Back to Zero? Why Q2 Might Have Been the Worst Since the Recession

The economy may not have shrunk, but it likely grew at the slowest rate since the recovery began

In April we noted that the economy took a step back. In May, things got a little worse. The June economic data is still pouring in, but so far it isn't much better. Those three months make up the second quarter, and this Friday we'll get its first GDP estimate. Was the quarter's economic growth even more anemic than the first quarter's paltry 1.9% annualized rate? Or did the economy shrink?

At this time, the consensus estimate for second quarter growth is 1.6%, according to MarketWatch. Economists aren't just being pessimistic here. Considering the economic reports we've seen so far, it's hard to imagine a much better result.

Let's consider the four components of GDP. Using the economic data we've got through May and June, we can construct scenarios for growth for last quarter. I've done an analysis, which is explained in detail below. Here are the highlights:

Real Consumer Spending: Even with the most optimistic of estimates, consumer spending didn't likely do much for GDP. We know real spending declined slightly in April and May, while retail spending unadjusted for inflation rose a bit in June. So at best we'll see a small bump to GDP from this component. The range for consumer spending's contribution to GDP is likely between 0.2% and 0.4%.

Trade: Net exports didn't likely help much either. The trade gap swelled in May. Even if it declined in June by the most in two years, it will provide little help to GDP. If May's trade deficit remained intact in June, then we'll see trade hurt growth. The contribution to GDP here was likely between -0.3% and 0.0%.

Business Investment/Spending: This is arguably the hardest of all the components of GDP to estimate. It doesn't seem likely that businesses invested a lot on equipment, considering that their weakening expectations drove them to slower hiring. Existing home sales were down, while new home sales were up. Put together, residential investment probably didn't soar. That leaves inventories. Incomplete data indicates that they appear to be in-line with their rate of growth from the first quarter, but additional inflation means that their contribution to GDP will be smaller. This component probably added somewhere between 0.0% and 0.6% to GDP growth.

Government Spending: Treasury outlays show that defense spending rose in the second quarter, which will likely result in an uptick in federal spending. Meanwhile, however, we can be pretty sure that state and local spending continued to fall. The Treasury's extraordinary measures to prevent puncturing the debt ceiling are believed to have made state and local budget management more difficult. We also know that state and local government jobs declined in the second quarter. This means that government likely contributed somewhere between 0.1% and 0.6% to GDP growth.

If you add these four components together, you find that it's pretty hard to realistically imagine GDP growth exceeding 1.6% in the second quarter. But it isn't crazy to see it drop all the way to near zero if the more pessimistic estimates are considered. The leading positive contributors will likely be business investment and government spending, both of which also happen to be very difficult to estimate.

This makes Friday's report extremely important. If GDP growth matches the consensus projection of 1.6%, which is at the high end in the estimate explained here, then it will match growth in the third quarter of 2009. That's also the weakest since the U.S. first saw GDP rise again after declining for four straight quarters. If it falls in-between the two scenarios explained here, it will mark a new recovery low.

My Basic Assumptions

Real Consumer Spending

In April and May, real consumer spending fell. We don't have the full data for June yet. We do, however, know that retail spending rose slightly, unadjusted for inflation. It returned to approximately its April level.

• Optimistic: If real consumer spending managed to rise by 0.1%, then its contribution added 0.4% to growth.
• Pessimistic: If instead, real consumer spending declined by 0.1% in June like it did in April and May, then its contribution to GDP would be 0.2%.

Trade

This is another component where we have some decent data at this point, though we're still lacking the numbers for June. Through May, the trade deficit had grown significantly.

• Optimistic: You could assume that in June the gap shrunk by the most it has in two years, which would result in around a 0.2% boost to GDP growth.
• Pessimistic: If the gap was unchanged from May to June, then trade subtracted around 0.3% from GDP growth.

Business Investment/Spending

This is arguably the hardest of all the components of GDP to estimate. Let's split it up into its component parts:

Nonresidential Investment

Businesses didn't likely invest a lot during the second quarter. Weakened expectations could have easily resulted in less money going to things like equipment and software as expansion plans slowed.

• Optimistic: Nonresidential investment grew at the same weak rate as it did in the first quarter.
• Pessimistic: It was completely flat.

Residential Investment

Home sales didn't likely help much. Existing home sales were down in the second quarter by about 5%, while new home sales remained at a very low level but were up around 8% through May (we don't have June's data yet here).

• Optimistic: Residential investment was flat.
• Pessimistic: A small 1% decline in residential investment.

Inventories

Again, here we lack June data. But April and May inventory growth has approximately matched the rate in the first quarter. That doesn't take the second quarter's much higher inflation into account, however.

• Optimistic: Inventories grew at one-third of the pace as they did in the first quarter.
• Pessimistic: They were flat.

Taking these three components into account:

• Optimistic: Business investment added 0.6% to GDP growth.
• Pessimistic: It added nothing.

Government Spending

Federal Spending

The Treasury's monthly outlays shows Defense spending rising in recent months. This component tends to drive federal spending. So let's leave nondefense spending flat, which was the case from the fourth quarter of 2010 to the first of 2011.

• Optimistic: Federal spending rose by 6% -- slightly more than the amount by which Treasury reports defense spending rose.
• Pessimistic: That estimate could give too much credit to defense, so instead let's say it only boosted federal spending by 4%.

State and Local Spending

Estimating state and local spending is even more difficult. It has been declining over the past few quarters. Considering that the Treasury's measures to avoid piercing the debt ceiling were likely to have an adverse affect on the states and that employment statistics show that the state and local layoffs continued, state and local spending likely kept declining in Q2.

• Optimistic: The same decline as in the first quarter.
• Pessimistic: A decline 20% greater than in the first quarter.

Combining these two factors for the government's contribution:

• Optimistic: Government spending adds 0.6% to GDP growth.
• Pessimistic: It adds just 0.1%.

Very Different Scenarios

Through this analysis, you find that the optimistic assumptions put you near the consensus estimate -- at 1.6% growth for Q2. But if you use the pessimistic scenario instead, then you have zero growth, with GDP virtually unchanged from Q1 to Q2. Anywhere in between would almost certainly displease the market, as it would indicate a very anemic rate of growth.

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