Third quarter Gross Domestic Product (GDP) rose at a 3.5% annualized rate. As always, there are pluses and minuses. The most important component of GDP is consumer spending, which rose at a very satisfactory 4.0%. Imports surged, which is not unusual when U.S. economic growth is faster than other developed countries. Pre-buying ahead of tariff increases likely played a role as well. Imports have the effect of reducing GDP. Largely offsetting this was higher government spending and increased inventories.
Consumer Confidence in October reached the highest level in 18 years. Included in the report was a notation that the proportion of consumers planning to buy a home or a car in the next six months has risen despite higher interest rates.
Growth in the manufacturing sector appears strong, although there is evidence that the prospect of further tariff increases is having an impact. A popular manufacturing survey put out by the Institute for Supply Management supports continued growth, but at a slower rate. Third quarter earnings reports from many companies suggest the same thing.
The employment picture remains healthy. 250,000 new jobs were created in October, a rebound from a subpar September that was affected by hurricanes. The unemployment rate continues at just 3.7%, the lowest rate in many decades. Also encouraging is that average hourly wages rose 3.1%, the strongest growth in nine years. Some of this is due to tightening labor conditions as businesses must compete for the dwindling number of job seekers. Accelerated job growth in high-wage occupations like manufacturing and construction has also impacted average wage growth.
Growth in the rest of the world is a mixed bag. The Eurozone reported annualized growth of just 0.6% in the third quarter. China’s growth of 6.5% was the slowest in a long time. The outlook is for further slowing due to internal policies and the impact of trade disputes. Japan has yet to report its third quarter growth.
Corporate sales and profit growth are robust despite slower growth outside the U.S. According to FactSet Research Systems, third quarter sales for the companies comprising the S&P 500 are expected to grow 8.5%. Earnings per share are expected to rise 25%, including a significant impact from lower corporate tax rates. These rates will likely moderate in 2019; comparisons will be made against stronger 2018 growth rates, and there won’t be a new stimulative factor like the tax cuts. Valuations remain reasonable at just 15.6x estimated earnings 12 months into the future.
Based on recent economic strength, the Federal Reserve is likely to raise interest rates another 0.25% at its December meeting. The early consensus is that at least two more rate hikes will be needed next year, and many think three or even four are possibilities.
Inflation remains surprisingly subdued given the strong economy, labor cost pressures, and rising costs of materials resulting from growth plus the impact of tariffs on global supply chains. It is reasonable to expect higher inflation next year, and this could prod the Fed to raise rates more than twice.
Higher rates are starting to have an impact on the economy. The goal isn’t to bring the economy crashing down, but to control inflation so it doesn’t get out of hand. This is the desired “Goldilocks Economy”—not too hot, not too cold. Home sales have moderated as housing is one of the most interest-sensitive industries. We heard that monthly mortgage payments on a median home rose 16% in October due to a 4% rise in average home prices plus the impact of higher interest rates. Auto sales seem to have comes less robust as well. Obviously there become a point when ever-higher interest rates choke off sales, leading to a recession. That is always the fear, but rates remain very low by historical standards.
Continued economic growth should lead to higher sales and corporate profits. These are the engines of long-term stock price appreciation. Valuations are reasonable. Sticking with high quality, durable businesses becomes more important later in an economic cycle, just in case a recession hits sooner than expected. There will be a recession out there someday, but there doesn’t seem to be any sign of one at present. In the meantime, a lot of good profit can be missed worrying about recessions that may not happen. The old economics joke is that economists are famous for calling nine of the last five recessions. It takes a lot to bring the U.S. economy down.
Let’s hope for Goldilocks, but keep an eye out for the Big Bad Wolf.
-- Reprinted from the December 2018 issue of the Investor Advisory Service. Subscribe to IAS today.