Calm before the storm
Positive Q3 GDP growth provides a respite.
Published October 31 2022
Bottom line
The U.S. economy grew for the first time in nine months during the recently completed third quarter, shrugging off the worst inflation in four decades and five sharp rate hikes by the Federal Reserve since March.
GDP rose by a better-than-expected 2.6% annualized rate in the third quarter, rebounding from declines of 1.6% and 0.6% in the first and second, respectively. Bloomberg consensus was for 2.4% growth, Blue Chip for 1.3%, the Atlanta Fed’s GDPNow model for 2.9% and our estimate here at Federated Hermes for 1.4%. The last quarter of positive growth was 7% in Q4 of 2021.
Personal consumption was stronger than expected at a gain of 1.4%, but with a decided split between goods (which fell by 1.2%) and services (which rose by 2.8%). Net trade was the most significant contributor to the strong quarter, as imports inexplicably declined despite the strong dollar. Corporate spending and government consumption also contributed positively. On the negative side of the ledger, housing plunged for the sixth consecutive quarter and the pace of inventory restocking slowed sequentially by more than 40% from the second.
Inflation is still a problem The core personal consumption expenditure (PCE) index rose for the second consecutive month to 5.1% year-over-year (y/y) in September, up from 4.9% in August and 4.7% in July. To be sure, this metric is down from its February 2022 peak of 5.4%, a 39-year high. But today’s month-over-month (m/m) gain of 0.5% in both August and September annualizes to a 6% increase. We’re not out of the inflation woods just yet.
Fed on track Consequently, we do not expect the Fed to deviate from its recent pace over the past three policy setting meetings and anticipate a fourth consecutive 75 basis-point rate hike on Wednesday. If inflation begins to slow meaningfully, the Fed may well throttle back to a half-point rate increase at its final meeting this year in December. But the Fed’s top priority at present is to tighten monetary policy sufficiently to slow the economy and slay the inflation dragon, targeting 2% in the longer run. That process, in our view, will be measured in years rather than months.
Savings rate slows The personal savings rate declined in September to 3.1%, just off a 14-year low. That’s less than half the 6.7% average over the past 30 years, representing a sharp decline from the 26.3% pandemic-induced peak in March 2021.
Ho, ho, humbug? With elevated inflation, rising interest rates and declining savings, Amazon forecast today its slowest holiday sales growth in its history, up only 2-8% y/y. That’s in line with Deloitte’s forecast for 4-6% industry sales growth during Christmas. Holiday sales last year were up by a robust 16.3% y/y, although highly correlated Back-to-School sales this year rose by 9.1%. So it appears that the consumer—particularly at the lower end of the spectrum—is starting to slow.
Yield curve inversions pointing toward recession The spread between 2- and 10-year Treasury yields, inverted since March, is an excellent early-warning recession indicator. With the 2-year yield now around 4.40% and the 10-year yielding around 4%, that 40 basis point inversion suggests growing recession risk in coming months. Despite a relatively solid third-quarter GDP of 2.6%, we are forecasting only 0.1% GDP growth in the fourth quarter, with negative readings for each of next year’s four quarters and full year.
Private domestic final sales slowing This metric is a much better indication of the economy’s underlying fundamental strength, because it excludes volatile net trade, inventory liquidation or restocking, and government spending. It rose by a healthy 2.6% in last year’s fourth quarter and slowed to 2.1% in this year’s first quarter, to 0.5% in the second quarter and to 0.1% in the third quarter of 2022. That suggests that we could be on a glide path into recession next year.
Another equity head fake? The S&P 500 has soared recently. Aside from the technicals, October is typically the month that bear markets go to die. Moreover, in a midterm election year like 2022, a choppy start during the year’s first three quarters usually reverses into a powerful year-end rally, when it appears that voters will deliver divided government, which the market loves. Fiscal policy gridlock is good in Washington. But fundamentals still matter, in our view, and soaring inflation and hawkish Fed policy could cut this rally short.
Details from the third-quarter GDP report:
Personal consumption (71% of GDP) rose by a stronger-than-expected 1.4% in the third quarter (accounting for 0.97 percentage points of the gain in overall GDP), versus consensus expectations for a 1% increase. This compares with a 2% second-quarter gain. Spending on services grew by 2.8% in the third quarter, as post-pandemic “revenge travel” continues unabated. But spending on goods declined for the third consecutive quarter and for the fourth time in the past five quarters, down by 1.2%.
Housing plummeted by 26.4% in the third quarter (which reduced GDP growth by 1.37 percentage points), the sixth consecutive quarter of declines. The second quarter fell by 17.8%. This is the largest decline since the start of the pandemic, as mortgage rates have more than doubled from 3% to 7% so far this year, prices and rents are at record highs, and affordability has plunged to its worst level since 1986.
Net trade was by far the biggest contributor this quarter, adding 2.77 percentage points to GDP, its largest such contribution since 1980. Exports rose by 14.4% in the third quarter (which added 1.63 percentage points), versus a 13.8% second quarter gain, despite the relative strength in the dollar against the yen, pound and euro that made our exports much more expensive. But imports surprisingly declined by 6.9% in the third quarter (after eight consecutive rising quarters), which added 1.14 percentage points to GDP growth, compared with a modest 2.2% second-quarter increase.
Inventories rose for the fourth consecutive quarter by $61.9 billion in the third quarter on a chained-dollar basis, down from $110.2 billion in the second quarter and $214.5 billion in the first quarter. But this 40% sequential decline in the pace of inventory restocking subtracted 0.70 percentage points from GDP growth.
Corporate nonresidential capital spending rose by 3.7% in the third quarter (adding 0.49 percentage points to GDP), versus a negligible 0.1% second-quarter gain. Structures declined for the sixth consecutive quarter, falling by 15.3% (subtracting 41 basis points from GDP). Equipment spending rose by 10.8% (adding 54 basis points to GDP). Intellectual property spending grew by 6.9% for the seventh consecutive quarter (adding 36 basis points to GDP growth).
Government spending rose by 2.4% in the third quarter, snapping five consecutive negative quarters (adding 0.42 percentage points to GDP). Federal spending rose by 3.7% for the first time in six quarters (adding 0.23 percentage points to GDP growth), goosed by a 4.7% increase in defense spending (17 basis points) for the second consecutive quarter, after five consecutive quarterly declines. State and local spending rose by 1.7% (adding 19 basis points).