Q3 GDP Shows More Growth for US and UK

Today we bring you two GDP reports released late last week-showing both the US and UK economies grew in Q3, and highlighting the underappreciated economic fundamentals that underpin this bull market.

Let's start in the Land of Brexit.^[i] Errr, Britain. Q3 GDP was the first comprehensive look at the post-referendum UK economy-up to this point, only narrow monthly data were available. The result: The UK grew 0.5% q/q in Q3 (2.0% annualized), exceeding expectations for 0.3% quarterly growth and notching its 15^th straight quarter of expansion. As Exhibit 1 shows, the latest figure falls right in line with recent history.

Source: Office for National Statistics, as of 11/2/2016. UK quarter-over-quarter GDP growth, Q1 2009 - Q3 2016.

Construction, agriculture and industrial production all shrank from Q2 levels-though the ONS's commentary on monthly data suggest there was some skew from oil production. Despite this, the UK's dominant service sector (which makes up about 80% of the economy) drove GDP, posting 0.8% quarterly growth.

The pound's plunge in the Brexit referendum's aftermath led many to forecast sagging consumption and a heavy industry boost, but neither has yet occurred. Heavy industry pulled back in Q3, in keeping with its extremely choppy long-term trend.

Exhibit 2: UK Industrial Production, 2009 - 2016

Source: Office for National Statistics, as of 11/1/2016. UK quarter-over-quarter industrial output, Q1 2009 - Q3 2016.

Precise consumption figures aren't available yet, but retail data indicate consumers aren't cutting back-sales volumes grew 1.8% y/y in Q3, the swiftest pace since Q4 2014. Plus, Britain's powerhouse services sector-which grew nicely in Q3-largely feeds off domestic consumption, further undermining the claim Brexit would curtail British demand. Like all GDP reports, this is an imperfect, to-be-revised snapshot of economic activity.^[ii] But it beats too-skeptical expectations which broadly anticipated post-Brexit weakness or worse. Reality beating expectations is about all the fuel UK stocks need.

Now across the Atlantic, where US GDP also surprised to the upside. As Exhibit 3 shows, Q3 growth accelerated to 2.9% annualized, the fastest rate since Q3 2014's 5.0%.

Source: Bureau of Economic Analysis, as of 10/28/2016. GDP growth, seasonally adjusted annual rate, Q1 2009 - Q3 2016.

Media greeted the uptick with cheer ("fastest growth in two years"), but this seems a tad overdone-for the same reason their dour take on Q1 and Q2 were. Much of the Q3 boost came from GDP's squishier, more volatile components-exports, inventories and government spending. These same components (or other temporary factors) understated Q1 and Q2 GDP. The skew is now positive, but the underlying trend is basically the same slow-but-steady growth we'd seen before Q3.

Delving in: Exports jumped 10% in the quarter, much faster than imports' 2.3% growth. Since imports (in one of GDP's oddities) count as a negative, the large spread between the two contributed 0.83 percentage point to GDP. Export growth was broad-based, but one contributor sticks out: Soybeans! Poor harvests in Argentina and Brazil forced soybean importers to look elsewhere, and US producers were happy to oblige. This is all well and good, but contributions of this magnitude from exports aren't likely in Q4 and beyond.

Inventories grew for the first time in five quarters, contributing 0.61 percentage point. This is another volatile, subject-to-interpretation category: Rising inventories can suggest firms are stocking up in anticipation of rising demand (good!), or struggling to unload unsold items from last quarter (not good). GDP doesn't differentiate. This ambiguity precludes drawing broader conclusions about the economy. That being said, since Q3 follows five quarters of falling inventories and solid consumption, it seems fair to see this as likely restocking.

Consumer spending grew, but at a much slower pace than last quarter-2.1% annualized instead of 4.3%. This is a fairly significant slowdown, but large swings aren't out of the ordinary. Moreover, it puts growth more in line with where it was during 2015, as Exhibit 4 shows.

Source: US Bureau of Economic Analysis, as of 10/31/2016. Seasonally adjusted growth in real personal consumption expenditures, Q1 2009 - Q3 2016

Imports' 2.3% annualized rise also indicates domestic demand isn't seriously weaker-and that's despite Korean shipper Hanjin's bankruptcy likely knocking imports somewhat. Plus, newly released September data show a consumption rebound-a move suggesting the preliminary report may understate growth.

Finally, business spending picked up slightly, rising 1.2% on the quarter versus 1.0% in Q2. Transportation equipment (a subset of business investment) detracted most, while intellectual property spending grew for the 13^th consecutive quarter, suggesting R&D is sound.

In sum, strictly domestic private sector categories-consumption, business investment and real estate-grew less than exports, inventories and government spending combined. Exhibit 5 shows this is a reversal from recent quarters: Headline GDP growth trailed domestic-focused private sector growth from Q4 2014 through Q2 2016 (when the orange bar is taller)-but then led in Q3.

Exhibit 5: Headline GDP Versus the Sum of Private-Sector Components

Source: US Bureau of Economic Analysis, as of 10/31/2016. Q1 2009 - Q3 2016.

So while this GDP report isn't exactly as robust as most media characterizes it, it is still better than most expected several months ago. Moreover, stocks look to the next 3-30 months or so, not backwards at Q3 GDP or any other old metrics. The Conference Board's Leading Economic Index (LEI) is more useful-it houses forward-looking measures like new orders and the spread between long- and short-term interest rates. The LEI ticked up 0.2% in September, led in part by the interest rate spread, (a good proxy for bank lending profitability). Since records began in 1959, no recession has begun while the LEI was rising. (UK LEI, for what it's worth, held steady in August.) In our view, this is evidence both economies will likely continue growing, providing stocks with further economic support.