Economic growth continues at a moderate to brisk pace as evidenced by the 3.9% growth rate in the third-quarter Gross Domestic Product, but that solid overall growth failed to create a basis for more normal trading patterns in the debt and equity markets.
The initial GDP report for the third quarter showed brisk growth at 3.9%, which was well above most estimates and followed the 3.8% annual rate advance in the second quarter. Those back-to-back GDP growth rates must be put into perspective. The last eight quarters have averaged 2.5% GDP growth, which is a clearer reflection of the long-term trend in the economy.
Slower GDP Growth Ahead
Slower growth—in the 2% to 2.5% range—is a reasonable expectation for GDP over the next couple of quarters. In its Oct. 31 statement, the Federal Open Market Committee said that "the pace of economic expansion will likely slow in the near term" and cited the "intensification of the housing correction" as one reason for below-average GDP growth.
That outlook for slightly sluggish growth does not reflect a fundamental deterioration in the underpinnings of the economy. It merely is one short-term snapshot in the nations economic long-term growth.
Consumer Spending Rises at a Measured Pace
Consumer spending advanced at a 3% rate the third quarter. While that is below the galloping pace recorded in the past couple years, it reflects a healthy level of spending in the face of the sagging housing market.
Exports Surge 16.2%
Exports were a major source of strength in the third quarter. They escalated at a 16.2% pace, which was more than double the 7.5% growth in exports posted in the second quarter. The export of goods, as opposed to services, surged 23% higher.
The Job Market Remains Healthy
The job market continues to hold up as evidenced by the 166,000 employment gain in the October report. That was almost twice the level as the markets had expected. It is consistent with the weekly unemployment claims, which have been stable and low for almost two years.
Job gains in October occurred in professional and business services, health care, and leisure and hospitality. Construction employment showed little change, while manufacturing employment continued to decline.
Signs Point to Lower Growth in Manufacturing Sector
Some signs of slower growth continued to appear in the manufacturing sector. The ISM Index has been trending lower in recent months. In October, it fell to 50.9% from the 52% level in September.
For the past 12 months, the average has been 52.4% with a high of 56% in June 2007 and a low of 49.3% in January 2007. A reading above 50% indicates the manufacturing sector is expanding, while below 50% signals the sector is contracting.
Housing Sector Slides Still Lower
The feeble housing sector of the economy provided no surprises in the third quarter. Investment in residential real estate plunged 20.1%, following a drop of 11.8% in the second quarter. The quarterly declines have been occurring since the fourth quarter of 2005.
Favorable Trend on the Inflation Front—for Now!
The Fed is seeing a favorable trend in the inflation outlook as its targeted inflation index, the core PCE Deflator, has been below the 2% target for the past four months. Despite that favorable trend, the Federal Open Market Committee stated that "recent increases in energy and commodity prices, among other factors, may put upward pressure on inflation."
Inflation concerns were put on the back burner, temporarily, by the Fed when it lowered rates again at its Oct. 31 meeting to a 4.5% target. The latest cut could be the last move the Fed makes. The reason is that it is becoming more difficult for the Fed to justify additional rate cuts with the last two quarters showing nearly a 4% growth in the economy.
The Fed also provided some rather clear signals that rate cuts are on hold. The FOMC meeting statement assessed "the upside risks to inflation roughly balance the downside risks to growth."
Stock Markets Stumble on Credit Concerns
The stock markets have been stumbling in reaction to credit concerns. Merrill Lynch and Citigroup took huge write-downs in the third quarter to reflect the deteriorating market for the sliced-and-diced securitized mortgage securities they held. The two firms also said "good-bye" to their top honchos. The stock market remains volatile and reflects the turmoil in the credit markets.
All Aboard the Treasury Train!
Negative news on the corporate earnings front—particularly in the financial sector—sparked another move to safety on the Treasury train. Treasury bill rates fell lower, and the spread of T-bills to fed funds returned to about 50 basis points below the normal spread. A month ago, the fed funds rate had been closing the gap.
Spreads in the corporate market once again widened, and volume in the commercial paper market has declined further. Concerns raised by a weak dollar and higher commodity prices may cause the yield curve to steepen in the months ahead.
What's the Future?
At some point, the housing sector will bottom out and stop being a heavy drag on the economy, and with the Fed pursuing a stimulative monetary policy, look for the economy to resume above-average growth in the second half of 2008. As that occurs, bond yields could begin to trend higher in conjunction with a steeper yield curve.
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