Consensus Forecast for 4Q GDP:Activity Down 5%

The 4Q 08 figures for Gross National Product will be available next Friday at 8:30 A.M. As always, the data will be a key gauge for measuring the current shape of the economy. And the news is not likely to be pleasant reading. It's easy to now generate an estimate that economic activity fell at a 5.1% annual rate last quarter, which indeed is the current Consensus forecast. The range of forecasts extends, however, from -2.0% to -7.5%.

By itself, the magnitude of the drop expected by Consensus would be the fastest since the middle of the 1981-82 recession. Peak-to-trough activity declined during that recession by 2.9% reflecting a pattern of sharp decline early, then nine months of stagnation. This time no such pattern is foreseen by Consensus estimates. Another sharp drop in GDP is expected for this quarter, 1Q09, then a slight decline in 2Q. A downturn following that pattern would make it severe and the harshest since the end of WWII.The Recession in Perspective from the Federal Reserve Bank of Minneapolis can be found here.

The table below contains a set of estimates for the 4Q GDP components, generated mostly from the monthly data that already is available. As might be expected, consumer spending and housing lead the downturn. Developing estimates for the worst case outcome of a 7.5% decline in activity is relatively easy by just changing the expectation for consumer spending to -8.0%, perhaps due to weaker vehicle sales, and eliminating the addition from an improved trade deficit.

General expectations are for a subpar, 2H recovery with quarterly gains of 1.0% to 2.0%. Persistent declines in consumer spending coupled with further weakness in housing would easily unravel those expectations. Moreover, lagged declines in business investment and weaker exports due to recessions abroad could add to any lack of forward economic momentum. However, there is the potential for some upside. Pent-up demand for consumer durables could be unleashed with the huge amount of monetary stimulus already in place and an easing of tight credit conditions.

In this era of recession and weak growth, price inflation seems not to be an issue. Growth in the GDP chain prices is expected to drop to 1.0% by 2010 where it is expected to remain in 2011.

Hooray! The MFG and Services PMIs for Europe in January have bounced. It’s too soon to call it a bottom but since they are bouncing off historic- or near-historic lows, maybe we have seen the worst of decay. Even if that is true it is a far cry from saying we are about to embark on recovery.

What it means - At a reading of 34 for MFG, the sector is telling us that about 34% of the industries are expanding… (That is strictly speaking an improper interpretation since the PMI reading is all the ‘up’ readings plus ‘half the unchanged responses’ and there are myriad ways to get that result. A given PMI reading does not tell you how many, or which proportion, of industries are expanding. But the reading of 34 is ‘as if’ 34% were rising and the rest falling although fewer may be rising and twice the residual might be unchanged. I will use this short hand of treating the PMI as if it were an ‘up only’ index for simplicity but the reader should understand that the truth is a bit more complex- I think nothing is lost by this expositional device.). For services the reading of +42 is coming off that (shorter) series’ all-time low.

Lots of weakness ahead - In any event it is clear that these two measures can rise for some time and still not get back to neutral (a reading of 50 is neutral- half the sectors expanding, half contracting).

‘Neutral’ is not ‘normal’ - And of course ‘neutral’ is not the same as ‘normal’. When you put your car in ‘neutral’ is neither in ‘drive’ nor ‘reverse’. If we were to average what gear your car were in most of the time the average would not be close to neutral. Similarly, since July 1998 when the services measure was launched it has averaged 54.2. Over the same span the MFG index has averaged 52. On balance more sectors are expanding than contracting in normal times. So the current readings are a very great distance away from being ‘normal’ and it should take a good deal of time to get back to normal.

Diffusion increases do not necessarily mean that output increases - When these diffusion indices rise, until they surpass a reading of 50, they are indicating contraction at a slower pace but still contraction and not expansion.. For now the PMIs are saying that the worst – most severe phase of the contraction - is behind us, not that recession is ending. And that is the message only if the December bottoms stay in place and are not replaced by new weaker readings.

More weakness ahead - Rest ‘assured’ that more declines lies ahead for conventional economic variables even if the diffusion indices continue to rise from their lows.

Diffusing as Mr Sensitivity - Diffusion readings are very valuable because they are so timely and because they are sensitive. Formally the PMI indices are measures are gauges of the BREADTH not of its strength. But everyone treats theses measure of breadth as if they are of strength. Financial experts are well aware that is not so. For stock markets analysts (for example) always looked at big ‘up’ or ‘down’ days in the stock indices to see if the breadth reinforced the trend or not. Breadth in fact is not the same as strength – but they are highly correlated. So again be careful how use diffusion data. They often are the first whiff of slowdown or of bottoming. But they are indicators and are not real economic variables so be careful how you interpret them.