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Peak Growth

Jul 29, 2021

Executive Summary

  • Real GDP increased by 6.5% (SAAR) in Q2, likely marking the peak in growth on a year-over-year basis.
  • Housing, inventory, and government spending dragged growth lower while consumption remained strong.
  • The real GDP per capita gap remains open and will struggle to close by 2023.
  • Any Fed tightening into a real GDP gap will negatively impact the economy.
  • A highly indebted economy results in lower real interest rates.

Peak Growth

Real GDP increased 6.5% in Q2 on a seasonally adjusted annualized basis. The increase in growth was far less than expected and only fractionally higher than the 6.3% growth recorded in Q1.

Real consumption growth ticked higher in Q2, from 11.4% to 11.8%, but government spending, residential fixed investment (housing), and private inventories were detractors.

The quarterly growth rate of the major components of GDP are outlined in the table below.

Residential fixed investment growth peaked in Q3 of 2020 and has declined to -9.8% on a quarterly basis. Weakness in a highly cyclical area of the economy like housing is a leading indicator of softer growth in the future.

Components of Real GDP:

Source: Charles Schwab, BEA

Quarter-to-quarter changes are too noisy. The growth rate in the following four charts is expressed via a smoothed six-month annualized formula. The result is an annualized growth rate that moves similarly to a year-over-year growth rate calculation but is less impacted by the year-ago base in the denominator.

Real GDP:

Source: BEA, EPB Macro Research

Real GDP increased at an 8.4% annualized pace on a smoothed six-month basis, the highest growth rate since the 1960s.

Of course, the growth rate is rebounding from the deepest contraction in well over 70 years. The Zarnowitz rule in economics tells us that sharper recoveries follow deep recessions, but only in the first year. After the first year of recovery, the economy starts to revert back to "trend" economic growth.

Real GDP:

Source: BEA, EPB Macro Research

With one year since the trough in the economy, the "sling-shot" effect that naturally comes after a recession is over.

We can already see the deceleration appear in the more cyclical areas of the GDP report.

Two of the most cyclical areas of the GDP report including housing and durable goods consumption. These two components of GDP exploded over the last several quarters, but now, the growth rate is starting to decline.

The combination of real residential fixed investment and real durable goods consumption peaked in Q1 and cooled to a growth rate of 20.8% in Q2.

Of course, a 20% growth rate is extremely high by historical standards. Still, when economic growth is translated to asset markets, the momentum or direction of growth is the dominant factor.

Real Residential Fixed Investment + Durable Goods Growth Rate:

Source: BEA, EPB Macro Research

Residential fixed investment (housing) peaked in Q4 of 2020 with a growth rate of 22.5% and has since cooled to a growth rate of 10.1% on a smoothed six-month annualized basis.

Real Residential Fixed Investment Growth Rate:

Source: BEA, EPB Macro Research

Coincident economic data peaked in March and has declined in April, May, and June. This means that the economy is facing downward economic momentum heading into Q3.

US Coincident Economic Growth:

Source: BEA, BLS, Federal Reserve, EPB Macro Research

Moreover, and important for Fed policy, the US economy still has a real GDP gap relative to the pre-COVID trend.

From the trough in 2009 to the peak in 2019, real GDP per capita increased at a 1.6% annualized pace. This sub 2% rate of real GDP growth was weak relative to history, but now the economy struggles to recover this trendline when measured in real per capita terms.

If the economy is going to close the real GDP gap by 2023, the next six quarters would have to come with a 3.1% annualized pace of growth.

What we know from the Zarnowitz rule tells us that doubling the previous trend rate of growth is an unlikely occurrence after the first 12 months of recovery.

Real GDP Per Capita Gap:

Source: BEA, EPB Macro Research

It would take a sustained 2.5% annualized pace of real GDP per capita growth to close the gap by the start of 2024.

The Federal Reserve has hinted at tapering their balance sheet in the coming months, and the last FOMC dot-plot placed a potential rate hike in late 2022, well before the economy can be expected to close the real GDP gap.

Real GDP Per Capita Gap:

Source: BEA, EPB Macro Research

The real GDP gap is a disinflationary gap. It will prevent the FOMC from sustainably tightening monetary policy.

As the bond market became convinced that Fed policy would start getting tighter with an existing GDP gap, the yield curve flattened to reflect this negative impact to future growth from premature tightening.

Fiscal stimulus will not sustainably increase the trend rate of GDP per capita. The trend rate of real GDP per capita is the best measure of the standard of living in the country.

Fiscal stimulus pushes resources towards the government spending and consumption line items of GDP.

As resources are pushed towards consumption and government activity, the economy becomes starved of real private domestic investment in physical infrastructure, the primary way to boost the standard of living sustainably.

Investment in Structures & Equipment as a % of GDP:

Source: BEA, EPB Macro Research

The rate of investment in structures and equipment continues to decline as the government incentivizes and encourages short-term consumption.

Investment in structures and equipment is critical to advancing the standard of living with categories including hospitals, medical buildings, medical equipment, manufacturing plants, power grids, mining and exploration equipment, construction machinery, and more.

The cyclical areas of the economy are now starting to cool after the stimulus push, and now we are left with downward economic momentum. Short-term thinking and a lack of national savings have prevented adequate private investment, and the long-term result will be a weaker trend rate of real GDP per capita.

Economic growth will start to soften in Q3 and Q4, which will bring a sustained change in market leadership in the defensive direction.

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