How in the world did we manage positive GDP Growth for Q3? Aren’t we supposed to be moving closer and closer to a recession—if not in one already? And if the first two quarters were negative but Q3 is now positive, does that mean we are out of the woods?
These are frequent questions I get from clients and even other financial professionals. There is no doubt that data can be incredibly hard to interpret at times and plenty of conflicting conclusions can be drawn from it. It all comes down to why the data may be showing those results and if there are better ways to measure it.
Here at Smith Anglin, we take a very pragmatic approach to analyzing data. There is no doubt that business activity, housing, and spending are all slowing down. However, is GDP the best measure for all of this. And consider also that this is an economy that experienced historic distortions following the Covid pandemic. Usually, two consecutive quarters of contracting QoQ (quarter on quarter) GDP growth is considered a recession, but multiple factors seem to be at odds with this barometer in the post-pandemic economy.
One influential element is the job market. Unemployment is at 3.5 – 3.7% and 4 million jobs have been added year to date! This has been a very good jobs market. Secondly, we are still seeing incremental growth in retail sales, services consumption, and manufacturing. Yes, credit delinquencies and consumer balance sheets have weakened, but they are realistically just heading back towards a more normal level. A consumer’s average checking account size, according to Bank of America’s Q3 earnings call, is still 2-5x pre-pandemic levels as of October. Yes, that is due to fiscal stimulus checks as well as depressed spending levels millions of Americans were home for 18 months, but that doesn’t change the fact that the consumer is in better shape now. Not to mention the wage growth they have experienced.
Although some of these facts are more a reflection of the pandemic, it has certainly fed its way back into the overall strength of consumer spending, and thus the economy. Ultimately, consumer spending and consumption drive about 60-70% of the US economy. Given all this information, and other supportive data, I still tend to think we have a way to go before a recession announcement (maybe a few months from the actual recession beginning) and those looking to GDP to determine if we are in one are misguided.
To better understand why GDP was negative in Q1 and Q2 we need to dive into the actual equation.
The formula for GDP is (C + I + G + (X-M))
C = Consumption
I = Capital Investment
G = government spending
X = exports
M = imports
Side note, Q1 GDP is an inflation-adjusted measure, nominal GDP is 6.7 – 8.5%, a little-known fact that would surprise most. For Q1 of 2022, the equation looked something like this:
(1.83% + 0.43% + -0.48% + (-0.68%-2.53%)) = -1.4% QoQ Real GDP contraction.
As you can see, the story here seems to be one of falling exports while imports were rising. The import growth of +2.53% needs to be subtracted from exports to reflect output for the domestic economy. The reasons for this import growth are twofold: one, we have had an incredibly strong dollar which made imports cheap and our exports expensive, and two, we had supply chain backlogs for all the durable goods demand that just began freeing itself up.
Additionally, companies were ordering goods like crazy to restock depleted inventories. Most durable goods are imported, not exported. The US is very much a services-based economy. This rationale could even argue why in a modern globalized system where developed economies tend to import and consume more and manufacture less, GDP is not a great measure of the health of the economy. But I digress. The point is if exports relative to imports were more in line with historical levels, you would have seen nearly a positive 2% in inflation-adjusted GDP.
The second quarter’s contraction was a continuation of issues from Q1, again distorted by consumer demand shifts and supply chain issues. To dissect Q2’s contraction of -0.93%, we need to break the capital investment component down into two parts: one, Fixed Investment and two, the change (Δ) in the growth rate of Private Inventories. Following Q1’s massive rebound in imports, mostly of durable goods, companies were chock-full of inventory. A lot of which were from orders placed with the anticipation that durable goods spending was going to continue at its prior trajectory. Boy were they wrong. Once people have upgraded their entertainment centers, appliances, and outdoor patio furniture, they moved on to spending on things like travel, going out to eat, and other services more readily available when an economy is open again. This shift in consumer spending behavior exacerbated the inventory build and created a situation in which there was very little need to build any further inventory from Q1 2022 to Q2 2022.
To illustrate the GDP formula as I did above, the equation for Q2 went something like this:
(+0.99% + -2.73%> of which (-0.72% Fixed Investment + -2.01% Δ Inventory), + -0.32% + (1.88% – 0.45%)) = -0.6% Q2 contraction
That may be a lot to digest all at once, but the takeaway here is that the -2.01% Δ inventory growth rate is really what caused the contraction of GDP in Q2. Had supply chain bottlenecks not been present and consumer spending not aggressively shifted back to services, these GDP numbers would have been positive. Understanding this, it is no surprise to me the resulting positive real GDP of 2.9% for Q3. Even Q4 estimates are shaping up to be positive as well.
When presenting these facts, it becomes clear to me that this is one reason the National Bureau of Economic Research (NBER), the arbiter of US economic health, has yet to hint at recession on the horizon. Usually, it is true that the recession announcement could be made 6-12months from when the recession began, given all the lagging indicators. So, we need to make a distinction between the announcement and the actual recession. Therefore, we may be within months of the of the recession, but even further (6-12months) from the actual announcement. According to their broad definition, a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months”. To determine this, the NBER uses a myriad of economic data points, the major ones being real gross domestic product (rGDP), real gross domestic income (rGDI), the unemployment rate + job market, and finally manufacturing/retail sales. If more of these numbers are contracting than not, the NBER may make that recession announcement.
Given these data points, the only negative was inflation-adjusted GDP, AKA “Real GDP” for Q1 and Q2. But as stated previously, Q3 was positive and Q4 is shaping up that way as well. Just like the other calculations, the driver of those numbers are single economic distortions, creating an artificially inflated rGDP number that isn’t reflecting the economy slowing. However, that does not necessarily mean growth rates are not slowing down; they certainly are when referencing GDI, manufacturing, and retail sales. We just haven’t seen any legitimate contraction in these data points yet. Looking at S&P Global Manufacturing PMIs, we saw the slowest growth for factory activity in October since it contracted in Q2 2020 of the pandemic. The unemployment rate is 3.7% for October, only a slight increase from the prior month. Retail sales figures were positive 1.3% from September to October, beating expectations of a 1% gain and finally, real GDI was positive at 0.3% for Q3 from the prior quarter.
These things are slowing down, but the key is, they are not negative on an absolute basis. The counter to this would simply be that a lot of these numbers are lagging, so although nothing is quite negative yet, it could be soon. I won’t argue with that, and it’s consistent with the Conference Board’s Leading Economic Indicators Index, showing contractions consistently over the past 8 months. I believe it’s reasonable to assume a recession could be on the horizon by Q2 or Q3 of 2023. The real question is will a near-term recession be deeper and longer than what is anticipated? If you would like to have a conversation about how we can help you manage your finances during this time of uncertainty, please feel free to reach out to us by clicking the “How To Get Started” button at the top right corner of this page.
Spencer Hamilton, CFP®
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