The advance report for third-quarter gross domestic product (GDP) provided further evidence that the modest economic expansion that began in summer 2009 continues apace. The economy expanded at an annualized rate of 1.5% during the quarter, a deceleration from the 3.9% growth rate recorded for the second quarter, but roughly in line with the trend of the past several years.
Importantly, personal consumption remains the primary driver of economic activity, contributing 2.2% to the third-quarter report. That marks the 23rd consecutive quarter in which personal consumption was additive to GDP growth. Government spending added 0.3% to growth, while net exports were flat compared with the previous period. If the math were to stop there, the economy would have expanded at a pace of 2.5%, but a decline of 1.0% in gross private domestic investment brought the headline figure down to the reported 1.5%. The largest culprit in the decline in domestic investment was a shrinkage of inventories, which cost 1.4% of GDP growth. In other words, had inventories in the third quarter remained at the second-quarter level, GDP growth would have been 2.9%. This inventory drag is the biggest since the fourth quarter of 2012.
We remain confident that the ongoing recovery in housing prices and the job market will fuel both the ability and willingness of consumers to keep spending money, and therefore support a continuation of this economic cycle.
Yet there is a curious and widening gap between activity in the manufacturing side of the U.S. economy and the services sector. As illustrated by the nearby graph of purchasing manager sentiment, activity in the manufacturing sector is suffering, even while non-manufacturing activity is robust. These data series are based on monthly sentiment surveys, and the output is a diffusion index, in which data points above 50 indicate expansion, while data points below 50 signal contraction. As the graph shows, the series tend to follow each other rather closely. Indeed, in October 2014, manufacturing sentiment was 57.9 and non-manufacturing sentiment was 56.9, signaling healthy confidence in both parts of the economy. The non-manufacturing measure improved to 59.1 over the past year, whereas manufacturing sentiment fell to 50.1, just on the edge of a recessionary signal. That gap of 9 points between these two measures in October 2015 has only been exceeded once in the history of the data series, at the peak of the dot-com boom in 2000.
What do we read into this divergence? Is this evidence of fragility in some parts of the economy, in spite of relatively robust personal consumption? Is there a risk that poor sentiment in the manufacturing sector might damage sentiment and spending in the far larger consumer sector? The threat is real, but for now we conclude that a sharp drop in energy spending is weighing on the manufacturing side of our own economy while leaving the services side relatively unaffected. Furthermore, the deceleration in economic activity in China is more keenly felt in American manufacturing than in American services companies. We believe that personal consumption will continue to drive a modest expansion in GDP growth, but we will continue to assess the threat that a slowdown in manufacturing poses to our thesis.
The relationship between economic activity and the equity market is usually tenuous at best. Financial markets tend to anticipate inflection points in the economy, although the wisdom of the crowds isn’t always accurate. The market did accurately anticipate the recovery from the global financial crisis: the S&P 500 bottomed in March 2009, whereas GDP growth didn’t turn positive until the third quarter of that year.
The linkage becomes more important as economic and market cycles mature. In the early stages of a cycle, companies can boost earnings by cutting costs and expanding margins. At some point, however, margin expansion reaches a limit, and growth in the bottom line relies more and more on growth in the top line, and therefore growth in the economy. In this seventh year of a bull market, operating margins are close to all-time highs, indicating that future earnings growth (or the lack thereof) will be a function of revenues, not cost cutting.
As of early November, 443 of the 500 companies in the S&P 500 had reported earnings for the third quarter of 2015, and those aggregate earnings were down 15.8% year over year. This drop marks the fourth consecutive quarter of declining earnings for the S&P 500, and, as the nearby graph illustrates, those declines are worsening. To be fair, just as the collapse in energy prices weighs on the manufacturing side of the U.S. economy, so, too, does it weigh on corporate earnings. Yet even if we adjust for the understandable drag of the energy sector, earnings growth was an anemic 0.2% in the third quarter. Energy is clearly a contributing factor to the profit decline, but the challenge to earnings is broader than just one sector.
This by no means spells the end of a bull market, but it does imply that price volatility is likely to remain elevated and that market leadership will likely narrow. Both dynamics have characterized market activity throughout this year. October was a good month across global equity markets and, with the exception of emerging markets, allowed equities to regain ground lost in the August and September sell-off. Nevertheless, for the first 10 months of the year, equity market gains are modest at best. U.S. and developed international markets were up 2.7%, while smaller capitalization domestic stocks were down 0.7%. Emerging markets continue to lag over every time period, off 9.2% so far this year as measured in dollars. Fixed income returns aren’t much different, as bond investors continue to play the waiting game regarding the Fed’s intention to begin raising interest rates.
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