"If I'd have had more time, I'd have written a shorter letter" ~Blaise Pascal
This week’s note is another excerpt from an excellent memo from Howard Marks of Oaktree Capital (the entirety of the memo can be found here). It was a tough one to pare down to a few bullet points, but I think it gets the message across:
We were all struck by the enormity of the reported decline in second-quarter real GDP. Before now, no one’s ever seen an economy contract by one-third in three months! However, thinking about the results in connection with writing this memo raised some questions:
I had immediately assumed Q2 GDP was down $1.81 trillion, or 32.9%, from Q2 of last year. But the actual decline was only $0.45T, from $4.76T to $4.31T, or 9.5%.
I couldn’t make sense of the numbers, so I consulted Conrad DeQuadros of Brean Capital to help understand them. I found his answer surprising, and you might as well.
Have you thought about what the reported 32.9% decline in second-quarter GDP really means? Answer: It’s the percentage by which 1Q2021 GDP would be below 1Q2020 GDP if GDP were to decline in the next three quarters at the same rate as it did in 2Q2020. If that seems incredibly complex, so was Conrad’s explanation:
Actual second-quarter real GDP (without seasonal adjustment or annualization) was $4.31 trillion. That was down 7.0% from $4.63T in Q1 on the same basis.
If the three subsequent quarters were also down 7.0% from quarter to quarter, 3Q2020 would be $4.00T, 4Q2020 would be $3.72T, and 1Q2021 would be $3.46T. (These are figures you would never see since they omit seasonal adjustment, annualization, and adjustment for inflation. But I think they present a fair if not technically correct picture for these purposes.)
It’s that figure of $3.46T for 1Q2021 GDP that – after annualization and adjustments for seasonality and inflation – would be 32.9% below GDP in 1Q2020.
Interestingly, after the assumed declines, GDP in the four quarters 2Q2020 through 1Q2021 (as enumerated above) would sum to $15.49T for the year. But that would be down only 18.9% from the actual total of $19.11T in the four prior quarters (2Q2019 through 1Q2020).
So, again, the 32.9% reported decline in Q2 is the difference between 1Q2020 GDP and projected 1Q2021 GDP assuming quarterly GDP continues to fall at the 2Q2020 rate. But nobody expects that to happen. Which means the 32.9% is a highly misleading, exaggerated figure. Nothing went down by one-third, and nothing is likely to do so.
It’s the same for nominal GDP. The decline in GDP from 1Q2020 to 2Q2020 was reported as $2.15T, or 34.3%, but those also are annualized figures. The $2.15T decline is the difference between 1Q2020 annualized GDP of $21.56T and 2Q2020 annualized GDP of $19.41T. But the decline in actual quarterly nominal GDP from Q1 to Q2 was only $0.38T (from $5.25T to $4.87T), or 7.2%. So, what do the reported annualized Q2 declines of $2.15T and 34.3% mean? Also, nothing.
Here’s Conrad’s conclusion:
Annualization is useful in normal times for comparing a quarter to recent years, but not very useful for current circumstances. Most other major economies do not report annualized changes in GDP (for example, when the change in Eurozone GDP is reported [on August 3], it will be a non-annualized change). It is not reasonable to expect the second quarter’s drop to continue for a year.
Finally, at year-end, the GDP that’s reported for each year is the sum of the actual dollar GDP in its four quarters (without annualization or seasonal adjustment). Thus, when GDP is reported for 2020, it’s unlikely to show a decline of 32.9% or anything like it. After reported quarter-over-quarter declines in annualized GDP of 5.0% in Q1 and 32.9% in Q2, Morgan Stanley (for example) expects increases of 21.3% in Q3 and 0.3% in Q4. If we were to chain those quarterly percentage changes as we do with quarterly portfolio returns, we would get a decline for the year of 22.5%. Or if we (incorrectly) added them together, ignoring the impact of compounding, we would get a decline of 16.3%. But MS expects full-year 2020 GDP to be down only 5.3% year-over-year and 6.2% Q4-over-Q4.
So, I’ve learned that annualized quarter-over-quarter changes are quite meaningless, including Q2’s reported decline of 32.9%.
IN SHORT: Even the experts are confused by the statistics we see on the news media. Perhaps the second quarter wasn’t as bad as initially understood by most of us…
Make it a great day!
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