Recession Economics: Stop Reading Into Consumption And Take A Look At Investment

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Investment is a smaller but more volatile component of GDP than consumption. Drops in investment have tended to precede recessions, consumption doesn’t always drop during recessions. Consumption gauges the health of consumers; Investment gauges the health of businesses. Investment is based on current and expected profits, therefore is…

Summary

Investment is a smaller but more volatile component of GDP than consumption.

Drops in investment have tended to precede recessions, consumption doesn't always drop during recessions.

Consumption gauges the health of consumers; Investment gauges the health of businesses.

Investment is based on current and expected profits, therefore is a fantastic forward looking indicator.

Investment is Small but Significant

Investment is responsible for about 19% of America's GDP. That's less than one third as much as consumption, which makes up 70% of GDP in a typical year. So why does investment matter so much in taking an accurate pulse of the economy? Investment allows financial market participants to get a sense of the health of businesses, whereas consumption allows participants to gauge the health of consumers.

Investment vs. Consumption in Gauging the Economy

Bullish economists and strategists have pointed to a selection of consumption metrics to justify favorable outlooks for the US economy. After all, the American economy is dominated by the consumer. We saw consumption decrease sharply during the epic '08 crash after the average American consumer was wiped out. We also saw consumption dip during the 1970's "stagflation" era due to excessively high inflation, particularly in oil prices. However, consumption held strong during the recessions of the 80's, 50's, and 40's and moreover, drops in consumption only occurred in the above examples once the recession was fully underway.

While the strategists forecasting strong US growth may not be wrong, the basis for the argument is flawed. Particularly in this economy, with commodity prices at unprecedented lows, consumption only provides an accurate picture of one sliver of the economy.

Let's look at why we should pay attention to investment. In traditional economics, investment is a function of both current and future expected profits, which makes it a fantastic measure of current business health as well as expectations. Some may doubt the practicality of using traditional economic functions in real world situations, but this equation holds logically; businesses invest now when they perceive that their new ventures will generate returns in the future. So, as long as businesses sense that the environment is favorable they will continue to invest and grow.

Consider what happens when businesses stop investing. When businesses stop investing, they cease to grow. But when does the growth slowdown materialize? In theory there should be some lag time between when businesses cut investment and when growth slows. Without spending any marginal dollars on capital expenditures, most businesses could continue to eke out growth through steady sales increases or cost reduction for some amount of time. Those intervals vary but seven out of the past eight recessions have been preceded by between one and seven quarters of declining investment. This is where the true value of investment as an economic indicator lies; it is forward looking.

The Evidence

Two key claims must be validated by data; first, steady consumption does not necessarily indicate a strong economy and furthermore drops in consumption tend to appear only once a recession is confirmed, and second, drops in investment tend to precede recessions and therefore investment is a useful forward looking indicator.

Note: All data from St. Louis Fed website, quarterly, seasonally adjusted data showing year over year percent changes from 1948 until Q3 2015 for the variables real GDP, investment (real gross private domestic investment), and consumption (real personal consumption expenditures). Recession defined as 2 or more quarters of GDP contraction.

Table : # of Quarters of Decreased Investment or Consumption Preceding Recessions [Source: author)

In this first table we see that seven out of the past eight recessions have been preceded by at least one quarter of negative YoY quarterly investment change while only one was preceded by negative YoY quarterly consumption change. This certainly acts as supporting evidence for both the first and second pieces of this article's thesis. This analysis does not take into account the magnitude of the investment decreases as they relate to the length or depth of the following recession. From a cursory look this sort of a correlation is much harder to support (and is potentially fodder for a future article).

Table : # of Quarters of Decreased Investment or Consumption During Recessions [Source: author]

From this table it is visible that consumption actually remained increasing in three out of the last eight recessions, while investment dropped during every one. This highlights that the consumer health is not always indicative of economic growth.

It is worth noting that there are cases of "false positives" where investment drops but a recession does not follow. This has occurred in three episodes in the past thirty years during the late '60's, mid-80's, and early 2000's. I won't go too deep into analyzing why this happens but consider the example of the early 2000's. This seven-quarter drop in investment closely coincided with the dot-com bubble, geopolitical fears, and a fairly severe bear market. Sure a recession did not follow the drop in investment, but fear was rampant in the economy and the stock market.

Taking the Pulse Now and Conclusion

The most recent data from the St. Louis Fed shows Q4 2015 investment rising 2.5% YoY, seasonally adjusted. In short, US investment is not showing any red flags for the economy going forward. Does that definitively prove that the US economy is as strong as ever? Certainly not, this is just one indicator but it is worth paying attention to in the coming quarters and will hopefully tell a lot about where the economy is headed and if the fears of a crash are justified.

Investment may also be useful in predicting stock market performance over the coming years and quarters but the evidence presented in this article only supports its correlation to overall economic growth. As history has dictated, bear markets don't always coincide with recession, and for the second time in this write up, perhaps this is material for a follow up article.

The important takeaway here is that consumption metrics should not be relied upon as an accurate measure of economic strength. It is difficult to reach a definitive conclusion about the economy given the investment metrics most recently reported, and regardless this is only one measurement. However, I will be paying close attention to investment in the next Fed report, and after a rocky January it could shed a lot of light on the US economy.


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