What? 3.5% GDP Growth Isn't Good Enough For You?

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Includes: FDX, MC, UPS, V
by: Trading Places Research

Summary

The 3.5% GDP headline is great, but many of the details are troubling.

Economic growth is becoming too dependent on the US consumer and government budget growth.

Inventories are sky-high right now, likely due to companies getting ahead of tariffs and stocking up for Christmas.

Trade was a huge drag on growth this quarter. Some of that is likely due to the inventory build-up.

If these trends continue, a recession may come sooner than people (including me) think.

It's here! The arrival of the new GDP report is kind of a big deal around my house.

Introduction: Never Trust The Headline Numbers

I have a rule of thumb when scrolling through my news feed: if a headline ends in a question mark, the answer is most likely "no" and I move on. This article is no exception. 3.5% isn't good enough for me.

Another rule of thumb: headline numbers are great for looking at long term trends, but often fail in telling us where we are today. This is especially true with GDP which is a single number that is the sum of many variables which themselves are sums of other variables and so on.

It's only one quarter, and I cannot stress enough that some of these preliminary numbers come with high error margins, so take everything with a grain of salt. But this quarter is much worse than the blowout Q2 in a number of ways, and once we get past Christmas, I worry that 2019 growth projections are overly optimistic.

But 3.5% Is Really Good!

Yes, it is. Here's the chart of quarterly GDP growth since Q1 2009. It's a very noisy data set, but looking at the purple 1-year moving average, we can see that it is moving up steadily after bottoming out in the 2015-2016 sectoral recession. Things are good, right?

Source: Chart mine, data from BEA

Well, yes and no. The Q2 print was truly impressive with strength in all the places you would want to see it, whereas this one, er, not so much. I like to look first at the broad categories, as a percentage of the total dollar gain in GDP. This will give us a good idea of what drove that 3.5% headline number. Good old Table 1.5.5 is our data source here (calculations mine).

Percentage Contribution to GDP Gain By Major Category

Major Categories Q3 2018 Q2 2018 Q3 2017
Personal Consumption 78% 53% 55%
Investment 43% 10% 33%
Trade -39% 24% 6%
Government 18% 13% 5%

Source: BEA

The first thing that stands out is that this quarter was a result of US consumers doing their thing, only more so than usual. If every other category were flat, GDP would have grown at 2.7% just from the US consumer. The same number for Q2 is 2.2%, so we can see that the US consumer is feeling their oats headed into Christmas season.

However, everything else combined in the US economy accounted for only 0.8% growth in Q3, and as we will see, much of that came from expanded inventories and government spending.

That investment number is not a misprint, but as we will see when we drill down further, it's actually a little limp, with companies filling up inventories in advance of Christmas and tariffs. There is, however, some good news on the IP investment front.

That trade number is, um, well it's something, isn't it? But it's also somewhat misleading and is offset by companies filling up inventories in advance of Christmas and tariffs. But worryingly, exports were a net drag on growth.

The growth in government spending continues unabated and is becoming a larger and larger part of the GDP growth story over time. It's pretty much the opposite of the beginning of this cycle, where reductions in state budgets and the Federal sequester kept aggregate government spending low. In any event, a surge in state and local spending and the growth in the defense budget are the main drivers here.

Drilling Down: Personal Consumption

Household services was one of the two key drivers of GDP growth this quarter.

Percentage Contribution to GDP Gain By PCE Subcategory

Subcategories

Q3 2018

Q2 2018

Q3 2017

Personal consumption expenditures

77.58%

52.84%

54.98%

Goods

23.11%

16.66%

21.35%

Durable goods

8.34%

6.52%

7.77%

Motor vehicles and parts

3.40%

1.64%

3.49%

Furnishings and durable household equipment

1.54%

1.94%

1.48%

Recreational goods and vehicles

3.56%

1.11%

0.74%

Nondurable goods

14.77%

10.14%

13.58%

Food and beverages

4.37%

2.62%

3.67%

Clothing and footwear

1.54%

2.51%

0.74%

Gasoline and other energy goods

2.23%

1.73%

3.67%

Services

54.47%

36.18%

33.62%

Household services

49.41%

32.17%

35.59%

Housing and utilities

10.97%

8.87%

8.73%

Health care

13.56%

7.23%

15.68%

Transportation services

1.82%

(0.27%)

1.14%

Recreation services

1.21%

1.78%

0.92%

Food services and accommodations

7.85%

7.20%

2.05%

Financial services and insurance

5.54%

3.21%

7.03%

Source: BEA

The Goods category did well, though not exceptionally so when compared with the same quarter last year, but accelerating from Q2. The leaders here were autos, food and beverage (not restaurants, that's under services) and an exceptionally strong number for recreational goods and vehicles, which I'll guess is a tribute to a strong summer tourist season. (Also, I hope my wife reads this and lets me buy an RV.)

Services is where all the action is. Household services alone account for almost half of the entire quarter's growth, a far larger portion than either last quarter or Q3 2017. Housing and health care continue to blot out the sun, accounting for almost a quarter of Q3 growth. The US consumer also continues to eat out and travel a lot, with strong numbers there.

Drilling Down: Investment

So, that top-line Gross Private Domestic Investment number is pretty darn cool. However, if you scroll to the bottom of this table, you will see where the problem lies. I'll wait.

Percentage Contribution to GDP Gain By Investment Subcategory

Subcategories

Q3 2018

Q2 2018

Q3 2017

Gross private domestic investment

43.06%

9.63%

33.19%

Fixed investment

6.31%

22.24%

16.46%

Nonresidential

6.48%

19.17%

13.23%

Structures

(3.36%)

7.87%

(1.31%)

Equipment

1.94%

4.37%

11.09%

Information processing equipment

0.77%

2.24%

3.28%

Computers and peripheral equipment

(0.40%)

1.11%

1.66%

Other

1.21%

1.11%

1.66%

Industrial equipment

2.91%

(0.13%)

1.97%

Transportation equipment

(2.14%)

0.75%

2.45%

Other equipment

0.40%

1.51%

3.41%

Intellectual property products

7.85%

6.98%

3.49%

Software

4.09%

3.05%

2.71%

Research and development

3.32%

3.61%

0.57%

Entertainment, literary, and artistic originals

0.45%

0.30%

0.22%

Residential

(0.16%)

3.05%

3.23%

Change in private inventories

36.75%

(12.59%)

16.72%

Farm

(0.49%)

0.11%

0.79%

Nonfarm

37.19%

(12.67%)

15.94%

Source: BEA

Do you see it? Non-farm inventories accounted for 37% of all growth in the quarter, and this is the second key driver after household services. In total, 62% of the quarter's growth is accounted for by housing, health care and nonfarm inventories, and that number is 87% when you add in the rest of household services. This is not a picture of strong growth.

However, the inventory picture is offset somewhat by imports of goods, which I will cover in the next section.

A few other observations here

  • Investment in residential and non-residential structures is a net negative on growth
  • Equipment investment is slowing
  • Investment in IP is an increasing portion of the GDP growth story

Drilling Down: Trade

Like with investment, the top-line number is an eye-opener, but the splits give some further insight.

Percentage Contribution to GDP Gain By Trade Subcategory

Net exports of goods and services

(39.13%)

24.10%

6.38%

Exports

(9.11%)

24.62%

18.34%

Goods

(13.11%)

21.11%

11.31%

Services

3.97%

3.53%

7.07%

Imports

(30.03%)

(0.51%)

(11.92%)

Goods

(27.11%)

0.16%

(6.24%)

Services

(2.91%)

(0.70%)

(5.72%)

Source: BEA

After a quarter where exports accounted for 25% of GDP growth and imports were a wash, this quarter was a dramatic turnaround as tariffs went into effect, and inventories piled up in advance of those tariffs and in preparation for Christmas.

The dramatic rise in imports shaved a full percent off growth, while inventories added 1.3% to growth. To some extent, these are linked and offset each other (we can assume many of these imports went into inventories), but it's hard to tell what the extent is until the next couple of quarters.

Additionally, as other countries feel the pain of Trump's neo-Mercantilism, and engage in retaliation and boycotts of US companies, exports are doing poorly, with goods exports providing a drag on GDP growth to the tune of 46 bps. This is what happens when you try and cut the rest of the world off at the knees.

Drilling Down: Government

It's not just this quarter -- the growth of government spending is becoming a large part of GDP growth, accounting for 18% of the growth in Q3. This was primarily driven by large increases in state and local budgets and the Federal defense budget.

Percentage Contribution to GDP Gain By Government Subcategory

Subcategory

Q3 2018

Q2 2018

Q3 2017

Government consumption expenditures and gross investment

18.49%

13.43%

5.37%

Federal

6.39%

4.91%

(0.09%)

National defense

4.45%

3.67%

(1.57%)

Nondefense

1.94%

1.24%

1.48%

State and local

12.18%

8.49%

5.46%

Source: BEA

State and local budgets by themselves added 43 bps to this quarter's GDP growth, and it's worrying that growth is becoming dependent on state budgets. Reductions in state budgets in 2009-2011 was a major drag on the recovery, and that may happen again in the next recession given this trend.

The other thing of note is the explosion of the Federal defense budget, which is driving the deficit on the spending side.

GDP Bullets

Too long? Didn't read? Just plain bored? Here's some handy bullets :

  • The 3.5% headline number is strong, but the underlying details are worrisome.
  • 87% of the growth this quarter came from household services and non-farm inventories.
  • The inventories number is offset somewhat by the surge in imports to get ahead of tariffs and stock up for Christmas. We won't know how much for a couple of quarters.
  • Exports may be starting to be a problem.
  • Health care and housing continue to blot out the sun, accounting for half the growth in household services and a quarter of GDP growth in Q3.
  • Government spending is becoming an increasing portion of the GDP growth story, led by state/local and the Federal defense budget.

Conclusions: Sleep With One Eye Open

Repeating My Caveat: These are preliminary numbers with high error ranges and additionally, it's only one quarter.

With the exception of the US consumer, Q3 was a disappointing quarter despite the high headline number. Except in IP properties, investment was a little limp, and the trade picture is obviously changing rapidly, and not for the better. Watching the progression of inventories moving forward will be key here. Hopefully some of these negative trends will reverse in Q4 or turn out to be errors when the revised report arrives around Thanksgiving.

How does this effect my Market Outlook? Not much really. These were trends I thought we would see, but not so early, and not so drastic. When I read the blowout Q2 report three months ago, it felt like the top of the economic cycle, and this report certainly does not change that opinion.

The strength of the US consumer going into Q4 doubles my conviction that this Christmas will be an all-timer, and select retail, consumer discretionary, Visa (V), Mastercard (MC), UPS (UPS) and Fedex (FDX) will see great Q4s. I continue to believe that the market has one last rally in it, between Election Day and Christmas, after which, the end is nigh.

There's no reason to panic, but sleep with one eye open.

Thanks for reading. I'll write an update when the final numbers come out in November. Comments/insults welcome.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.