goldman sachs report that asks, "will the kids move out of the basement?"

May 23, 2014

Issue No: 14/21

US Economics Analyst

Economics Research

Sticking with Stronger

We currently estimate that real GDP fell -0.7% (annualized) in the first

quarter versus a December consensus estimate of +2½%. On the face

of it, this is a large disappointment. It raises the question whether

2014 will be yet another year when initially high hopes for growth are

ultimately dashed.

Today we therefore ask whether our forecast that 2014-2015 will show

a meaningful pickup in growth relative to the first four years of the

recovery is still on track. Our answer, broadly, is yes. Although the

weak first quarter is likely to hold down real GDP for 2014 as a whole,

the underlying trends in economic activity are still pointing to

significant improvement.

From a “nowcasting” perspective, the extreme weakness in Q1 GDP

contrasts with a much smaller downside surprise in our current activity

indicator (CAI). In fact, the CAI has continued to accelerate on a year-

on-year basis, from 1.7% in early 2013 to 2.6% now. We believe the

CAI is a better measure of broad economic activity than GDP because it

is more timely, more broadly based, less noisy, and less subject to

revision.

The broader rationale for stronger growth in 2014-2015 also remains

intact. The fiscal policy drag of 2013 has ended. The household sector

debt/income ratio seems to have bottomed. And while we recently

shaved our homebuilding numbers a bit, our forecast remains one of

recovery. One reason is that a reversal of the “doubling up” of

households should support stronger household formation in coming

years.

An update of our financial balances model—which consists of

equations for ex ante changes in the different components of the

private sector financial balance (personal saving, net residential

investment, and the corporate financing gap), the external balance,

and the fiscal impulse—suggests that the net impulse from all sectors

combined points to clearly above-trend growth in 2014-2015.

Jan Hatzius (212) 902-0394 [email protected] Goldman, Sachs & Co.

Alec Phillips (202) 637-3746 [email protected] Goldman, Sachs & Co.

Jari Stehn (212) 357-6224 [email protected] Goldman, Sachs & Co.

Kris Dawsey (212) 902-3393 [email protected] Goldman, Sachs & Co.

David Mericle (212) 357-2619 [email protected] Goldman, Sachs & Co.

Shuyan Wu (212) 902-3053 [email protected] Goldman, Sachs & Co.

Michael Cahill (801) 884-4621 [email protected] Goldman, Sachs & Co.

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certificationand other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.

The Goldman Sachs Group, Inc. Global Investment Research

May 23, 2014 US Economics Analyst

Goldman Sachs Global Investment Research 2

Sticking with Stronger

Six months ago, we predicted that the US recovery would accelerate from the 2¼%

average over the prior four years to a 3%+ pace in 2014-2015.1 The rationale for this

forecast was that the post-bubble adjustments in the private sector seemed to be ending,

and the fiscal retrenchment that held growth back in 2013 was set to end in 2014 as well.

So far, the GDP data have told a different story. Growth in the first quarter was initially

reported at a disappointing 0.1% (annualized), and we currently estimate that it will be

revised down further to -0.7%. As shown in Exhibit 1, this would be a very large

disappointment, on a par with that seen in early 2011 when many economists—ourselves

included—predicted a pickup in growth but were then wrongfooted by a sharp slowdown

in most indicators, including a reading for real GDP growth in 2011Q1 that started out as

only mildly disappointing but was eventually revised into negative territory.

Exhibit 1: A Big Downside Surprise in Q1 GDP

Source: Department of Commerce. Blue Chip Economic. Goldman Sachs Global Investment Research.

The first-quarter disappointment has resonated among economists and market participants

for two reasons. First, it brings to mind the 2011 precedent, and more broadly the repeated

downside surprises on growth in recent years. Second, it comes in the wake of the debate

around “secular stagnation” that was kicked off by the speech by Lawrence Summers at

the November 2013 IMF research conference. If the US economy cannot accelerate to a

clearly above-trend pace even after the end of the private and public sector retrenchment at

a time when monetary policy and financial conditions still look very supportive, then it is

certainly appropriate to ask whether the forces holding the economy back are deeper and

more structural in nature. In that sense, it is really “showtime for the recovery”, the title of

our 2014 outlook article published last November.

In today’s article, we therefore ask whether the evidence still supports the notion of a

fundamental US growth acceleration in 2014-2015. Our answer, broadly, is yes. Although

the weak first quarter is likely to hold down real GDP for 2014 as a whole, the underlying

trends in economic activity are still pointing to significant improvement.

1 See Jan Hatzius and Dominic Wilson, “Showtime for the DM Recovery,” Global Economics Weekly, 13/38, November 20, 2013.

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1-2

-1

0

1

2

3

4

5

6

-2

-1

0

1

2

3

4

5

6

Blue Chip Consensus*

First BEA Estimate

Final BEA Estimate**

Percent change, annual rate Percent change, annual rate

Real GDP Growth

* Consensus estimate at the end of the prior quarter. ** 14Q1 based on GS current tracking estimate.

2011 2012 2013 2014



The Acceleration Is Intact

For many people, the Commerce Department’s GDP report is the benchmark for how

quickly the US economy is growing. It tells an unpleasant story. After climbing to a 4.1%

pace in the third quarter of 2013, growth slowed in Q4 and likely turned negative in Q1.

Given these numbers, it will be mathematically difficult for GDP growth in the year as a

whole to be much above 2½%, and a lower outcome is very possible.

But more fundamentally, we believe the quarterly GDP report is often a poor measure of

economic growth. It is reported with a lag of 2½ months after the midpoint of the quarter

to which it refers. Its scope is narrowly focused on aggregate dollar expenditure, as it puts

no weight on survey measures of activity, employment, or income. Its quarterly moves are

disproportionately affected by noisy indicators such as inventory investment and net

foreign trade. And it is heavily revised.

We therefore prefer broader measures of economic growth such as our current activity

indicator (CAI), a weighted average of the 25 most important weekly and monthly

indicators of US economic activity. We can calculate a preliminary version of the CAI just

three weeks after the midpoint of the month to which it refers, which makes the CAI almost

two months more timely than the quarterly GDP report. The CAI includes not just

measures of aggregate expenditure but also business and consumer surveys as well as

various labor market indicators. It is much less sensitive to noisy measures such as

inventories. And it is much less subject to revisions than the GDP report.2

It is therefore noteworthy that the CAI showed a much less pronounced disappointment

over the winter than the Commerce Department’s real GDP numbers, as shown in Exhibit 2.

While real GDP growth disappointed by about three percentage points in Q1, the CAI

slowed by just one point. We have argued that about ½ point of this disappointment can

be explained by the unusually severe winter, which leaves just ½ percentage point, a

relatively trivial number in the imprecise world of economic forecasting. Moreover, the

March/April CAI shows a respectable bounce-back to a 3¼% average pace.

Exhibit 2: CAI Sends a More Upbeat Message

Source: Department of Commerce. Goldman Sachs Global Investment Research.

2 See David Mericle, “The CAI: A Timely and Stable Measure of Economic Momentum,” US Daily, March 20, 2013.

-2

-1

0

1

2

3

4

5

-2

-1

0

1

2

3

4

5

Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul

Current Activity Indicator*

Quarterly GDP Growth

Percent change, annual rate Percent change, annual rate

* First principal component of 25 weekly and monthly US activity indicators.

2010 2011 2012 2013 2014



From a longer-term perspective the picture also looks encouraging. Exhibit 3 shows that

the year-on-year CAI has shown only three inflection points since 2008—a pickup off the

bottom in mid-2009, a slowdown in early 2011, and a reacceleration in early 2013. Since

the last of these, the CAI has accelerated from 1.7% to 2.6%, with no sense of a significant

slowdown in the early part of 2014 when the quarter-on-quarter GDP numbers showed

such a pronounced dip. As a matter of “nowcasting,” our conclusion is that the

acceleration in US economic activity remains intact.

Exhibit 3: The Year-on-Year Acceleration in the CAI Remains Intact


The Rationale for the Acceleration Is Also Intact

The basic rationale for our acceleration forecast of late 2013 was twofold—(1) an end to the

fiscal drag that had weighed on growth so heavily in 2013 and (2) a positive impulse from

the private sector following the completion of the balance sheet adjustments specifically

among US households. Both of these points remain intact.

On the fiscal side, the picture now actually looks a bit more supportive for growth than it

did six months ago. The reason is that the impact of the Affordable Care Act (ACA) on

healthcare consumption is a bit bigger than we had expected, at least in the near term.3

Including this effect, we now think that the net impact of fiscal policy on GDP growth is

likely to be about zero in the remainder of this year, whereas we had previously thought it

would be slightly negative.

On the private-sector side, one key development is the end to the household deleveraging

process in 2013. As illustrated in Exhibit 5, both the Financial Accounts of the United

States (formerly known as the Flow of Funds) from the Federal Reserve Board and the

Quarterly Report on Household Debt and Credit from the New York Fed suggest that the

decline in the debt/income ratio has now ended.4 Over the next few years, we expect a

mild upward trend, implying that household debt may grow a bit faster than disposable

income. At the margin, this implies a boost to aggregate demand and real GDP growth

compared with the first 4-5 years of the current recovery.

3 See Alec Phillips, “The Affordable Care Act: How Much More of a Boost?” US Economics Analyst, 14/19, May 9, 2014.

4 It is useful to look at both of these measures, as they are constructed using independent data sources that can serve as cross-checks on one another.

-4

-2

0

2

4

6

-4

-2

0

2

4

6

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Current Activity Indicator*

Quarterly GDP Growth

Percent change, year ago Percent change, year ago

* First principal component of 25 weekly and monthly US activity indicators.



Exhibit 4: Fiscal Drag Is Now Behind Us

Source: Goldman Sachs Global Investment Research.

Exhibit 5: The Household Debt/Income Ratio Has Probably Bottomed

Source: Federal Reserve Bank of New York. Federal Reserve Board.

Another key development is the healing in the housing sector. Admittedly, we just have

shaved our estimates for the growth contribution of residential investment in 2014H2, and

to a lesser extent 2015H1.5 But these changes were small in terms of the contribution to

real GDP growth, averaging only about 0.1 percentage point at an annual rate. The more

important point is that the underlying trends in the housing sector are still pointing toward

recovery. As discussed in greater detail last week, we can explain the decline in the

housing indicators in the last two quarters with a combination of higher mortgage rates

and bad weather, and this drag should wane in coming months.

Meanwhile, some of the longer-term trends that have been weighing on the housing sector

seem to be ending or reversing. An important one is the “doubling-up” of more people in

one home. As shown in Exhibit 6, the share of 18-34 year olds who live with their parents

increased by five percentage points from 2006 to 2012, which is equivalent to 3½ million

individuals. In 2013 the share began to edge down, and we expect further significant

5 See Sven Jari Stehn, “Housing: Near-Term Rebound, Softer Trend,” US Economics Analyst, 14/20, May 16, 2014.

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

TaxSpending

Impact of Federal Fiscal Policy on Real GDP Growth:

Percentage points Percentage points

2012 2013 2014

60

80

100

120

140

60

80

100

120

140

1999 2001 2003 2005 2007 2009 2011 2013

Flow of Funds

FRBNY Household Debt & Credit Report

RatioRatio

Household Debt to Disposable Income



declines in coming years. This should bring down the average household size, pushing the

growth rate in the number of households from below the 0.8% population growth rate to

above the population growth rate.

Exhibit 6: Will the Kids Move Out of the Basement?

Source: Department of Commerce.

Consistent with this, we expect household formation in absolute terms to rise from the

800,000 average of the past six years to 1.2-1.3 million by 2015-2016. 6 Assuming

demolitions of existing homes of around 300,000 per year, this implies that total housing

starts can rise from the current level of about 1 million to the 1.5-1.6 million range, as

shown in Exhibit 7.

Exhibit 7: Supply/Demand Balance Still Looks Favorable for Housing


We conclude with an update of our financial balances model, which consists of equations

for ex ante changes in the different components of the private sector financial balance

(personal saving, net residential investment, and the corporate financing gap), the external

6 The 800,000 household formation estimate for the past six years is an average of the Census Bureau’s monthly and annual series, which can diverge sharply from one another.

26

27

28

29

30

31

32

26

27

28

29

30

31

32

1976 1980 1984 1988 1992 1996 2000 2004 2008 2012

PercentPercent

Share of 18-34 Year Olds Living With Parents

0

400

800

1200

1600

2000

2400

2800

0

400

800

1200

1600

2000

2400

2800

86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

Household Formation

Thousands Thousands

* Assumed demolition rate of 300,000 per year.

Fcst

Housing Starts

Demolitions*



balance, and the fiscal impulse. As shown in Exhibit 8, our model suggests that the net

impulse from all sectors combined points to clearly above-trend growth in 2014-2015. We

thus continue to expect a pickup in growth from the 2¼% pace of the recovery so far to a

3%+ pace in the next couple of years.

Exhibit 8: Our Financial Balances Model Points to Above-Trend Growth


Jan Hatzius

2009 2010 2011 2012 2013 2014 2015 2016-8

-6

-4

-2

0

2

4

-8

-6

-4

-2

0

2

4Private and Public Sector Impulse*

Net ImpulseForecast

Percent of GDP Percent of GDP

Private Sector

Public Sector

* Relative to trend growth. Impulses calculated from GS financial balances model.



The US Economic and Financial Outlook


(% change on previous period, annualized, except where noted)

2013 2014 2015 2016 2017 2014 2015(f) (f) (f) (f) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

OUTPUT AND SPENDINGReal GDP 1.9 2.5 3.1 3.0 3.0 0.1 3.7 3.3 3.3 3.0 3.0 3.0 3.0

Consumer Expenditure 2.0 3.0 2.8 2.5 2.5 3.0 3.9 3.1 3.1 2.5 2.5 2.5 2.5Residential Fixed Investment 12.2 0.8 9.2 12.3 12.3 -5.8 2.4 7.5 7.5 10.0 10.0 12.5 12.5Business Fixed Investment 2.7 3.6 6.2 5.5 5.4 -2.0 4.3 7.2 7.2 6.1 6.1 5.5 5.5 Structures 1.3 4.3 5.7 5.0 5.0 0.2 3.2 7.5 7.5 5.0 5.0 5.0 5.0 Equipment 3.1 3.7 7.9 6.1 5.9 -5.5 6.1 10.0 10.0 7.5 7.5 6.0 6.0 Intellectual Property Products 3.1 2.7 4.2 5.0 5.0 1.5 2.4 3.0 3.0 5.0 5.0 5.0 5.0Federal Government -5.2 -2.8 -1.4 -1.3 -0.6 0.7 0.0 0.0 -3.0 -3.0 0.0 0.0 -2.0State and Local Government -0.2 0.4 1.9 2.0 2.0 -1.3 1.2 1.5 2.0 2.0 2.0 2.0 2.0Net Exports ($bn, '09) -412 -403 -400 -410 -428 -414 -398 -401 -399 -398 -400 -401 -403Inventory Investment ($bn, '09) 82 68 71 84 90 88 61 61 61 69 69 69 75

Industrial Production, Mfg 2.7 3.1 3.6 3.5 3.5 2.1 4.2 3.8 3.8 3.5 3.5 3.5 3.5

HOUSING MARKETHousing Starts (units, thous) 930 1,023 1,219 1,364 1,468 924 997 1,059 1,113 1,157 1,204 1,240 1,277New Home Sales (units, thous) 430 469 555 620 668 434 454 482 506 527 548 564 581Existing Home Sales (units, thous) 5,073 4,777 5,007 5,210 5,354 4,603 4,787 4,835 4,883 4,932 4,981 5,031 5,082Case-Shiller Home Prices (%yoy)* 9.8 3.9 2.8 2.1 1.1 7.9 6.1 4.8 3.9 3.6 3.3 3.0 2.8

INFLATION (% ch, yr/yr)Consumer Price Index (CPI) 1.5 1.8 1.9 2.1 2.2 1.4 1.9 1.8 2.0 1.9 1.8 1.9 2.0Core CPI 1.8 1.8 2.0 2.1 2.2 1.6 1.8 1.8 1.9 2.0 1.9 2.0 2.0Core PCE** 1.2 1.4 1.6 1.8 1.9 1.1 1.4 1.4 1.5 1.6 1.6 1.6 1.7

LABOR MARKETUnemployment Rate (%) 7.4 6.4 5.9 5.5 5.2 6.7 6.4 6.3 6.1 6.0 5.9 5.8 5.7

GOVERNMENT FINANCEFederal Budget (FY, $ bn) -680 -525 -475 -525 -550 -- -- -- -- -- -- -- --

FINANCIAL INDICATORSFederal Funds^ (%) 0.08 0.13 0.13 1.25 2.50 0.07 0.13 0.13 0.13 0.13 0.13 0.13 0.1310-Year Note^ 2.72 3.25 3.75 4.00 4.25 2.71 3.00 3.15 3.25 3.40 3.50 3.60 3.75Euro ($/€)^ 1.35 1.32 1.27 1.23 1.20 1.37 1.38 1.34 1.32 1.30 1.29 1.28 1.27Yen (¥/$)^ 100 109 115 120 125 102 103 107 109 110 112 113 115Brent Crude Oil ($/bbl)^ 111 103 100 100 100 107 105 105 103 100 100 100 100

* Weighted avg of metro-level HPIs for 366 metro cities where the weights are dollar values of single-family housing stock reported in the 2000 Census. ** PCE = Personal consumption expenditures. ^ Denotes end of period.NOTE: Published figures are in bold.



Economic Releases and Other Events


Time

Date (EDT) Indicator GS Consensus Last Report

Tue May 27 8:30 Durable Goods Orders (Apr) -1.5% -0.7% +2.5%

8:30 Durable Goods Orders Ex Transport (Apr) -1.0% -0.1% +2.1%

8:30 Core Capital Goods Orders (Apr) -1.0% -0.3% +2.9%

8:30 Core Capital Goods Shipments (Apr) -0.5% -0.1% +1.5%

9:00 FHFA House Price Index (Mar) n.a. +0.5% +0.6%

9:00 S&P/Case Shiller Home Price Index (Mar) n.a. +0.7% +0.8%

9:45 Markit Services PMI—Prel (May) n.a. 54.5 55.0

10:00 Consumer Confidence (May) 82.0 83.0 82.3

10:00 Richmond Fed Survey (May) n.a. +4 +7

Thu May 29 8:30 Real GDP— Q1 Annualized (Second) -0.7% -0.5% +0.1%

8:30 Personal Consumption (Q1) +3.2% +3.1% +3.0%

8:30 Initial Jobless Claims n.a. 318,000 326,000

8:30 Continuing Claims n.a. 2,655,000 2,653,000

10:00 Pending Home Sales (Apr) n.a. +1.0% +3.4%

17:00 GS Analyst Index (May) n.a. n.a. 57.3

Fri May 30 8:30 Personal Income (Apr) +0.3% +0.3% +0.5%

8:30 Personal Spending (Apr) Flat +0.2% +0.9%

8:30 PCE Price Index (Apr) +0.2% +0.3% +0.2%

8:30 Core PCE Price Index (Apr) +0.18% +0.2% +0.2%

9:45 Chicago Purchasing Managers’ Index (May) 61.0 60.8 63.0

9:55 Reuters/UMich Consumer Sentiment—Final (May) 82.5 82.5 81.8

Estimate



Disclosure Appendix

Reg AC

We, Jan Hatzius, Alec Phillips, Jari Stehn, Kris Dawsey, David Mericle, Shuyan Wu and Michael Cahill, hereby certify that all of the views expressed in

this report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships.

Disclosures

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goldman sachs report that asks, "will the kids move out of the basement?"

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