Orlando's Outlook: Soybeans? Really?

10-28-2016

Bottom line Despite a sharp decline in personal consumption and a second consecutive negative quarter for housing, the Commerce Department flashed a much stronger-than-expected GDP gain of 2.9% for the third quarter this morning, more than double the second-quarter’s 1.4% tepid pace. While this marks the U.S. economy’s single-best quarter in two years, the details behind the headline growth are decidedly mixed. To be sure, capital expenditures (capex) were slightly better in the third quarter, and government spending and inventory accumulation also improved from negative levels. But the biggest positive swing factor was a massive 14.5% surge in goods-related exports, which Commerce attributes to an unsustainable, weather-related sale of soybeans to China.

Without this soybean activity, third-quarter GDP growth would have approximated 2%, roughly in line with our own more conservative estimate here at Federated and the Atlanta Fed’s GDPNow forecast of 2.1%. So we could easily see this healthy 2.9% flash reading revised lower in coming months, or witness a return to weak 2% trend line GDP growth in the fourth quarter.

To that point, net trade and inventories are two of the most volatile components in the GDP report. If we strip them out, then domestic final sales grew only 1.4% in the third quarter versus a 2.4% gain in the second quarter, providing us with a much clearer trend for soft underlying domestic demand.

Fed on hold for next week We continue to believe the Federal Reserve will do nothing at its next policy-setting meeting on Wednesday, Nov. 2, less than a week before the presidential election. The Fed, in our view, has no interest in making a possible policy error that could potentially impact the economy, the financial markets or the election itself. But we fully expect it will hike rates by a quarter point at its Dec. 14 meeting, followed by two additional hikes in calendar 2017.

Something for everyone With the election less than a fortnight away, today’s GDP report has something for everyone. Hillary Clinton will seize upon today’s relatively strong headline GDP growth rate of 2.9% and argue that the fiscal policy status quo is the way to go. Donald Trump, on the other hand, will point out that the domestic final sales reading of only 1.4% is pathetic, and that the stronger headline reading must be adjusted for the unsustainable surge in soybean sales to the Chinese, pointing to the dire need for a change in policy course.

Here are the key details regarding today’s third-quarter GDP flash report:

Weak consumer spending Personal consumption expenditures, which account for 70% of GDP, rose a much weaker-than-expected 2.1% in the third quarter, less than half the healthy 4.3% pace in the second quarter, the largest quarterly increase since the fourth quarter of 2014. This contributed 1.47 percentage points to overall third-quarter GDP growth, compared with 2.88 percentage points in the second quarter. We were expecting this softness in personal consumption, due to weak Back-to-School retail sales in July, August and September, compared with very robust second-quarter results. However, the third quarter still compares favorably with an even weaker gain of only1.6% in the first quarter, when first-quarter retail sales were quite poor.

Housing declines again Housing appears to be rolling over, perhaps due to peaking seasonality, tight inventory and rising prices. Residential investment fell for the second consecutive quarter, declining 6.2% in the third quarter, which reduced GDP by 0.24 percentage points. That compares with a larger decline of 7.7% in the second quarter—the largest quarterly decline since the third quarter of 2010—which cut GDP by 0.31 percentage points. Contrast that with strong gains of 7.8% in the first quarter and 11.5% in the fourth quarter of 2015. Housing clearly appears to be slowing, a trend we expect to last through the slower winter months.

Inventory hits bottom The new inventory-restocking cycle we’ve been expecting officially kicked into gear in the third quarter. Businesses increased inventories by $12.6 billion, which added 0.61 percentage points to GDP. That compares with an outright reduction in inventories of $9.5 billion in the second quarter—the most since the third quarter of 2011—which subtracted 1.16 percentage points from second-quarter GDP growth. Companies have been gutting bloated inventories amid a decelerating economy for the past 18 months, from the addition of $114.4 billion in the first quarter of 2015 to last quarter’s $9.5 billion reduction. That reduction in inventory accumulation certainly contributed to slower GDP growth for five consecutive quarters, the longest such period in almost six decades. But with inventories now significantly leaner than at the beginning of 2015, we have been expecting a new inventory restocking cycle to commence, such as we saw at the end of 2011, after companies kitchen-sinked their inventory levels in the third quarter of 2011.

Government spending rises Total government spending, which accounts for about 17% of total GDP, rose 0.5% in the third quarter, which added 0.09 percentage points to GDP growth, led by federal spending. That compares with a decline of 1.7% in the second quarter for total government spending (the most in two years), due to cutbacks in defense spending at the federal level, and stronger gains of 1.6% in the first quarter and 1% in 2015's fourth quarter. Federal government spending rose 2.5% in the third quarter, while state and local spending collectively fell 0.7%.

Net trade is all about the soybeans The most surprising aspect of today’s GDP report was a surge in soybean sales to China. The U.S. is the world’s largest soybean grower, and weather issues related to La Nina negatively impacted Brazil and Argentina, the next two largest producers. As a result, China, which desperately needs soybeans as feedstock for the world’s largest hog herd, took advantage of record U.S. soybean inventories, an excellent growing season this year and a 52-week low in prices at $9.70 per bushel in July and purchased some $38 billion of 106 million metric tons of soybeans from the U.S. over the summer. But the magnitude of this seasonal export to China is unsustainable, as Latin American competitors normalize their growing seasons and production levels.

So the trade deficit shrunk in the third quarter, which added to GDP by 0.83 percentage points. Exports rose 10% in the third quarter, compared with a gain of 1.8% in the second quarter. But goods exports (which includes the massive soybean shipments to China) soared 14.5%, which added an unsustainable 1.17 percentage points to GDP. That compares with a modest gain of 1.7% in the second quarter, a marginal 0.1% first-quarter gain and a 4.6% decline in the fourth quarter of last year. Imports rose 2.3% in the third quarter and 0.2% in the second quarter, compared with a 0.6% decline in the first quarter and a modest 0.7% increase in last year’s fourth quarter.

Corporate capex rises Real business fixed investment rose for the second consecutive quarter 1.2% in the third quarter, which added 0.15 percentage points to third-quarter GDP. That compares with an increase of 1% in the second quarter and declines of 3.4% in the first quarter and 3.3% in the fourth quarter. Looking at the key components, business equipment and software fell for the fourth consecutive quarter, dropping 2.7% in the third quarter, versus declines of 2.9% in the second quarter, 9.5% in the first quarter and 2.6% in last year’s fourth quarter. Business structure investment—a very volatile category that includes factories and office buildings—rose 5.4% in the third quarter, versus a decline of 2.1% in the second quarter, a marginal first-quarter gain of 0.1% and an ugly 15.2% decline in last year’s fourth quarter. The former was largely due to the sharp decline in energy prices, which led to significantly less capital spending on oil wells and shafts. Intellectual-property spending remained steady, rising 4% in the third quarter, 9% in the second quarter, 3.7% in the first quarter and 4.6% in last year’s fourth quarter.

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