- GDP grew 2.6% in the third quarter of 2022, better than analysts expected.
- The growth was fueled by exports and government spending rather than private domestic demand.
- The 10-year / 3-Month bond yields have inverted, raising the likelihood that GDP falls within the next year.
On Thursday, the Bureau of Economic Analysis announced U.S. Gross Domestic Product (GDP), a measure of all economic activity, increased by 2.6% in the quarter, outpacing estimates of 2.4%.
The return to growth, which follows back-to-back negative GDP in the first and second quarters, is welcome, given the concern Federal Reserve rate hikes would slow the economy, causing layoffs.
Dig into the data, however, and the picture gets murkier. The headline GDP strength masks trouble spots, adding worry that a recently inverted yield curve could still forecast a recession next year.
GDP growth delivers a mixed message
Exports contributed heavily to GDP growth last quarter, led by surging petroleum products sent to faraway lands to offset Russian supply shortages caused by War in Ukraine. For example, those oil and petroleum exports were a record 11.4 million barrels per day last week, roughly 2 million more than the previous week. As a result, exports contributed 2.8% to the change in GDP, the most significant contribution since 1980, according to Charles Schwab’s Liz Ann Sonders.
It remains to be seen if elevated levels of export activity continue. The Dollar declined over the past week, but it remains historically strong. If energy markets ease because global economic activity dips or geopolitical tension declines, that tailwind could be short-lived.
Government spending also supported growth. Federal, state, and municipal spending flipped positive from negative in Q2. Federal spending was mainly on defense, while state and local spending were primarily on wages.
Although government spending was strong last quarter, it was negative in every quarter since Q3 2020. Spending can continue, but more government spending isn't necessarily the best source of GDP growth.
Instead, you'd want to see robust consumer spending, given it contributes the most to GDP. Consumer spending increased by 1.4% but contributed less than it did in Q2 and was down from 3% growth in Q3 2021. Also, spending was driven mainly by services, primarily healthcare costs. Spending on goods fell by 1.2%. Hardly reassuring.
The non-residential contribution was positive, but that was because of “equipment and intellectual property products” rather than the purchasing of structures. There was a 26.4% decline in residential fixed investment as single-family home construction fell dramatically, offsetting growth in non-residential economic activity and causing an overall 4.9% decrease in the fixed investment component of GDP.
Overall, eliminating the impact of trade, you’re left with domestic GDP growth that was a meager 0.5% in the third quarter, according to Pantheon Macroeconomics’ Ian Shepherdson.
That’s positive, yet hardly barn-burning economic growth worth cheering.
Will GDP be negative in 2023?
The San Francisco Federal Reserve’s number crunchers long ago determined that it's a harbinger of recession when short-term interest rates eclipse long-term rates. That’s an uncommon phenomenon because long-term bonds typically yield more than short-term bonds to compensate investors for the additional time.
Yield curve inversions can happen when the Federal Reserve increases short-term rates like this year to battle inflation. These rate hikes cause Treasury bills and note yields to rise faster than long-bond yields, partly because investors anticipate rates will fall over time because of slowing growth driven by higher funding costs. Long bonds are also historically viewed as a haven alternative to stocks during periods of economic distress, resulting in lower long bond yields (remember, when bond prices are falling, yields rise and vice versa).
Research by the San Franciso Federal Reserve shows every recession since 1955 has been preceded by a yield curve inversion, with one false positive in the 1960s when growth slowed, but the economy avoided an official recession.
Initially, yield curves flatten before they invert. Then, intermediate-term bond yields invert versus longer-term bond yields. Finally, yields on very short-term bills invert versus intermediate-term yields. Generally, inversions signal a recession anywhere from six months to two years in advance.
In March, the 10-year yield slipped below the 2-year yield, increasing the likelihood of a recession within that two-year window. This week, the much shorter 3-month bill yield finally inverted to the 10-year yield. That’s particularly important because the San Francisco Fed has concluded that the 10-year/3-month inversion is the best predictor of recession within one year.
If, as Twain said, history rhymes, then the current inversion means we’ll likely be in a recession next year.
The Smart Play
Consumer spending is the most significant contributor to GDP, accounting for about 70%. Therefore, financially healthy consumers are paramount to the economy sidestepping a recession.
Since early 2021, higher costs of living have hamstrung consumers as inflation has outstripped wage growth. Negative real wages have caused consumers to draw down personal savings and take on record levels of revolving credit, including credit card debt. This pressure is why Walmart and other big retailers said that spending on discretionary items was shifting to essentials earlier this year. It’s also why the consumer spending contribution to GDP has declined for three consecutive quarters.
Steady employment has offset some pain by keeping cash flowing into consumers' wallets. However, employment is a lagging indicator because employers hesitate to let go of workers they’ve invested in heavily. Only when C-suites determine economic weakness isn’t temporary do they bite the bullet and send pink slips.
For this reason, investors should watch the unemployment rate closely. If jobs remain sticky, and the Central Bank’s rate hikes this year tamp down inflation, then perhaps, real wages will improve, taking the brake off consumer spending. Perhaps, this isn’t far-fetched given year-over-year inflation comparisons get ‘easier’ next year. Next year, there could be a tailwind to jobs from increased spending associated with the Infrastructure bill and the misleadingly named Inflation reduction act.
The big question for investors is whether recession risk provides enough incentive for the Federal Reserve to press pause on future rate increases. This so-called pivot from hawkish to dovish policy has been a driving force in bear market rallies this year.
The odds overwhelmingly favor a 0.75% hike next week, followed by another increase of 0.25% to 0.75% in December. After that, decisions should be increasingly data-dependent. If GDP weakens again and unemployment climbs, the path to higher stock prices could be clearer if it causes the Fed to go to the sidelines.
I’ve shared the following table from Martin Zweig’s 1997 book, Winning on Wall Street, many times this year. It shows how much more likely stocks deliver positive returns when the Federal Reserve is friendly (cutting rates) versus unfriendly (raising rates).
Unfortunately, this year's pace of hikes has Zweig’s indicator in the “extremely bearish” camp. Investors can get more aggressive when that changes. Until then, continue to embrace risk control strategies, such as dollar cost averaging into a major market index if you’re a long-term investor, and play defensively, using progressive exposure and stop losses if you’re an active investor.