Recession fears persist despite solid Q3 GDP growth

There was plenty of concern earlier this year when two consecutive quarters of negative GDP raised concerns about the potential that the U.S. was in recession. At the same time, the labor market was strong and consumer spending was growing moderately.

Conversely, the first estimate of third-quarter GDP came in at a more than solid 2.6% headline growth number. However, there are underlying signs that the headline growth number may mask an underlying weakening in domestic demand.

Personal consumption growth slowed to 1.4% as continued weakness in demand for goods partially offset a solid 2.8% increase in spending on services. The shift in consumer spending patterns away from the spending spree on “stuff” has continued, replaced by increased spending on leisure, travel, and other activities that have benefited from reduced social distancing.

The slide in housing accelerated in Q3 as the combination of higher home prices and surging mortgage rates extinguished what had been a red-hot housing market not that long ago. The 26.4% annualized decline marked the weakest quarter for housing since the second quarter of 2020, when lockdowns sent the economy into a steep slump.

The steep decline in housing, coupled with slower personal consumption growth, serves notice that the consumer sector is feeling the effects of inflation and higher interest rates. Taken together, consumer spending and housing were flat in Q3. That’s bad news for near-term growth prospects but good news for a Federal Reserve that is looking for evidence that their aggressive tightening is having the desired effect.

Overall growth for the quarter would have been much weaker but for two factors: good news on the trade deficit and, to a lesser degree, a surge in defense spending in the form of aid to Ukraine. Exports grew for the second consecutive quarter and the trade gap was further aided by a reduction in imports. Global trade has been choppy as the unkinking of supply chains, China’s zero Covid policy, and the restocking of inventories have distorted the picture at times. Although the value of net exports pales in comparison to domestic demand, improvement in the trade balance was a key driver of GDP growth in recent months.

The bottom line? Top-line growth improved in Q3, but that improvement doesn’t signal an “all clear” for recession worries. The all-important consumer sector is feeling the combined effect of inflation and higher interest rates, despite an abundance of cash stockpiled since 2020. That loss of momentum appears poised to continue as the full effects of Fed rate hikes and the tightening of financial conditions take hold.