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Q3 GDP Growth Moderates - October 29, 2018

The U.S. BEA reported on Friday that Q3 Gross Domestic Product (GDP), which is the largest measure of goods and services in the economy, expanded at an annual pace of 3.5%. Consumer spending continued to be a big contributor to GDP, but business spending softened.

Notably, export growth fell sharply from the prior quarter, as companies likely shifted exports into Q2 to beat upcoming tariffs. Meanwhile, inventory accumulation added 2.1 percentage points to GDP. Friday’s release was a preliminary reading, and we’ll get two more revisions over the next couple of months.

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High anxiety

That brings us to the next question. If the economy is expanding a reasonable pace and the near-term outlook is relatively sanguine, what’s going on with stocks? While there’s not a specific catalyst we can blame, there are three factors that are pressuring sentiment. 

  1. Interest rates and a Fed policy mistake. Stocks performed admirably in the face of eight rate hikes by the Fed since late 2015. But a recent spate of Fed speakers (CNBC, various sources) point to continued rate increases, albeit at a gradual pace, and investors may be getting anxious about an overshoot on rates that could put the brakes on economic growth.

  2. China, slower global growth, and tariffs. This may be the biggest reason why we’re seeing the latest round of volatility. For firms that conduct a substantial amount of business overseas, we may see a moderation in earnings growth in Q4 and next year. And tariffs, which weren’t bothering investors a few weeks ago, have taken centerstage. Fear—it will further slow economic growth among some industrial names and boost inflation at home.

  3. A U.S. economic slowdown? Odds of a near-term recession are low, and the Conference Board reported its Leading Index hit another high in September. The Fed expects moderate growth to continue, we’re not seeing tremors in the credit markets, but housing has stalled—one important leading indicator—and auto sales have moderated.  Strong earnings growth this year is expected to give way to a slowdown in 2019. Some investors may be questioning current 2019 profit estimates, which they may view as too positive.

Positives

Upbeat economic data at home and strong earnings have helped cushion the recent slide, and rate hikes are in response to economic growth not rising inflation.

There were soft spots in the Q3 GDP report, but the economy is in good shape overall. Q3 earnings growth has been strong—projected to rise 25.2% (with 48% of S&P 500 firms having reported, 10.26.18, Thomson Reuters). We have received anecdotal remarks about higher costs and anxieties over trade (FactSet, various sources), but the overall numbers are impressive.

Additionally, China’s economy is slowing, which was primarily responsible for a sharp but quick selloff in late summer 2015. However, U.S. exports to China account for just 0.95% of U.S. GDP (U.S BEA, Office of U.S. Trade Representative).

China tremors may pressure short-term sentiment. Still, China isn’t falling off the map, taking U.S. exports with it.

It’s normal

I can’t overemphasize that pullbacks aren’t uncommon. According to LPL Research, the average maximum intra-year pullback for the S&P 500 Index since 1980 is 13.7%; total peak to trough pullback this year has been 10%. 

  • Half of all years (19 out of 38) saw at least a 10% correction during the year.

  • 13 of the 19 years with a correction finished higher on the year.

  • The average total return for the S&P 500 during a year that had a correction was 7.2%.

So far, the S&P 500 Index is down a modest 9.4% from the September 20th peak (St. Louis Federal Reserve thru Oct 24, the recent low). The Dow is down 8.4% from its Oct 3 peak (thru Oct 24, the recent low). 

Perspective

Here is a partial list of all the worries that have forced short-term investors to the sidelines since the bull market began in 2009: the European debt crisis, global growth worries, U.S. growth is slowing, China is slowing, the dollar is too strong, Japan earthquake/tsunami/nuclear disaster, U.S. debt downgrade, fiscal cliff, Obama will be re-elected, Trump will get elected, Fed will cut back bond buys, Fed will start hiking interest rates, falling oil prices, Ebola scare, North Korea, Russia invades Ukraine, ISIS, Syria, Brexit, Greece, Spain, and Italy. That’s a mouthful.

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Each time, investors have refocused on the more favorable economic backdrop when risks, which never disappear, didn’t materially affect the U.S. economy.

Market pullbacks are never fun but are a part of investing. Historically, investors who have avoided emotional decisions and maintained a disciplined approach that encompasses their risk tolerance, even in steep declines, have historically reaped the longer-term rewards.

@LWMLLC