GDP Continues to Advance
In the second quarter, the U.S. economy grew at one of the fastest paces of the current expansion as GDP advanced at an annualized rate of 4.2%. Third quarter GDP is looking positive at an estimated 3.0% rate, somewhat less than second quarter 2018 growth due to a widening trade deficit and softening business investment. The early impact of the federal tax cuts and spending increases is beginning to wane, while trade tensions may begin impacting future capital expenditure plans. Despite the increased probability of slower growth in the third quarter, economic conditions remain above average and GDP for full-year 2018 is on track to hit near 3.0% according to BBVA Research.
Consistent with solid economic growth, manufacturing output has been expanding at a healthy pace. In August, American factory activity grew despite ongoing trade tensions. According to the Institute for Supply Management, the manufacturing index rose to 61.3, a 14-year high. In September, the index remained elevated but declined somewhat to 59.8. Any reading above 50 indicates growth in the manufacturing sector. The reports suggest signs of continued growth in the second half of 2018, but manufacturing may be reaching its peak. Trade tensions have begun impacting future growth as new export orders have declined two months in a row.
While manufacturing output has decelerated slightly in the past few months, business activity in the services sector continues to ramp up. The Institute for Supply Management’s survey of non-manufacturing firms rose from 58.5 in August to 61.6 in September. September’s reading was the highest in over 20 years. Data over 50 show signs of acceleration, while anything over 55 is considered to be exceptional for the economy. The services index includes an array of companies in sectors like finance and healthcare, which employ nearly 80% of all Americans. With all industries reporting growth in September, the economy looks poised for a strong finish to the year.
Momentum in the economy has been strongly supported by the consumer. In the second quarter, consumer spending, which accounts for more than two thirds of growth, rose at an annual rate of 3.8%. In July and August, retail sales grew 0.7% and 0.1% respectively. Over the past 12 months, retail sales have increased 6.6%. While retail sales cooled slightly in August, sales are still growing strongly and data suggests another strong quarter for consumption. According to the consumer confidence index, consumer activity is expected to accelerate even further in the upcoming holiday season as Americans are the most confident in the U.S. economy than they have been in 18 years due to strong job growth, increasing wages, rising household wealth, and solid household balance sheets.
The jobs report for September marked the 96th straight month of employment growth -- the longest jobs expansion in history. The Department of Labor reported that employers added 134,000 jobs to the economy, the smallest gain this year due to employers’ struggles to find talent. Despite this dilemma, the unemployment rate came in at its lowest level since 1969 at 3.7% down from August rate of 3.9%. Only those actively seeking work are considered to be unemployed. Year to date, employers have added an average of 211,000 workers to the economy each month.
The chart above shows increases/decreases in non-farm payrolls (in blue) since June 2015. The green line represents the change in the unemployment rate over the same time period. The non-farm payrolls stats are the numbers from their original release dates and do not include payroll revisions.
Recent payroll reports also suggest that wage gains are starting to materialize. Since the financial crisis in 2008-2009, wages have remained stubbornly low and have yet to grow above 3%. In August,\ average hourly earnings rose by 0.4% pushing the annual rate to 2.9% - the fastest pace since June 2009. In September, the annual rate declined slightly to 2.8%. While wage gains are still hovering below 3%, they have increased faster than in the early stages of the expansion. Similarly, in the past 12 months, wages have grown more for low-wage earners than for other income brackets.
Other measures of wages and compensation have also begun to rise. Most recently, Amazon increased its minimum hourly wage to $15 starting in November and is estimated to affect 250,000 Amazon workers. Amazon’s increase may put pressure on other companies, particularly retail companies, to increase their minimum hourly wage, which may serve as a tailwind to future wage growth throughout 2018 and 2019.
While the September job report shows that the strength in the labor force is finally filtering down to workers, it may be potentially problematic for the Federal Reserve if inflation begins to ramp up, a phenomenon known as the Phillips curve. The Phillips curve suggests that inflation rises as unemployment falls and vice versa. However, Federal Reserve Chairman Jerome Powell has said that he sees little sign of the labor market overheating or pressuring up prices. Core personal consumption expenditures, the Fed’s preferred inflation gauge that strips out food and energy, held steady at the central bank’s 2% target in August despite continued signs of a tightening labor market. If inflation surprises to the upside, it would force the Fed to accelerate its quarterly interest-rate increases.
On September 26th, the central bank raised short-term interest rates another 0.25% for the third time this year -- the first time in a decade that the Fed-Funds rate has been above inflation. The Fed is still penciling in one more interest rate hike this year and three more in 2019. Projections from the meeting suggest that the Fed doesn’t feel the need to signal a more restrictive policy as it anticipates that the unemployment rate will remain below 4% and inflation will not rise significantly above 2% over the next three years.
A separate risk to the strength of the U.S. economy is the current state of the trade gap. In the second quarter, a narrowing trade gap due to strong exports helped lift the U.S. economy, mainly due to a surge in exports of soybeans before tariffs from China went into effect. The same cannot be said, however, for the third quarter and likely the fourth. In August, the U.S. trade deficit in goods and services widened for the fourth month in a row rising to $53.34 billion in August. An increasing trade deficit due to a decline in exports and a rise in imports is expected to weaken GDP. Exports have declined significantly in the past couple months, particularly in foods, feeds, and beverages as a result of China’s tariffs on U.S. goods. The continued uncertainty around trade wars may serve as a significant headwind to the U.S. trade deficit.
Uncertainty around the North American Free Trade Agreement has ended as a treaty was reached between the U.S., Canada, and Mexico at the end of September. The revised agreement has made significant changes to the quarter-century-old continental commercial bloc requiring a greater portion of vehicles to be made in North America, setting a minimum fixed wage for automakers and compromises on dispute resolutions, labor rules, exchange rates, financial services, and online businesses. The agreement still must go through U.S. Congress, but, if passed, the agreement could add to future long-term growth.
As the trade tiff over NAFTA has settled, the trade brawl between China and the U.S. is intensifying. As of now, there are no formal negotiations under way with China. The continuation of a trade war with China could impede future growth in the U.S. as the impact of the tariffs has already started to filter into exports and the manufacturing sector. The tariffs could also cause an upside risk to inflation as higher import prices begin to filter into consumer inflation. However, it appears that the trade dispute is having a bigger impact on China’s economy as Chinese manufacturers are scaling back production and growth has weakened slightly.
While inflation and geopolitical events pose potential risks to the U.S. economy, it appears to be in good shape heading into the final quarter. American consumers continue to be supported by a strong labor market and increasing wealth just as the busy holiday shopping season is about to kick off, boding well for a pickup in consumer spending. Industrial and business activity has also been accelerating in recent months. Current GDP consensus estimates suggests that the U.S. economy will post growth around 4.0% for the last two quarters and 3.0% for the year.
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