% from total GDP growth.
Figure 2
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Source: Moody’s Economy.com
Breaking down gross private domestic investment further reveals where the weakness lies in why gross private domestic investment shaved 1.64% off GDP growth. As is no surprise, residential fixed investment subtracted 1.18% from GDP growth. It’s not hard to see why residential fixed investment subtracted 1.18% from GDP growth when it fell at an annualized 23.92% in the fourth quarter, accelerating from the 11.77% and 20.53% rates seen in the second and third quarter respectively. One tailwind that became a headwind was the change in inventories that reversed course in the fourth quarter by subtracting 1.25% from GDP growth while it added 0.89% in the third quarter.
The bright spot of the fixed investment component was nonresidential fixed investment, which helped offset the negative contributions of residential fixed investment and change in inventories by adding 0.79% to growth in the fourth quarter.
Figure 3
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Source: Moody’s Economy.com
What is interesting to note, and which helps explain why the decline in residential fixed investment hasn’t had a more drastic affect on GDP growth, is that the growth in real nonresidential fixed investment in 2007 completely offset the decline in residential fixed investment. In 2007, real nonresidential fixed investment grew by .9 billion while real residential fixed investment fell by .7 billion, more than offsetting the entire decline from the housing recession.
Though nonresidential fixed investment helped offset the decline in residential fixed investment in 2007, this may not be the case for this year as growth in the component appears to be decelerating and trends in nonresidential fixed investment lag movements in residential fixed investment. For example, growth in nonresidential fixed investment has decelerated since the second quarter of last year when it grew at an annualized 10.99% rate, falling to 9.36% and 7.53% in the third and fourth quarters respectively. Additionally, based on the historical script, nonresidential fixed investment should start to drop off as it tends to lag residential fixed investment by three quarters.
Figure 4
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Source: Moody’s Economy.com
One of the components that make up nonresidential fixed investment is structures (commercial real estate). As business trends lag consumer trends, it is not hard to see how commercial real estate lags residential real estate, with Figure 5 below showing the lag tending to be by five quarters.
Also note that there was a slight pause in the decline in residential real estate in the fourth quarter of 2006 after the peak in the third quarter of 2005, before residential real estate began to sharply decline. This same pattern is now being witnessed in commercial real estate (“structures”), where the peak was seen in the second quarter of 2006 and a slight increase (pause) was seen in the fourth quarter of 2007, exactly five quarters after the pause in residential real estate.
Figure 5
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Source: Moody’s Economy.com
What also supports the notion that commercial real estate has peaked is that nonresidential vacancy rates are starting to rise, a trend that is seen just heading into a recession. Of the four components of nonresidential real estate, only downtown office vacancy rates have yet to increase while the other three categories have.
Nonresidential vacancy rates rise when the consumer slows down and lending standards for commercial and industrial (C&I) loans become more stringent. The historical relationship between nonresidential real estate vacancy rates and lending standards for C&I loans shows that C&I lending standards lead vacancy rates by two and a half years, indicating one can expect nonresidential vacancy rates to rise into the end of the decade and that nonresidential real estate may become a headwind instead of a tailwind to GDP growth going forward.
Figure 6
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Source: Moody’s Economy.com
Figure 7
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Source: Moody’s Economy.com
With nonresidential real estate lagging residential real estate, it’s not surprising that we are just starting to see serious deterioration in commercial real estate asset-backed securities (CMBX) much like we did with residential asset-backed securities last year. Evidence of this can be seen with the explosive move in the spreads for commercial real estate asset-backed securities. Looks like the big hedge fund profitable trade will be shorting commercial real estate asset-backed securities this year. Looks like the next shoe to fall is commercial real estate but don’t worry, corporate balance sheets are in excellent shape!
Figure 8
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Today’s Market
The markets traded flat for most of the day before vaulting northward once the Fed announced it would cut interest rates by half a percent. The Dow Jones Industrial Average rose nearly 230 points after the announcement before giving back all of the gains on the day to finish in negative territory as investors locked in short-term gains amidst worry of a slowing economy.
The Dow Jones Industrial Average fell 37.47 points to close at 12442.83 (-0.30%), the S&P 500 gave up 6.49 points to close at 1355.81 (-0.48%), and the NASDAQ fell 9.06 points to close at 2349.00 (-0.38%).
Treasuries fell with the yield on the 10-year note rising 7.5 basis points to close at 3.733%. The dollar index was down, falling 0.46 points to close at 75.08. Advancing issues represented 41% and 43% for the NYSE and NASDAQ respectively, reflecting a mostly negative market move.
