After a free-fall of output in the last quarter of 2008 and the first quarter of 2009, second derivatives of U.S. economic activity have turned positive between Q2 and Q3 of 2009. That was a clear indication of a significant slowdown in the pace of contraction and the first step toward positive growth (and therefore positive first derivatives of economic activity, which in the end are what really matter). An aggressive and coordinated policy response put a floor to the free fall of output and pulled the global economy back to positive growth.

As reported in our latest RGE Global Economic Outlook (Q4 and Beyond – available here for paid clients), RGE expects a strong second half of the year in 2009. We forecasted real U.S. economic growth to come in at 3% in Q3 2009.  We expect growth to be a bit weaker in the fourth quarter, at 2.5%.

Today’s GDP report surprised on the upside, revealing a 3.5% growth rate after consensus forecasted a 3.2% rate; yesterday, Goldman Sachs cut their estimates ahead of the report from 3.0% to 2.7% in wake of a lower-than-expected durable goods report.

Even if the report displayed growth just slightly above expectations, markets rallied. Both the DJIA and S&P 500 closed the day up over 200 points.  It is a bit puzzling why markets went up when the report was almost in line with what was expected by consensus. Market psychology is complicated, but could this be more of a sign of high uncertainty? It almost feels like the markets took a deep breath.

Some Details of the Report

Inventories contributed to 1% of this strong performance. This is smaller than anticipated and might slow down significantly when private demand shrugs off the support coming from policy measures. The only real quasi-surprise came from residential investments, which snapped back and displayed a 23% annualized growth rate in the quarter (after contracting at an average annual rate of 20% since 2006). This rebound accounts for the 0.5% difference between our prediction and the actual reported growth. This is not entirely a surprise. The policy incentives set in place to revive the housing sector have produced positive effects; homebuilding activity, as a consequence, has stabilized. Yet housing starts are still moving sideways, shy of the 600,000 per year mark (but above the 480,000 bottom of April 2009), and completions are still falling. This implies that a portion of the residential investment improvement was due to spending related to home improvement, which is perhaps the only surprise here. So, we are back to the U.S. consumer.

The full piece is available only to RGE paid subscribers and is available here. It includes an analysis on the outlook for the U.S. consumer and overall economic performance.