Q3 2018 Foreshadows A Slowing Economy

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by: J.G. Collins

Summary

While GDP printed above expectations at 3.5 percent, more than 200 bps was attributable to restocking inventory.

The GDP bump in agricultural exports in 2018Q2 that came from trade tensions is normalizing and returning to normal levels.

Consumer spending that had also driven robust GDP growth in 2018Q2 is likely to slow.

There is still no considerable increase in equipment investment, despite generous incentives from the Trump Tax Cut.

An array of indicators, from home sales to oil inventories, all turned negative in September.

Data and information as of October 27, 2018.

Gross Domestic Product growth for the third quarter of 2018, or “2018Q3 GDP”, printed at 3.5 percent, 20 bps above the consensus estimate, but 70 bps below the final 4.2 percent reading of the last quarter, 2018Q2, but also 70 bps above 2017Q3 of 2.8 percent.

The Data

Average GDP growth for the past four quarters is 3.1 percent. That compares to average GDP growth for the four quarters ended September 30, 2017, of 2.4 percent. We had anticipated growth in the third quarter, at between 2.7 and 3.2 percent growth, in line with the consensus.

Third Quarter GDP (C) 2018 The Stuyvesant Square Consultancy from BEA Data

Stacking

We’re seeing an echo of the “stacking” we cited in our analysis of the 2018Q2 GDP report affecting 2013Q3 GDP.

Exports, which had printed in 2018Q2 at the highest level since 2013Q4, showed net imports this quarter. Some had suggested, that the substantial increase earlier in the year was attributable to China building-up US agricultural reserves in anticipation of the tariffs President Trump imposed on July 6th. That certainly seems to have been the case, as soybean exports as of August were up nearly 75 percent over the entire amount of soybean exports for 2017.

2018 Net Exportss (C) 2018 The Stuyvesant Square Consultancy from BEA Data

The other big echo was in the inventory build-up, an incredible 200 bps of the 3.5 percent GDP. That counteracts the big drop in inventories in 2018Q2. GDI improved substantially after a showing last quarter.

But most of that came from replacing non-farm inventories which had been substantially “burned off” in the second quarter in what was then the biggest decline in that number since 2012Q4. We had predicted a likely restocking in the remaining quarters of 2018, and it seems to have come to pass. That may continue into 2018Q4, but is more likely to decline both then and further into 2019Q1.
We would prefer GDI to be in factories, equipment, and the like that are more likely to “bootstrap” growth with jobs and productivity, and particularly given the investment advantages of the Trump tax bill. But those incentives do not seem to be playing out, at least not yet.

2018 Third Quarter Gross Domestic Investment. (C) 2018 The Stuyvesant Square Consultancy from BEA Data

Personal Consumption Expenditures, or PCE, continued the rebound it started in 2018Q3 to 2.69 percent, building from the paltry 0.36 percent of the first quarter, which had been the lowest PCE number for the first quarter since 2013Q3.

2018 Personal Consumption Expenditures (C) 2018 The Stuyvesant Square Consultancy from BEA Data

This could also be seen as stacking. Our take is that likely means consumers continue in the “catch-up” spending they started in 2018Q2 that they had forgone in 2018Q1.

Notably, food services and accommodations printed strong, again, for the second quarter in a row; the highest numbers in over a decade. Part of that, we think, is more confident consumers buying prepared meals and taking long-delayed vacations. Another part is likely hurricane refugees bedding down at hotels and eating at restaurants. It’s also a reflection of increasingly convenient meal delivery services.

We don’t have much faith in continued strong consumer spending, given recent setbacks in the stock market, which will likely inhibit the spending attributable to the wealth effect. But consumer spending is somewhat of a jump ball at the moment because the ratio of consumer debt to disposable income is decreasing, as we had predicted with withholding being reduced to reflect the new tax law., and consumer confidence continues to remain high.

Summary Analysis

The Short-Term View

As we stated, the strong performances in PCE and GDI are likely not sustainable. 2018Q4 GDP will, perhaps, likely print around 2.6 to 3.1 percent, but we expect 2019 Q4 to will print only in the range of 2.5 to 3.0 percent.

The IBD/TIPP index of Economic Optimism for October bumped up, to 57.8, after having fallen four points in September. That speaks well for the start of the fourth quarter.

But we continued to troubled by continuing volatility in the 3Mo/10Yr yield curve, which has been narrowing, on-and-off, since the end of 2017. It ended at 75 bps Friday, the lowest since mid-August. Moreover, the 10 year now seems to be declining; closing Friday at 3.08 from a 2018 high of 3.23 on October 5th.
This is a reversal from last quarter, when the 10 year was moving upwards and we anticipated a greater “risk-on” environment. The decline in the 10 year 10 year shows investors are moving toward bonds; moving cash from equities to Treasuries.

M2 velocity also flattened going into Q3, even as the Fed tightened the money supply. That's also indicative of an slowing economy.

Other significant data released this month has been mixed: existing home sales, new home sales, building permits, crude oil inventories, and employment all disappointed; durable goods and the manufacturing PMI printed positively, although the PMI declined somewhat from its August reading.

Medium Term

We are somewhat pessimistic over the medium term because we see recent distinct signs of a slowing economy. We expect exports and consumer spending to return to rates consistent with the averages of the results we’ve seen in prior results we’ve seen since the Great Recession, +/- 50bps. We expect similar levels of inventory build, which would make GDP much more modest, in the 2.3 to 2.8 percent range in mid-2019.

Long Term

Our long-term view of the economy, beyond 2020, remains unchanged. Aside from AI, there’s very little in this economy we see on the horizon to create rapid, robust, growth; the “next big thing” in the way of a product or service that ramps up a sustained, substantial, uptick in production and consumption to drive growth. The battering we’ve seen in the FAANG sector in October seems to signal dormancy and a relatively flat broad market.

It may be that President Trump’s more protectionist trade rhetoric could add foreign-owned domestic production to drive GDP growth. But, so far, that rhetoric has only been a threat to induce more fair trade policies from our trading partners. Much remains to be seen. Direct foreign investment in the USA has actually declined as trade issues ramp up.

Absent growth from some major consumer-oriented innovation, or some significant reshoring of manufacturing or other direct foreign investment in the USA, we anticipate managers will look for growth in certain low-margin industries and consolidate to realize cost savings.

We also expect internet retailers, like Amazon, to realize enhanced growth by adding to their business of selling “stuff” to their nascent business of selling “experiences” - concert tickets, airlines, cruise lines,car rentals, theme parks, hotel chains, etc. We also note that many companies in the Third Quarter are reporting income beats but revenue disappointments. That kind of profitability tends to be short-lived.

Outperform: Consumer Discretionaries in the mid-to-high end retailers; certain leisure and hospitality, transports (particularly trucking, on speculation of consolidation and acquisition as the business works out another model to compensate for the dearth of drivers.)

Perform: Consumer Staples, Energy, Telecom, Utilities and Materials, Financials, Pharmaceuticals.

Underperform: Healthcare, Real Estate, Technology, and Industrials.

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