Steady Growth, Subdued Inflation: Can the U.S. Economy Keep Surpassing Expectations?

by Hubert Marleau, Market Economist, Palos Management

November 1, 2024

The U.S. GDP rose uniformly at a 2.8% annual rate in Q3 for a 2-year streak of steady and above trend growth. It came in below the 3.1% predicted by Wall Street because of a miss in the trade deficit that was much larger than expected and a reduction in inventories. As a matter of fact, the final sales to domestic purchases grew 3.5% without a major decrease in personal savings. Acknowledging that firms are either firing workers or hiring new ones as the Jolts and non-farm payroll reports indicated, a big chunk of the increase in the national output must have come from the ongoing productivity boom, particularly in the technology and oil and gas extraction sector, which has allowed private wages to increase much faster than inflation. Indeed this may extend into Q4 because business spending on software, research and development is humming, with no indication that it's about to stop, thanks to an artificial-intelligence boom. Investment in business equipment alone jumped 11.1%, led by information processing.

The Atlanta Fed’s NowCasting model has an estimate of 2.3% for Q4. In this connection, consumer confidence surged in October, thanks to good feelings about the economy, rather than negative ones about a recession, along with job security and plenty of room to go.

Meanwhile the price index for gross domestic purchases increased at an annual rate of 1.8% in Q3 and only 1.5% for personal consumption expenditures. On Thursday, the Bureau of Economic Analysis (BEA) reported that core inflation pressures held steady in September, registering a 2.7% year-over-year increase. Nonetheless, the headline PCE index - the preferred inflation gauge of the Fed - rose at a small 2.1% pace - just a hair above the 2% official target - with a 3-month annualised rate of 2.05.

Concurrently, in a separate report, the employment cost index, a critical indicator, published by the Bureau of Labor Statistics, showed that wages and benefits had risen 0.8% in the third quarter from the prior one, the smallest advance since mid-2021 and in line with what the Fed wants to see. Interestingly, the swap market for government bonds is suggesting that in one year’s time consumer inflation should run at the annual rate of 2.2%. Given that the U.S. policy rate (5.00%) is roughly 300 bps above inflation, the Fed will very likely reduce interest rates by another 25 bps on November 7, regardless who wins and how the election is won. The CME FedWatch tool placed 98% odds on that on Friday.

Although the economy is doing well on the growth and inflation fronts, the stock market suffered a horrible Halloween sellout, snapping a 29-day streak without a daily loss of 1% or more, as investors feared that big tech may not reap the anticipated benefits from their massive spending on AI after all. Put simply, this is not about companies going about AI investments the wrong way, but about valuations running too fast ahead through sky-high growth expectations. The bar is higher because the market now wants signs of immediate AI-increased productivity because depreciation and energy costs are bound to rise. The big internet firms ( MSFT, META, AMZN, GOOG) invested $60 billion in Q3 alone, with more to come.

Thus a valuation adjustment may ensue, but it won’t detract from the fact that AI will deliver substantial rewards down the road, assuming that the tech sector will command higher multiples than the larger market. Investors should take note that the Magnificent 7 are on course to generate 18%-plus earnings growth year-over-year. The WSJ wrote: “Among S&P 500 companies that had reported through October 31, earnings were up a robust 8.4% from a year earlier, according to an analysis by LSEG I/B/E/S. Excluding the volatile energy sector, which is being hit by lower oil prices, earnings were up 11.2%. Earnings were on average 7.8% better than estimates, far better than the historical average of 4.2%. Revenue growth was 4.8%, or 5.9% excluding energy.

Additionally, one should not discount the possibility that election jitters have played a role in Thursday’s rout. Election lawsuits are piling up, adding complexity and serious concerns over disputes like mail-in ballots. The S&P fared a lot better on Friday, nevertheless it lost 39 points in the last 5 days, and was 2.3% lower than the all-time high of 5865 registered 2 weeks ago.

According to a survey conducted by the Conference Board, a business research group, Americans were asked whether they expected stock prices to increase in the coming year. More than half of the respondents answered yes. Only a quarter anticipated a decline. Price momentum, peak bond yields and acceleration of profit growth expected by corporate executives support their optimism.

 

 

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