What Recent Data Suggest About America’s Economy

Mixed. That is the word most coverage used to describe the US Q3 GDP report, which hit the wires Thursday morning. On the bright side, the 2.6% annualized growth erased Q1 and Q2’s sequential declines and brought GDP to a fresh high, with consumer spending and business investment also notching new records.^[i] But residential real estate detracted bigtime, and two of the three biggest contributors were the relatively less meaningful government spending and net trade. Looming over everything, the most meaningful segment of the yield curve—the stretch between 3-month and 10-year US Treasury yields—slightly inverted in recent days, fanning fears that recession is just around the corner. To be fair, it is possible economic conditions get worse from here. But it isn’t a foregone conclusion, and for stocks, a mild recession probably lacks much surprise power.

The GDP report did clear up one thing: It cuts against the argument that the US economy was already in recession when GDP slid in Q1 and Q2. In both quarters, consumer spending and business investment rose—and even when you factor in residential real estate’s burgeoning slide, pure private sector components overall grew. That repeated in Q3, contributing to GDP more than erasing its Q1 and Q2 slide. But deeper under the hood, the script flipped a bit. Government spending and fast-rising imports pulled headline GDP negative in Q1, while Uncle Sam and falling private inventories were Q2’s detractors. Yet in Q3, net trade added 2.77 percentage points to headline growth as exports rose 14.4% and imports fell -6.9%.^[ii] That isn’t great news, considering imports represent domestic demand and the strong dollar—in theory—should have enabled businesses and consumers to import a higher quantity of goods for less money. So that is something to watch. Meanwhile, consumer spending growth slowed from 2.0% in Q2 to 1.4% as spending on goods contracted again (-1.2%) and spending on services slowed from 4.0% to 2.8%.^[iii] Business investment was more of a bright spot, accelerating from 0.1% annualized growth in Q2 to 3.7%, but residential real estate’s -26.4% plunge weighed heavily on total private sector growth.^[iv]

Now, we aren’t of the school that believes slowing private sector growth is an automatic prelude to a contraction. Past behavior doesn’t predict. However, we also think it is fair to presume elevated inflation forced consumers to cool their jets a bit, and that could continue. Imports’ slide could be a sign domestic demand overall is slipping. Inventories’ continued slide could mean businesses are in cost-cutting mode. A lot of this stuff is open to interpretation.

So yes, we acknowledge the possibility that economic conditions worsen and a recession materializes. However, we don’t think the ever-so-slightly inverted yield curve makes that much likelier than it was last week. Yes, the yield curve is one of the most reliable leading indicators on the planet. But we must consider the why behind that. Some argue its powers exist because when long rates are below short, it means markets are pricing in the high likelihood that a recession will arise and force the Fed to cut rates. That may be so to an extent, but that view ignores the yield curve’s real-world impact. Bank lending is the lifeblood of economic growth, and the interest rate spread is typically its main influence. Banks borrow at short-term interest rates and lend at long rates, making the difference between the two their net interest margin—the potential profit on each new loan. The wider the spread, the bigger the profit, the greater the incentive to lend. A negative spread means the profit well may have run dry, which freezes lending.

Normally, 3-month rates are a good approximation of banks’ borrowing costs, while the 10-year Treasury is the reference rate for most long-term loans. Today, however, banks’ funding costs are far below 3-month rates. Per Bankrate, the national average savings account rate is 0.16%, miles below the current 4.0% US Treasury bill rate. That means banks haven’t passed Fed rate hikes on to consumers, and with deposits still nearly $6.3 trillion higher than the total amount of loans outstanding, they don’t need to raise rates to compete for deposits.^[v] They already have far more than they need, especially with the Fed having scrapped reserve requirements in 2020. Meanwhile, with 10-year Treasury rates also near 4.0%, the prime lending rate is now over 5%.^[vi] That means banks can lend quite profitably, which we think is a big reason loan growth is running north of 11.0% y/y.^[vii]

In our experience, rip-roaring loan growth is inconsistent with a brewing recession. But we also think it is important to consider the possibility that we are wrong. So, what if? Well, when in doubt, think like markets, which look forward. From its January 3 high to its most recent low on October 12, the S&P 500 fell around -25.0%.^[viii] That is a shallow bear market and consistent with stocks’ pricing in a shallow recession. It doesn’t mean a recession is automatic, but it likely shows stocks have spent much of the year considering the possibility. None of this week’s news provided stocks with materially new and negative information. Slower private sector growth? GDP Nowcasts have hinted at that for weeks. A mild yield curve inversion? Historically (and notwithstanding the difference between bank rates and Treasury rates) that would point to only a mild recession. Nothing on the dashboard today points to a severe shock where consumer spending and business investment tank, which is what it would likely take to deliver a negative surprise at this juncture.

Stocks don’t need perfect conditions to mount a recovery—all they need is a reality that goes a little better than feared. Right now, economic expectations are rock bottom. Recent surveys show a majority of economists expect the US to slip into a pretty bad recession early next year. An economy that muddles through or has only a minor slide would probably qualify as positive surprise, and to us, that looks pretty likely. So no, today’s backward-looking GDP report isn’t reason to be bullish. But it isn’t reason to be bearish, either, and nor—in our view—is a very mild yield curve inversion.