United States / Spotlight Reports
Q3 2018 Macroeconomic Update
by Mario Ismailanji, Analyst; Anna Amir, Analyst; Rachel Hyland, Analyst
Dec 13 2018

Real gross domestic product (GDP) grew at an annualized rate of 3.5% during the third quarter, down from 4.2% in the previous quarter, according to the Bureau of Economic Analysis (BEA). This significant growth is primarily a result of positive trends in personal consumption expenditure, nonresidential fixed investment and federal, state and local government spending. However, poor growth in exports and residential fixed investment limited overall growth. The deceleration in GDP growth in Q3 is primarily a result of decreased exports and decelerations in nonresidential fixed investment and personal consumption expenditure. With continued growth, consumer spending has continued to exert inflationary pressure, leading to a likely fourth interest rate hike in 2018 when the Federal Open Market Committee meets on December 19.

Labor markets and consumer spending

The third quarter of 2018 continued to post gains for the domestic labor market. A total of 529,000 jobs were added during the quarter, with an additional 250,000 being added in October, according to data provided by the Bureau of Labor Statistics (BLS). This increase was close to consensus estimates for the month and helped to drive down the domestic unemployment rate even further, declining 0.1% to 3.7% in September. This brought the unemployment rate down to an average of 3.8% for the third quarter as a whole.

The largest growth in employment for Q3 was in professional and business services, which added 143,000 jobs. This was followed closely by gains in education and health services, which added 127,000 jobs. Professional and business services, as well as education and health services, continued to add jobs through October, further increasing the dominance of those jobs in the current market. The retail industry had the largest decline in jobs, as it lost 43,000 in Q3.

No sector experienced job losses in October, adding to the substantial one-month growth and leading to further increases in wages during the quarter as the labor market continues to remain competitive, forcing companies to offer increased wages to maintain employees. Average hourly earnings for nonfarm employees grew $0.26 over the third quarter to reach $27.25. This increased an additional $0.05 in October, leading to a year-over-year increase of 3.1% from October of last year.

labor

Amid rising nominal incomes, personal consumption expenditure, which accounts for more than two-thirds of all economic activity, grew 0.6% in October. Overall consumer spending is increasing and supporting sectors of the economy that supply discretionary goods and services. The Personal Consumption Expenditure Price Inflation Index (PCEPI), the Federal Reserve’s favored measure of inflation, increased 0.2% in October, or 0.1% when excluding food and energy prices. When considering the latest October data, the PCEPI exhibited a trailing 12-month 2.0% increase, in line with the Federal Reserve’s target. However, when removing food and energy prices, the PCEPI increased 1.8% over the past year. As inflation continues to rise, the Federal Reserve is likely to continue to gradually increase interest rates through the end of 2018.

Fixed investment and construction trends

Fixed capital investment also exhibited signs of growth during Q3, albeit at a slower pace in relation to previous levels. According to BEA data, total private nonresidential fixed investment increased 1.0% to $2,819.3 billion in Q3. While this is slower than the previous quarter’s growth of 2.6%, the level of investment is up 8.1% from the same period last year. This significant increase in investment activity over the past year can be attributed in part to changes to the federal tax code passed in 2017 and enacted at the start of 2018. The Tax Cuts and Jobs Act is a sweeping tax reform reducing the potential tax liability for businesses and enabling them to increase capital expenditure and other capital-intensive projects.

construction

Construction spending is another method of analyzing nonresidential investment. Businesses often spend on building projects when they believe demand growth will make new locations profitable, indicating long-term trends for nonresidential markets. In October 2018, nonresidential construction spending increased a slight 0.1%, reaching $763.8 million. However, construction spending has been somewhat volatile over the past year due to the implementation of steel and aluminum tariffs that have caused input prices for construction projects to increase significantly. Contractors and business may have decided to delay projects due to these increased costs. Over the third quarter of 2018, the largest decline in nonresidential construction was in the conservation and development sector, which decreased 8.6%. Conversely, public safety construction increased over 3.5% during Q3 of 2018.

While nonresidential construction spending has slightly increased, residential construction and housing activity have fallen. In October 2018, residential construction spending decreased 0.5%, reaching $545.1 million. Although new multifamily construction spending increased in October, these gains were offset by decreases in new single-family home construction. Housing permits fell sharply in the latter half of the quarter, falling 5.5% in September alone before rebounding 1.5% in October; this represents a 2.9% decline from October 2017. Similarly, housing permits fell 4.1% in August, resulting in housing permits reaching their lowest level in 2018. Overall, when a six-month moving average is applied, the trend for housing permits has declined. Similar to nonresidential construction, the residential construction market has been hampered by increased labor costs and supply costs associated with ongoing tariff disputes. Additionally, concerns regarding how rising mortgage rates will affect consumer demand for housing have begun to manifest themselves in the market.

Financial markets and monetary policy

Financial markets experienced steady growth in the third quarter of 2018. Volatility remained low throughout the quarter as a majority of trade tensions, inflationary fears and other concerns were already priced into the market. The Federal Reserve maintained its stance on monetary policy and its macroeconomic outlook overall, which was in line with many expectations from investors. The market continued to reach all-time highs in Q3, and officially marked the longest bull market in recorded history.

However, the market experienced a sharp correction early in the fourth quarter, declining substantially in October due to a flurry of events in October that concerned many investors. This includes uncertainty regarding the midterm elections, a likely fourth interest rate hike and continued criticism of the major market drivers in the information technology sector, among other concerns. Additionally, oil and other major market indicators have been volatile, creating further uncertainty among investors. The heavy sell-offs in information technology impacted a large section of the market and was among the hardest hit stock groups in October. The consumer staple sector, however, only experienced mild losses at the beginning of the month but then reversed toward growth for the remainder of the month and through November. This comes as investors rebalance their portfolios to include more blue-chip stocks and other low-risk securities.

The low volatility experienced in the third quarter of 2018 proved to be an ideal time for many companies to make their Initial Public Offerings (IPO). As of the end of Q3, IPO filings were up 17.9% compared with Q3 of 2017. This was the most active third quarter for the IPO market since 2014, with 52 IPOs raising over $11.2 billion in total. Not only was the number of deals up in Q3 2018 from the same quarter a year earlier, but the size of the deal has also increased 24.0% since last year. A large reason for the growth in deal values is the increase in the number of “unicorn” companies, or companies that receive a valuation of over $1.0 billion, that have decided to go public. There were three major unicorn companies that launched in the third quarter of 2018 that together raised almost 40.0% of the total quarter’s IPO value.

The Federal Reserve continued to remain firm on their economic forecast, despite negative comments from other branches of the US government that placed increased criticism and pressure on the organization to stop raising rates.  The Federal Reserve raised rates in September as inflation remained around their target of 2.0% and the labor market continued to remain strong. These rate hikes are the Federal Reserve’s attempt to return to the “new normal” and are aimed to help keep the economy from growing too fast or too slow. As a result, rate changes strongly affect sentiment concerning financial markets. The increase in the interest rate during Q3 raised the yields on many of the US Treasury Bills and corporate bonds. Investors are anticipating one more rate hike on December 19, 2018, with the latest indication from the Federal Reserve being that interest rates are near-neutral.

North American trade

As of September 30, the three North American countries finalized a new trade agreement called the United States-Mexico-Canada Agreement (USMSA). Overall, USMCA is a revised version of NAFTA with changes in a few key areas such as automobile production, dairy markets and intellectual property protections.

In terms of automobile production, the agreement stipulates that by 2023, 40.0% of product value is required to be made by workers earning a minimum of $16.00 per hour. Auto manufacturers set up production facilities in low-wage countries such as Mexico to reduce labor costs. This would disproportionately impact production in Mexico, potentially dissuading further offshoring to Mexico. In addition to changes in hourly earnings, USMCA also increases the North American content requirement from 62.5% to 75.0%, resulting in more automobiles and auto parts being made in North America. Overall, these changes to the automotive industry are expected to impact the cost of cars and trucks for consumers, partially protecting American auto workers from low-wage competition.

trade

Another point of contention for the administration has been Canada’s dairy market, which is highly regulated and protected by high tariffs on certain dairy goods, discouraging foreign competition. As a result of the new trade agreement, Canada has agreed to provide American farmers with greater access to the Canadian dairy market. The United States can now export up to 3.6% of Canadian production value before being subject to the high tariff rates.

Given that NAFTA was negotiated over two decades ago, the new agreement has also made significant changes to intellectual property protections and digital trade guidelines, impacting many industries such as biotechnology, pharmaceuticals and software production. For instance, US drug companies will be able to sell pharmaceuticals in Canada for an additional two years before facing generic competition. USMCA is set to take effect in 2020, but must first be ratified by the three countries’ legislatures, which is expected to be completed in 2019. Once ratified, the three countries will meet after six years for a joint review process, where they will determine if the agreement will remain in place for another 16-year term.

Steel developments

After steel tariffs went into effect for many US trading partners, steel prices shifted dramatically. US steel prices peaked at the beginning of Q3, primarily due to the fulfillment of orders that were placed before tariffs were enforced, but arrived in much of Western Europe, Canada and Mexico after tariffs were already implemented. Since peaking in early July, however, steel prices have declined considerably.

Initially, domestic producers opted to procure foreign steel because it remained a cheaper option despite the 25.0% tariff, as US steel prices were over 50.0% and 80.0% higher than European and Chinese steel counterparts, respectively. At first, this weighed on US steel prices while foreign steel prices remained unchanged, or in fact inched up. In recent months, however, demand for steel in China has waned while oversupply worries have deepened; annual winter production cuts put in place by the Chinese government to combat smog appear to be weaker this year. The oversupply has already begun to weigh on US steel producers, with US price declines intensifying in Q4. Conversely, this development is a boon for industries such as construction or automobile manufacturing that use steel as an input. Moving forward, US and global steel prices will likely hinge on whether demand for steel will harden after a period of cooling or continue sliding. Any further cooling of demand in China will likely result in an influx of cheap Chinese steel into the US marketplace, further shaking up the economic outlook for the United States.

Edited by Stephanie Conte