Trade Impact Creeps In

Third-quarter GDP may also be heavily influenced by two highly volatile components: inventories and net exports, both of which also may have been affected by trade. The change in private inventories weighed on GDP in the second quarter, making the strong growth level even more compelling. Rebuilding inventories may make a strong contribution to third quarter GDP, with the Atlanta Fed model attributing 2.2 percent of the overall 4.1 percent growth expected to inventories. On the other hand, the model has net exports reversing direction after strong activity ahead of new tariffs in the second quarter.

These changes exemplify trade’s growing impact on output, for better or worse. Wholesale inventories have been climbing at the fastest pace since 2015, indicating companies’ expectations for stronger consumer demand, which is supported by the lowest inventory to sales ratio in nearly four years. However, the most recent uptick is partially due to supply chain disruptions, which could eventually weigh on growth. Unfilled orders for durable goods continue to increase with inventories, hinting at breakdowns in the supply chain as manufacturers and firms digest growing labor shortages and rising input costs. We attribute these disruptions to stress from trade tensions, a tight labor market, and the impact of extreme weather in regions of the country. An increase in exports boosted second-quarter GDP as purchasers rushed to beat the implementation of retaliatory tariffs, but the glut of exports was just borrowing growth from future quarters. U.S. exports have dropped for three straight months for the first time since January 2016, as the amount of levied Chinese goods is now $250 billion and the U.S. dollar hovers near a 15-month high. While we are optimistic that the U.S. and China will eventually reach an accord on trade, we expect these conditions to persist until that agreement.

What About The Fed?

Despite another quarter of potentially strong growth behind us, we don’t expect the Fed to accelerate the pace of rate hikes, as inflation remains manageable. We believe the solid macroeconomic environment combining solid growth and low inflation reflects the effectiveness of Fed policy, while at the same time effecting a smooth transition from monetary policy to fiscal policy as the driver of the business cycle.

Conclusion

If third-quarter GDP comes in near consensus Friday, it will be our sixth consecutive quarter of GDP growth above 2 percent, a level of stability not seen since 2004, reflecting a positive overall growth environment in the United States. We continue to emphasize that while we may see some impact from trade on the data, the impact of fiscal policy continues to be much larger. We expect more of the same from the third quarter and looking forward—a moderate pace of economic growth accompanied by gradual interest rate increases, potentially resulting in U.S. GDP growth near 3 percent this year and sustainable at 2.5–3 percent growth in 2018.

John Lynch is chief investment strategist for LPL Financial.

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