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Why gross domestic product rocketed in Q3—but there is a caveat

Brent Nyitray, CFA, MBA

Increases in gross domestic product measure economic growth

Gross domestic product is what’s referred to generally as “the economy.” It’s the sum of consumption, investment, and government spending. Another way to think of GDP is the output of goods and services produced by labor and property in the U.S. economy. This number is an estimate of growth. The U.S. economy is roughly $16 trillion.

The Bureau of Economic Analysis puts out three estimates of GDP growth after a quarter ends. The advance estimate is released within a month of quarter end, and it’s based on incomplete data or data subject to revision. The second is released after two months, and the third and final revision is released after three months.

Consumption is by far the biggest driver of GDP growth, and it accounts for something like 70% of GDP. The Fed’s quantitative easing program targets consumption. If the Fed can lower mortgage rates enough that people can refinance, then they will have more disposable income and hopefully spend more. Investment is basically corporate investment in growth—also known as “capital expenditures.” Government spending is the final component.

Highlights of the Q3 release

The second revision to Q3 GDP showed GDP grew at an annualized pace of 3.6% between the second quarter of 2013 and the third quarter of 2013. Consumption grew 1.4%, while investment fell 1.4%. Government spending fell 1.4%. Second quarter GDP was revised downward from 2.6% to 2.5%. The price index increased at 2%, which is more or less where the Fed would like to see inflation.

A buildup in inventories drove a large part of the increase. If demand does not increase enough to work off that inventory, we will see a deceleration in Q4. It would amount to the third quarter “borrowing” growth from the fourth quarter.

The effect of government spending is igniting a political debate in Washington. Certain economists are in favor of increasing government spending to push economic growth. This is what’s known as “Keynesian stimulus spending”—when the private sector won’t spend, the government can step in and pick up the slack. Politicians on the left will point to the effect decreasing government spending has had on GDP growth. Politicians on the right will point out that government spending is roughly 24% of GDP, the highest since the Truman Administration.

Implications for homebuilders

Homebuilders are sensitive to the general economy—particularly the job market. GDP growth of 3.6% should be enough to slowly heal the labor market and increase the capacity utilization numbers. Stronger consumption numbers are clearly a good sign for them. That said, this hasn’t been a rip-roaring recovery by any stretch of the imagination.

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Lennar (LEN), KB Homes (KBH), Toll Brothers (TOL), Meritage (MTH), and NVR (NVR). Housing starts have been so low for so long that there’s some real pent-up demand that will unleash as the economy improves. The secular (long-term) story for homebuilders is optimistic. Household formation numbers will be a real wind at their backs.

Homebuilding can become a real virtuous circle for the economy, and it explains why the recovery has been tepid so far. Historically, homebuilders were the first to recover after a recession. Construction and homebuilding usually led the economy out of a recession. This time around, that didn’t happen because of shadow inventory, which meant that economic growth was more tepid during this recovery. That appears to be changing.

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