An Unremarkable GDP Report and Why Trend Growth is Still 2%

Today’s preliminary Q3 GDP number of 3% growth at a QoQ annualized rate has been met with a mix of relief and hope. Relief that one of the most destructive hurricane seasons ever didn’t completely sap growth and hope that two consecutive quarters of 3%+ growth is evidence that trend growth has, finally in the 9th year of this recovery, accelerated above 2%. While we are careful to not completely write off the decent number, evidence from two components in particular point to the underlying trend of domestic product growth still being closer to 2% than 3%.

The first and most obvious such component is inventories. An analysis of today’s report shows that inventories contributed .7% of the 3% growth for the quarter. Said differently, inventories accounted for 23% of the growth in Q3. The last two times inventories contributed such a large share of growth (4Q16 and 3Q15), they subsequently detracted 1.5% and .6%, respectively, the following quarter. The first chart below shows the QoQ contrition to growth by the major components of GDP.

The second, and more structurally worrying component of GDP growth, is personal consumption expenditure (PCE). PCE is the largest and most stable component of GDP growth in the United States. In Q3 PCE contributed 1.6% of the 3% growth, or a little over half of overall growth. This is the smallest contribution from PCE since 3Q14, suggesting that PCE may possibly be a source of growth in the quarters ahead. PCE’s contribution to growth is represented by the dark blue bar in the chart above.

But here is where things start to get more interesting. Year-over-year growth in PCE peaked back in 2014 and has been on a declining trend since, as the next chart below shows.  It would be one thing if trend PCE growth had room to accelerate, but indicators of household savings and credit point to exactly the opposite.

For example, one way PCE growth could accelerate would be for households to draw down their savings rate. Today that isn’t really an option. The household savings rate stands at 3.6%, which is just about the lowest level since 2007.

The next chart below shows the relationship between savings (blue line, left axis) and PCE (red line, right axis). We can see that before both of the last two recessions consumers significantly reduced their flow of savings to support PCE, just as they have done since 2016. Future GDP growth becomes constrained when the flow of savings is reduced to its practical baseline.

With no more room to cut savings, the other option households have to juice their consumption is to borrow money, bringing forward future consumption to the current period. From 2013 to today household have done exactly that, raising their credit to disposable income ratio to the highest level going back to at least 1958, when the time series began. Low interest rates have most certainly raised the stock of debt consumers are able to service. Still, with debt to income levels so elevated, we wouldn’t view consumer credit as a major source of consumption growth in the quarters and years to come.

All in all Q3 was a decent quarter, but investors need to be careful about extrapolating two quarters of 3% GDP growth. Inventory building was a major source of Q3 GDP growth and not a line item likely to be repeated in the quarters to come. More structurally, PCE may be constrained by the already low level of savings and high level of consumer credit. Both factors suggest trend growth may not have budged off of the 2% mark.