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By Annaly Capital Management:

We learned in Econ 101 the basic formula for gross domestic product: GDP = C + I + G + Net Exports.  Perhaps in the same lecture we were told that consumption was the least volatile and largest component of output, accounting for roughly 2/3rds of the sum. It took no forecasting wizard to draw these conclusions: From 1960 to 2000, consumption’s share of output averaged 65.6%, fluctuating with a standard deviation of only 1.8%. As the chart below shows, one consequence of U.S. consumer’s great borrowing and spending spree was a “breakout” of consumption’s already massive share from its long-held “trading range.” Since 2006, consumption has accounted for over 70% of GDP.  In hindsight, it’s not a pretty picture of what it takes to reach this level of consumerism-mainly massive and unsustainable deficit financing across the economy.  So then, with last Friday’s GDP report, we find that the U.S. consumer is still wielding its clout. After hitting an all time peak of 71.3% in Q3-2009, consumption still accounted for 70.7% of Q4-2009 GDP.

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While secular factors partly underpin the evolving consumption story, the other components are following their typical cyclical scripts. In the response part of the cycle, government spending does more heavy lifting (e.g. the post-apocalyptical “cash for clunkers”), and investment turns cowardly. Government spending stood at a low of 18.4% of GDP in Q4 2007, and has since risen to 19.6%.  Investment’s contribution to output dropped to 1991 levels as the tightening of credit and inventory correction in both residential real estate and business stocks spurred a contraction greater than witnessed in other sectors. So, with six months of data since the presumed trough, has investment’s contribution to growth taken on a more “expansionist” slant? The answer is only modestly and only in the last quarter (thanks to the dramatic inventory correction) as the chart below shows.

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When investment’s relative contribution to output is rising, the employment picture tends to improve. Call it causation or coincidence, but the graph above also illustrates the strong inverse relationship between the private investment/GDP ratio and the unemployment rate.  Conceptually, this relationship holds for two reasons. First, firms manage at least to a loose labor/capital relationship. If investment is underperforming the rest of the economy, labor will be adjusted accordingly. Second, the lion’s share of investment is labor intensive, such as residential and non-residential structures and heavy equipment (as opposed to inventory swings and software and computer investment, which are not as labor intensive). In sum, looking at the pictures here, one gets the sense the policy mix should be geared more towards investment than consumption, if the goal is lowering the unemployment rate

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