Behind the GDP Numbers

The equity markets reacted positively to the lower GDP numbers released on Wednesday.

Though the headline drop was much worse than expected, the market cheered the following:

(1) There was a big drop attributed to reduction in inventories which portends well for future production
(2) Consumer spending grew at the highest rate seen in the last two years
(3) Reduction in government spending was down significantly; something which will not last given all the stimulus spending coming forth.

Government Spending: Will it truly come back

A big component of the drop in government spending was attributed to state and local governments, and not Federal spending. Unlike Federal Government which can use budget deficits to fund its spending, state and local governments are required to have a balance budget.

Their ability to issue debt

to fund their spending is limited by the size of their tax base. However this tax base is under pressure:
(a) The big drop in home prices resulting in lower house tax revenues
(b) Higher unemployment has reduced income tax collection
(c) Higher savings, lower credit sources has lowered consumer spending lowering sales tax collection.

Many of these revenue sources are going to be under continuous pressure while the economy continues

to be in a slow growth.

Unlike the Federal government which can sell Treasury bonds to inves

tors world over, most non-Federal governments rely primarily on US investors to fund their bonds and are going to be constrained in their ability to raise spending via debt.

As a result the non-Federal component of government spending is unlikely to recover soon.

Though Federal spending is likely to kick in, non-Federal spending will continue to remain depressed compared to historical norms.

Consumer Spending
Spending by consumers was one bright spot which propelled the markets higher.

However many observers are showing caution with regards to the sustainability of consumer spending, given the poor unemployment situation, tighter credit standards, decline in home values and a greater propensity to save.

An article from Bloomberg notes the same: U.S. Consumer Spending Probably Fell for First Time in 3 Months –

Many leading consumer oriented stocks like Amazon and Research In Motion were very weak today.

Clearly a few market observers felt that the euphoria over the consumer was not justified and used the market strength to distribute their holdings.

Were they being smart or were they just scared


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