Tuesday, October 5, 2010

Where Will Growth Come From? Part II; Investment

Let's continue out look at where growth will come from by looking at the second part of the GDP equation: investment, which accounts for 14.8% of US GDP. Investment has three sub-categories: residential investment (housing), non-residential structures (commercial real estate) and equipment and software.

Let's start with a look at overall construction spending:

The above chart shows the year over year rate of change in overall construction spending. While the rate of decline as lessened, it is still printing negative numbers indicating that construction spending is still having problems.

The month to month percentage change has been getting less bad, but is still in a very negative situation.

Construction spending is composed of two data subsets: residential -- which accounts for 30.68% of all construction spending and non-residential which accounts for 69.31% of construction spending. Residential investment accounts for 22.33% of construction spending in the GDP equation and 3.3% of US GDP. Commercial real estate is 28.53% of investment spending in the GDP equation and 4.22% of total GDP. However, construction spending is incredibly important because of its ancillary benefits. Construction employs construction workers and increases purchases of durable goods. That's what makes these numbers so important.

Notice that residential has started to print positive year over year numbers; it's commercial real estate that is in the doldrums, although it does appear the rate of decline has hit bottom.

Taking a closer look at the housing market, we see the following two data sets:

Total building permits are bouncing along a bottom, as are

housing starts. Both of the above charts indicate that residential housing construction has bottomed. The main issue is when will it start to add to the recovery? The good news there is the absolute level of new homes for sale is at incredibly low levels:

The bad news is the economy is weak and households are de-leveraging. So while a quick resurgence in new home demand could really provide a spark for the economy, the reality is that probably won't happen anytime soon.

Regarding commercial real estate -- the largest part of construction spending -- change may be on the horizon.

First, fewer and fewer institutions are tightening lending standards for commercial real estate.

In addition, demand for CRE loans appears to be picking up. However (and it's a big however)

The non-current rate on C and I loans is very high, indicating the market is experiencing serious problems. In addition,

The total amount of C and I loans outstanding has decreased. However, also note that in the last two recoveries, this number decreased for an extended period of time into the recovery, indicating the current situation is not abnormal.

So, the short version for real estate investment is it won't be a major player going forward. This leaves equipment and software investment. Equipment and software investment accounts for 50.74% of total investment spending and 7.5% of GDP.

Above is a graph that shows the quarter to quarter percentage change at the seasonally adjusted annual rate. Notice the rate of increase has been increasing, largely because of the sharp downturn this part of GDP growth experienced during the recession -- note the extreme negative readings preceded the recent increases. However, this number is constrained by a low capacity utilization rate:

Some of this capacity may have to be replaced because it is no longer technologically valid. However, there is also a fair amount of unused capacity that can come back on line.

So to sum up.

1.) Commercial real estate -- the largest component of construction spending may by bottoming, but it has a long way to go before it can play a meaningful part in the recovery. Current C and I loan delinquencies are high total C and I loans outstanding are decreasing.

2.) Residential real estate is bouncing along the bottom. While the low level of the current new home inventory is potentially encouraging, the high unemployment rate creates a major constraint on this number.,

3.) Equipment and software investment spending is picking up, but may be constrained by low capacity utilization.

So, investment may add a touch to growth, but not a lot.