The first estimate of third quarter GDP was released this morning and logged an impressive 3.5% annualized quarter-over-quarter growth rate, beating the 3.3% forecast, but the internals were a little less impressive. The result follows a robust 4.2% second quarter with both driven by consumer consumption. Consumer spending grew 4.0% versus 3.3% expected and 3.8% in the prior quarter. Final Sales to Private Domestic Purchasers (which weeds out the often volatile trade, inventory and government categories) was a solid 3.1% but off the second quarter’s 4.3% as an inventory build in the third quarter aided GDP but is likely to be reversed in the fourth. Also, business investment was negative for the first time since the tax cuts passed and residential investment (housing) was negative for a third straight quarter. The bigger question is can the consumer continue the heady consumption levels when wage growth remains below 3.0%? We think not. Thus, while the back-to-back solid quarters were impressive the Fed and most other forecasters look for GDP to trend back into the 2% level next year. Latest estimates are for fourth quarter GDP to average 2.7% and first quarter 2019 at 2.4%. Finally, Core PCE QoQ rose 1.6% which was below the 1.8% consensus estimate and below the 2.1% second quarter rate. That downtrend should give even the most hawkish Fed members reason to believe inflation is well-contained and, in fact, trending lower. Treasury prices were higher before the GDP release as a risk-off tone prevailed but with the headline beat some price reversal has occurred. We think, however, once the details of the report are understood Treasuries have a chance to rally further. The 10-year is currently up 7/32nds in price to yield 3.09%.
|Economic News||Consumer Consumption Carries 3rd Qtr. GDP||Market Rates|
The housing sector has been a notable victim of higher rates as sales activity has slowed noticeably as noted in a variety of reports. Whether it’s new home sales or existing home sales the pace has fallen off from the upward trend that had characterized the sector for most of this economic expansion.
That’s why we think the rebound in pending home sales for September, which followed two months of declines, will likely be a temporary phenomenon as demand drifts lower as a consequence of higher mortgage rates. Pending home sales rose 0.5% in September compared to a no change expectation. On a year-over-year basis sales declined 3.4% and looking ahead recent declines in mortgage applications, most likely due to rising mortgage rates, implies further weakness in home sales.
Housing affordability has deteriorated from the peak reached in 2012, with the impact much more prominent in the western states. Data from the National Association of Realtors show that homes are more affordable in the Midwest and roughly in-line with overall affordability levels in the Northeast and South.
Relating this back to GDP, we do not anticipate the increasing weakness in the housing sector to play a dramatic role like it did leading up to the recession when the housing market was red hot before falling off a cliff. In the current trend housing hasn’t contributed significantly to post-recession economic growth. And likewise an expected slowdown in the sector’s growth is unlikely to meaningfully be a drag on overall GDP numbers in the fourth quarter and beyond.
So while the economy can’t rely on housing in the coming quarters it won’t necessarily detract from growth numbers either. But that still leaves unanswered why equity markets have reacted so forcefully to marginally higher rates with all major indices in correction territory with some moving past the correction of last February. The banking sector has been particularly hit hard and the downtrend has been in place for most of this year, not just the last few weeks.
While bank industry earnings are still strong and credit metrics still solid, bank stocks entered a bear market with this latest equity downdraft. The KBW Regional Bank Index is down 23% from its high hit back in June. That volume of selling doesn’t occur just due to profit-taking and sector reallocations. Perhaps it’s the thought that despite rates heading higher, the yield curve is flattening and that will compress margins as banks finally have to acquiesce and raise deposit costs.
Also, while higher rates are a net positive for most banks, they’re not for their borrowers and other consumers so the idea that peak earnings and credit quality are behind us is also hurting bank stocks. And when one looks at GDP forecasts that show a slowing from the current 3-handle GDP to high 2-handle and then lower it’s not hard to see that causing some handwringing with bank investors. Combine that with Fed rhetoric that points to continued rate hikes, even with the expected downtrend in GDP, and it’s not hard to envision that the salad days of this expansion may be behind us.
Consumer Consumption Carries 3rd Qtr. GDP
The consumer carried the day as 3rd quarter GDP was an impressive 3.5% vs. a 3.3% estimate which follows a robust 4.2% print in the 2nd quarter. Consumer spending was 4.0% which beat an impressive 3.8% in the 2nd quarter. But just as we posed last quarter the question remains can the consumer continue at 3+% consumption given a more pedestrian increase in earnings that was most recently 2.8% YoY? The answer is probably not, and that expected slowdown is also the reason behind the expected slowing in GDP with the fourth quarter forecast at 2.7%, the same as the 2.7% forecast for consumer spending. As long as wage gains remain modest long-run GDP will struggle to stay near 3%.