Orlando's Outlook: Strong consumer drives solid Q3 GDP

10-26-2018

Bottom line GDP grew at a better-than-expected annualized pace of 3.5% in the third quarter, driven by a healthy labor market, lower tax rates and the strongest consumer spending in four years. Combined with the second quarter’s 4.2%, GDP is enjoying its strongest growth in back-to-back quarters since 2014. GDP in the U.S. has now grown to slightly more than $20.6 trillion.

Today’s third-quarter report was precisely on point with our own 3.5% forecast here at Federated. It was ahead of both the Bloomberg and Blue Chip consensus estimates at 3.3%, but slightly less than the Atlanta Fed’s volatile “GDPNow” estimate, recently revised lower from 4% to 3.6%.

Aside from the strength in consumer spending, the expected snapback in inventory rebuilding, a moderate increase in government spending and a modest gain in capital spending (capex) helped to offset anticipated declines in net trade and housing.

Amid the sharp 10% decline the S&P 500 has suffered over the past five weeks, two of the fundamental catalysts we believe could potentially help to engineer a rebound in coming weeks are now in place. In addition to today’s GDP report, we’re now halfway through the third-quarter corporate reporting season, and earnings have risen a stronger-than-expected 23.6% year-over-year (y/y), with three-quarters of the companies beating consensus estimates by nearly 7%.

The next important signposts on our list are next Friday’s payroll report for October, which we believe will be strong, and the midterm elections in less than a fortnight on Nov. 6, whose results we believe will be less bad than feared.

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

No go on Flo Hurricane Florence, which made landfall in North Carolina on Sept. 14, tragically killed at least 51 people, with estimated economic losses of $50 billion, as the storm disrupted consumption and business activities. While the Commerce Department was unable to estimate the overall negative impact of the storm on third-quarter GDP, we expect there will be some positive impact in coming quarters, as the rebuilding begins.

Consumer spending surges again Personal consumption expenditures, which account for 70% of GDP, rose a much stronger-than-expected 4% in the third quarter (versus consensus expectations for a 3.3% increase), modestly higher than the second quarter’s 3.8% increase. Today’s gain added 2.69 percentage points to overall third-quarter GDP growth. Because of President Trump’s tax cuts and the healthiest labor market in nearly half a century, we had expected strong consumer spending in the third quarter. Back-to-School (BTS) spending from July through September rose 5.9% on a y/y basis, marking the strongest such period in seven years. We expect this positive trend to continue into the important Christmas season.

Negative reversal on net trade Due to Trump’s ongoing trade and tariff tiff, the second-quarter surge in shipments of goods overseas (particularly soybeans and petroleum products) ahead of retaliatory tariffs reversed with a vengeance in the third quarter, resulting in the largest drag on trade in 33 years. As we had feared, exports fell 3.5% in the third quarter, compared with a powerful surge of 9.3% in the second quarter, which subtracted 0.45 percentage points from GDP growth. Imports soared 9.1% in the third quarter, versus a modest decline of 0.6% in the second quarter, which subtracted 1.34 percentage points from third-quarter GDP. So net exports plunged by $939 billion in the third quarter, which subtracted 1.78 percentage points from GDP.

Inventory rebuilding reverses recent liquidation Due to tariff-related supply chain disruptions, inventories actually declined by a surprising $36.8 billion in the second quarter of 2018 (compared with a strong increase of $30.3 billion in the first quarter), which subtracted 1.17 percentage points from second-quarter GDP growth, the most since 2014. But inventory rebuilding surged by $76.3 billion in the third quarter, which added 2.07 percentage points to GDP in the third quarter, the most in more than three years. This third-quarter surge effectively wiped out the second-quarter liquidation, getting inventories back on track.

Housing remains weak As we’ve been discussing ad nauseam, residential construction fell for the third consecutive quarter and for the fifth time in the past six quarters, declining 4% in the third quarter of 2018 (versus declines of 1.3% in the second quarter and 3.4% in the first quarter), which subtracted 0.16 percentage points from third-quarter GDP. With winter rapidly approaching, that doesn’t bode well for the fourth quarter, as mortgage rates, home prices and labor and material costs are rising, while first-time home buyers are hampered by $1.5 trillion in student loan debt. 

Government spending rises Total government spending, which accounts for about 17% of total GDP, rose for the fourth consecutive quarter by 3.3% in the third quarter (versus 2.5% in the second quarter), adding 0.56 percentage points to GDP, the most since 2016. Federal government spending rose 3.3% in the third quarter (paced by a 4.6% increase in national defense), while state and local spending rose 3.2%.

Business fixed investment decelerates Nonresidential real business fixed investment rose for the tenth consecutive quarter, but only by a modest 0.8% in the third quarter (versus 8.7% in the second quarter and 11.5% in the first quarter of 2018), which added 0.12 percentage points to third-quarter GDP. Looking at the key subcomponents, nonresidential structures plunged 7.9% in the third quarter (compared with gains of 14.5% in the second quarter and 13.9% in the first quarter), which subtracted 0.26 percentage points from third-quarter GDP, the largest drop in three years. Business equipment and software rose for the eighth consecutive quarter, inching up 0.4% in the third quarter (versus 4.6% in the second quarter and 8.5% in the first quarter), which added a paltry 0.03 percentage points to GDP, the least since 2016. Intellectual property rose a healthy 7.9% in the third quarter (compared with 10.5% in the second quarter and 14.1% increase in the first quarter), which added 0.35 percentage points to GDP, a three-quarter low.

Final sales remain strong Private domestic final sales—which exclude volatile net trade, inventory building and government spending—rose at a solid 3.1% pace in the third quarter, compared with a robust 4.3% pace in the second quarter (the second-fastest pace since 2014) and 2% in the first quarter. Many economists point to this metric as a better indication of underlying fundamental demand, which suggests that economic growth remains sustainably strong.

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