HIGHLIGHTS OF THE WEEK

  • It was a sea of red in equity markets this week as risk off sentiment set in. As it stands, downturn in October has erased all the stock market gains from the start of the year.
  • International developments didn’t help to lift investors’ spirits. The U.S. – China trade negotiations appear to have hit a stalemate, and the European Commission has rejected Italy’s government budget.
  • Domestically, the advance estimate of Q3 GDP was the only major data release this week. After an impressive Q2, the U.S. economy has downshifted slightly in Q3, but at 3.5% (annualized), growth has nonetheless remained very hot and well above potential, giving the Fed ammunition for another rate hike in December.

 

 

Economy is Hot, but Markets Worried About the Future

This was a tough week for financial markets. All major indexes fell precipitously, set to end the week deeply in the red. As it stands, markets’ downturn in October has erased all the gains from the start of the year. While domestic economy remains on solid footing and Q3 corporate earnings have so far exceeded expectations, investors’ conviction that corporate profits may have peaked is growing. Forward-looking investors are increasingly worried about slowing global growth, mounting trade tariffs, rising interest rates and a fading boost from fiscal stimulus.

International developments didn’t help to lift investors’ spirits. It seems that the U.S. – China trade negotiations have hit a stalemate. This threatens to undermine a scheduled meeting between the two presidents in November, and raises the probability of further tariffs.  Also, in an unprecedented (even if widely expected) step, the European Commission has rejected Italy’s budget.

Domestically, there was relatively little on the economic radar this week, with the advance estimate of Q3 GDP the only major data release.  As anticipated, after an impressive 4.2% print in Q2, the U.S. economy has downshifted slightly in Q3, but at 3.5% (annualized), growth nonetheless remained very hot and well above potential (Chart 1). Looking under the hood, consumer and government spending were both exceptionally strong, advancing by 4% and 3.3% in the quarter. Coming on the heels of a similarly robust 3.8% gain in Q2, this marks strongest two-quarter pace for consumer spending in over three years courtesy of a tight labor market and income tax cuts.

Even as consumers are hitting malls in masses, the housing market remains unloved due to deteriorating affordability and lack of supply. Sales of new and existing homes are down by 11% and 6%, respectively, since December (Chart 2). With both homebuilders and prospective buyers facing a number of hurdles, residential investment has been contracting for three consecutive quarters.

Business investment was another fly in an ointment in today’s GDP report. After setting a blistering pace in the first half of the year, spending took a breather in the third quarter, up only 0.8%. While one quarter does not make a trend, given the tensions on trade front this is where the risks lie going forward. Tariffs have already dented business confidence and could lead to further delays in investment in the coming quarters. If investment spending continues to be soft, dampening economic growth, the Fed would likely temper the pace of rate hikes.

All in all, with trade risks percolating and the boost from fiscal stimulus expected to fade, performance over the last two quarters likely represents the high water mark for the U.S. economy. So far though, despite President Trump taking yet another jab at the Fed this week, it certainly looks like current economic fundamentals warrant another interest rate hike in December, bringing the upper end of the target range to 2.5%.

Ksenia Bushmeneva, Economist | 416-308-7392

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