Government and Consumer Spending Juice GDP

Real GDP rose at a 3.5% pace in the third quarter with persistently strong gains in consumer spending and the ramping up of defense spending fueling overall gains. Higher prices at the gas pump could put a damper on those gains in the fourth quarter. The good news is that the number of hours worked and wages are expected to edge higher. Federal government spending is expected to remain strong, at least through the summer of 2019. The budget passed for fiscal years 2018 and 2019 included hefty increases in defense spending. Orders for aircraft and parts in the defense sector surged at a 119% pace in September alone.

Business investment was tepid, as the uncertainty associated with tariffs and escalation of trade tensions with China have intensified. The word “tariffs” was mentioned as a concern by businesses 41 times in the 38 pages of the Federal Reserve’s recent Beige Book report.

Inventories were built more rapidly than expected as firms scrambled to order ahead of additional tariffs. The rise spanned retailers to manufacturers who worry about supply chain disruption associated with additional tariffs. Many firms are stuck with China as their sole supplier for key inputs with no domestic counterpart to shift demand and orders toward. The downside is that those inventories will have to be drained going forward, which will likely take a toll on fourth quarter GDP.

Separately, residential investment contracted for the third consecutive quarter. Rapidly rising home prices coupled with rising mortgage rates have begun to lock out first-time buyers from the market. The hope is that rising incomes, especially among recent college graduates, will breathe some life into housing in the months to come. The overhang of student debt could make that more difficult to achieve than during previous cycles.

Bottom Line
Overall economic growth remained robust in the third quarter. The composition of gains was uneven and raises red flags about the toll that tariffs could take on the economy including the housing market, which imports materials. Housing is also typically the first sector to peak during an economic expansion.

Growth appears to be slowing a bit in the fourth quarter but will remain well above the economy’s potential growth rate. That suggests we will see further declines in the unemployment rate.

Separately, the president is slated to meet with his Chinese counterpart at the Group of 20 meeting in late November. A de-escalation of tensions would be a plus for the economy. The White House, however, has deliberately dampened hopes of a meaningful breakthrough.

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