John Lynch Chief Investment Strategist, LPL Financial
Financial markets have had the roughest October in years as investors have grown wary over future corporate profits and the Federal Reserve’s (Fed) monetary policy plans. Even as markets fluctuate, we encourage investors to focus on the fundamentals. We remain optimistic on the U.S. economy, and we believe that continued solid growth would likely support corporate profits and asset prices.
Third-quarter gross domestic product (GDP) and the Fed’s Beige Book—both released last week—confirmed that the U.S. economy is on solid footing. Third quarter GDP, which grew 3.5%, topped the Bloomberg-surveyed economists’ median consensus forecast. While healthy growth remains the main story investors should focus on, there are signs that global trade tensions are having an impact on the global and U.S. economies. We continue to believe that the impact will be small relative to the overall impact of fiscal stimulus, but we are starting to see the effects of trade tensions appear in the hard economic data, particularly around business spending.
SOLID GROWTH OUTLOOK
GDP grew 3.5% last quarter, boosting average growth over the last two quarters to 3.9%, the strongest pace since 2014 [Figure 1]. Last quarter’s growth in output was driven by strong consumer spending, as well as the biggest contribution from private inventories in years. The strong undercurrent of consumer demand continues to drive the economy, aided by accelerating incomes and fiscal stimulus. Change in private inventories is typically a volatile component of output, so we wouldn’t be surprised to see some of this tailwind reverse and weigh on fourthquarter growth. However, other economic data support the trend of increasing inventories, and we interpret this as a positive sign for continued strong demand. Government spending’s contribution to third-quarter GDP was also higher than average, thanks to a surge in state and local expenditures.
While growth has been strong over the last several quarters, overall confidence has also been boosted by how steady the economy has been. U.S. GDP has grown at least 2% for six straight quarters, the first such streak since the first quarter of 2005.
The Fed’s latest Beige Book, which reflects data collected in the weeks before October 15, shows that Main Street’s outlook aligns with continued steady economic growth. The Beige Book is a qualitative assessment of the domestic economy and each of the 12 Fed districts that is prepared eight times per year. At LPL Research, we maintain a straightforward (but informative) indicator called the Beige Book Barometer (BBB), which measures the difference between the number of times the word “strong” or its variants appears in the Beige Book and the number of times the word “weak” or its variants appears. When the BBB is declining, it suggests the economy is deteriorating; when it’s advancing, it suggests the economy is improving.
The BBB’s headline reading was +76 in October, higher than a September reading of +71 and above its 12-month rolling average of +67 [Figure 2]. There were 95 strong words in the October Beige Book, the most in 18 months. Weak words ticked up to 19, the most since November 2017. However, weak words remain near expansion lows, reflecting a solid macroeconomic environment.
Although both reports showed solid growth, the underlying details hinted at areas of concern, primarily among U.S. businesses amid uncertainty from trade tensions and higher costs. The biggest drag on last quarter’s GDP was a decline in net exports, and both exports and imports were net drags on headline GDP for the first quarter since the fourth quarter of 2016. Business’s fixed investment contributed 0.1% to GDP, about 0.4% below its 3-year average contribution. These numbers are confirmed by recent data on orders and shipments of core capital goods, which, on a year-over-year basis, both slowed in September to levels not seen since 2014.