Show Me the Growth!

Last week’s news that the economy grew at a 3% pace for the second straight quarter has led to a lot of optimism about the economy finally breaking out to the upside. In fact, Tuesday morning I heard a guest on CNBC say that it’s possible economic growth will accelerate to over 4% in the fourth quarter, which would bring full-year growth very close to 3%. Is he right? Is the elusive 3%, promised by the new presidential administration, finally at hand? In short, no.

First a little background. The Bureau of Economic Analysis reports quarterly GDP growth on a sequential annualized basis. This means that the 3Q17 growth rate of 3.0% reported last Friday represents the annualized growth rate in the economy from the 2Q17 to the 3Q17. Likewise, the growth rate of 3.1% reported for the 2Q17 represents the annualized growth rate from the 1Q17 to the 2Q17. Two consecutive quarters of 3% or greater GDP growth has been rare during this economic recovery, but not nonexistent. In fact, we did it in 2013 and again in 2014. However, getting to a full-year growth rate of 3%, as suggested by the aforementioned CNBC guest, would require a 4Q17 growth rate of 4.5% or higher on top of the two consecutive quarters of 3% growth we just enjoyed. A three-quarter growth rate of that magnitude (~3.5%) has only happened once since 2006. In 2014, the economy grew at a 3.9% annualized rate from the first quarter to the fourth quarter. However, that outsized growth followed a -0.9% contraction in the economy in the 1Q14. We don’t have that easy comparison this year as the economy grew by +1.2% in the 1Q17.

Source: Bureau of Economic Analysis.  Assumes a 4.5% growth rate in the 4Q17.

Now, based on what we know, how likely is it that the economy will grow at anywhere close to 4.5% in the fourth quarter?  I’d say it’s highly unlikely.  Consider the following:
Inventories
The +3.0% growth in GDP for the third quarter of 2017 included a +0.73% impact resulting from additions to inventories.  These inventory builds represent real economic activity because goods are being manufactured and delivered to distributors.  However, distributors will not continue to build inventories beyond a certain level, even if demand is improving.  So, because inventory builds are generally capped at some level, economists generally discount the contribution to GDP from inventory builds.  And if underlying demand is actually improving as many suggest, we may even see a 4Q17 drag on GDP as previously accumulated inventories are depleted.
Impact from Hurricanes
The hurricanes undoubtedly disrupted economic activity in large swaths of the country in the third quarter.  However, we learned yesterday that Personal Consumption Expenditures rose at a 1.0% pace in September – the largest increase since August, 2009 – driven largely by the replacement of vehicles ruined by the storms.  This spending on new cars was included in the 3Q17 GDP reading of 3.0%, and there will undoubtedly be additional hurricane-recovery spending in the months to come.  However, these expenditures cannot be assumed to continue indefinitely.  For the 4Q17, it’s anybody’s guess what the impact of the hurricanes will be.  The strength in spending on cars in September, though, makes 4Q17 comparisons a little more difficult.
Savings Rate
The Personal Savings Rate (Personal Savings dividend by Disposable Personal Income) plunged to 3.1% in the month of September – the lowest monthly reading since 2008 – from an average of about 6% from mid-2014 to the end of 2015.  Because incomes/wages have not been growing very fast, consumers have either been taking on more debt or saving less to finance their current consumption.  As such, the drop in the savings rate has been a boon for an economy that is 70% comprised of consumer spending.  Can we reasonably expect that further decreases in the savings rate will continue to boost economic growth now that the savings rate is back close to pre-recession levels?
Source: Bureau of Economic Analysis.
Exports
Following a long period of strength from 2011 through 2016, the dollar (on a trade-weighted basis) has weakened significantly in 2017.  Why is this important?  Because a falling dollar is supportive of exports (and therefore domestic economic growth) while a rising dollar makes our exports less competitive.  Indeed, as the dollar has been falling in 2017, exports have contributed heavily to economic growth in the first three quarters of the year (+0.85% in the 1Q17, +0.42% in the 2Q17 and +0.28% in the 3Q17).  However, the dollar bottomed out on September 8, 2017, and has since bounced by nearly 4%.  If this strengthening trend continues, it will become much less likely that significant increases in exports will boost GDP growth in the 4Q17 and beyond.
Sources: Bureau of Economic Analysis, Federal Reserve.
Rising Interest Rates
There have been some sectors of the economy exhibiting promising momentum.  For example, consumer purchases of autos and other durable goods have been growing at a rapid clip.  On the business side, investment in equipment and intellectual property has been quite strong of late.  Looking forward, the economic optimists are hoping that the “animal spirits” resulting from a stronger economic outlook will lead to continued robust growth in consumer spending and business capital investment.  But there are significant question marks regarding this thesis.  Will consumers continue to buy cars, houses, appliances and home improvements as the Fed continues to increase the cost of borrowing?  Low interest rates have been a much smaller factor in the growth (or lack thereof) of business investment.  But in the face of steadily increasing interest rates, it seems to me that increases in corporate investment will be heavily dependent on fiscal stimulus (tax cuts, repatriation, infrastructure spending).  Even if we do get lower tax rates, it is not completely clear that companies will use their windfalls to expand.  After all, most companies have not taken advantage of the ultra-cheap money available over the past nine years for business expansion.  Greater tax and regulatory clarity will help, but big increases in corporate investment will only materialize if and when the demand picture improves.Conclusion
So what’s the message?  In a nutshell, don’t get too excited about the back-to-back quarters of 3% growth.  The 4Q17 will clearly benefit from hurricane recovery, but there are several other factors that suggest the 4Q17 and beyond could be challenging.  From where I sit, it is becoming increasingly clear that fiscal stimulus will be needed just to offset the impact of higher interest rates.  Having said that, we doubt that the Fed will follow through with its planned rate hikes in the absence of tax reform.   So, enjoy it while it lasted, because 3%+ growth remains a fantasy for now.  Finally, there is no cause for getting too despondent if the next few quarters do not bring the growth acceleration that many expect.  Growth of 2.0%-2.5% has been pretty good for the markets over the past several years.  Failure to break out from that range now is not a fail-safe sign that the bull market is over.