Delta, Shortages Bite in 3Q

The economy rose at a 2% pace in the third quarter, a figure that would have been considered good pre-pandemic but marks a sharp slowdown from the 6.7% pace of the second quarter. The Delta variant flared, cases surged and supply chain bottlenecks worsened. Consumer spending was hit hardest, slowing to a 1.6% pace; that’s less than a quarter of the torrid 12% pace of the second quarter.

Shortages, price hikes and a slowdown in employment gains, notably in the service sector, took a toll on spending in the third quarter. A sharp drop in spending on big-ticket items - vehicles, appliances and furniture - was partially offset by continued but slower gains in spending on services, which surprised to the upside. The more than $2.4 trillion in savings we amassed earlier in the pandemic helped keep spending going but looks on track to be depleted, especially across low- and middle-income households by year-end.

The good news is that credit card usage suggests those trends reversed as the Delta wave abated in October. Halloween is the second largest spending holiday of the year for most consumers and if my neighborhood is any indication, we will be slammed by trick-or-treaters after the pandemic-induced calm of last year. Spending on travel and leisure is expected to soar during the holiday season, although we will be watching the Delta plus variant that has caused a surge in cases in the UK.

Housing was a drag on growth for the second quarter in a row, mostly because of supply shortages. The subprime crisis triggered widespread consolidation in the housing market, which compounded the shortfall in both existing and new homes for sales that occurred when the pent-up demand triggered by the pandemic was unleashed.

Supply constraints extend to rental properties. Surging prices have already crowded out many first-time buyers and supported the development of rental properties. Build-to-rent single-family home projects have picked up over the last year, notably in Florida.

Business investment edged only slightly higher as companies redeployed cash reserves to attempt to ramp up and embrace new technologies. Shortages remain the primary hurdle. The pandemic has triggered the most robust investment boom in equipment and intellectual property since WW-II. This is ushering in large productivity gains, which could have some legs as we saw in the wake of the leapfrog investments made to head off disruptions associated with the change in the calendar to the year 2000, also known as Y2K. (Google it if you don’t know what that means; I am getting old enough to teach some parts of history.)

The problem is that productivity gains accrue mostly to large tech behemoths but are not widely shared. Those firms will continue to gain market share while margin compression for midsize firms will likely worsen. The great surge in entrepreneurship we saw during the pandemic was concentrated in online retail, which will have the hardest time competing with the retail tech behemoths, especially given supply disruptions as we get into the fourth quarter.

Inventories showed the largest upside surprise during the quarter, as they rose instead of falling farther. The rebuilding in inventories alone contributed 2% to overall growth in the quarter after placing a substantial drag on growth during the first half of the year. That is not enough to fully restock dealer lots and store shelves. Ford said it was up to a 20-day supply of inventories by late October, down from a pre-pandemic norm of 75 days; we are not likely to reach those norms in the vehicle industry which is pivoting more toward selling vehicles online.

Backlogs at major ports in the U.S. continued to grow in October. Large retail behemoths are better at circumventing delays and exerting more control over their own supply chains, which means they will gain an even greater edge over small and midsize firms during the crucial holiday season.

Government spending edged slightly higher after losing ground in the second quarter. Another sharp drop in federal spending was more than offset by a rebound in spending at the state and local levels. The stimulus from the pandemic is fading rapidly. Federal spending is poised to fall again in the fourth quarter as supplements to unemployment insurance come to a halt and the continuing resolution for the federal budget kicks in. Congress has failed to agree on passing the bipartisan infrastructure plan, let alone compromise on a budget agreement with more spending for social programs, education and funds to curb carbon emissions.

Federal spending is poised to slow even if the most aggressive versions of the budget could be passed. They just do not compare to the surge in fiscal stimulus during the crisis. We will need the private sector to pick up the baton and carry the expansion going forward.

State and local spending rebounded after contracting in the second quarter. Funds allocated by the most recent round of fiscal stimulus to the states take time to spend. Spending to reopen schools more safely enhanced the bounceback for state and local in the third quarter.

Finally, the trade deficit exploded as producers scrambled to replenish empty dealer lots and store shelves in the third quarter, while exports contracted. Demand abroad suffered from the Delta wave. Travel restrictions to the U.S. for the vaccinated will be lifted on November 8. That will provide an additional boost to travel and tourism in the fourth quarter. The trade deficit was the single largest drag on overall growth in the third quarter when the U.S. economy came roaring back faster than economies elsewhere in the world.

Bottom Line
The economy held up better than expected during the Delta wave. That underscores the importance of vaccines and natural immunity in keeping the economy open even as infections surge. The risk is the onset of winter in the Northern Hemisphere and the emergence of a Delta-plus variant that is spreading in the UK. Vaccinations of kids and the natural immunity achieved during the Delta wave are critical to achieving the rebound in growth we expect for the fourth quarter. After that, employment gains will have to replace the savings that have been drained to keep the economy humming.

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