A Read on the State of the Economy

Yesterday morning we received word that the economy grew at an annualized rate of 3.5% in the third quarter, which was in line with the prior estimate. While that certainly seems like robust growth, it is not as strong as it appears. The growth was heavily dependent on a surge in inventories at US companies. Inventory increases are included in estimates of GDP, while inventory drawdowns are subtracted from GDP. The inventory increase in the third quarter contributed a whopping 2.3% of the 3.5% increase in GDP, leaving just 1.2% growth from all remaining categories. This 1.2% figure, which economists refer to as growth in “Real Final Sales”, was the lowest growth rate since the fourth quarter of 2016 and represents a sharp deceleration from the 5.3% rate reported for the second quarter.

Why the sudden deceleration in growth? Well, the first and most obvious reason was a big increase in the trade deficit in the third quarter (alternatively a decrease in net exports). According to the Bureau of Economic Analysis, the trade deficit increased over $100 billion (annualized rate) in the third quarter to an annualized rate $651 billion. This increase more than offset the $89 billion decrease in the trade deficit in the second quarter. The reversal could reflect a couple of factors. First, the tax cuts passed in the US late last year led to increased demand for all kinds of consumer products. We can see this improvement reflected in the strong rates of growth in Personal Consumption Expenditures (PCE) over the past couple of quarters. At the same time, a stronger dollar has made imports relatively more affordable than goods produced in the US. The combination of rising demand and a stronger dollar caused a surge in imports in the third quarter. Yes, it would be preferable if US consumers were buying more products produced in the US rather than more imports. But that said, the data still signal a willingness and ability to spend by the US consumer, and that’s a good thing for the US economy.

The second factor affecting the trade deficits is the trade war with China. Plenty of anecdotal evidence suggests that demand for imports surged in the third quarter due, in part, to US companies buying Chinese goods in anticipation of tariff increases by the US government. We saw that same thing by the Chinese in the second quarter. Specifically, the Chinese bought a lot of US soybeans prior to its government’s imposition of tariffs on US soybean imports. Neither of these trends should be seen as positive developments. Increased trade barriers, if they are ultimately imposed, will be a bad thing for both the US and Chinese economies. But for purposes of this exercise, we just point out that the surge in US exports we saw in the second quarter was offset by the surge in imports we saw in the third quarter. And both were driven by trade-war developments.

Another potentially ominous sign of things to come was revealed in the data we just received. If we exclude the change in inventories, the contribution to third-quarter GDP from Private Investment (depicted by the orange bars in the chart below) fell to just 0.25% from 1.10%, 1.34% and 1.05% in the prior three quarters. Why is this important? Because the corporate tax cuts were supposed to lead to sustainable increases in corporate investment rather than just a near-term surge. It appears that management teams have once again become reluctant to invest in future growth. Rather, many are still using their tax windfalls to reward shareholders with stock buybacks and dividend increases – actions that don’t help economic growth and exacerbate economic inequality. In any case, most anecdotal evidence points to increasing uncertainty over trade policy as a primary factor inhibit growth in corporate investment. Another factor is the plummeting price of oil, which is reducing the amount of capital investment at our domestic energy companies. With regard to falling oil, what’s good for the US consumer is not necessarily a net positive for the economy at large anymore. Our ascent to the world’s largest oil producer has its drawbacks.

Source: Bureau of Economic Analysis 
The good news, as you can see from the blue bars in the chart above, is that the consumer remains willing and able to spend. If this trend endures, corporate management teams will ultimately begin to invest again. However, the prospects of continued interest rate increases against the backdrop of massive and rising debt will likely put a cap on the growth rates we can expect. Rising trade barriers, falling energy prices, and the fading effects of fiscal stimulus are additional risks that should keep us cautious.