October 28, 2016—U.S. economic growth returned to an encouraging 2.9% in the third quarter of 2016 following three consecutive disappointing readings. As we had expected, there was a significant slowdown in consumer spending to an annualized rate of 2.1%; that had been 4.3% in the second quarter. The slowdown coincided with a slowdown in job growth and was largely expected based on monthly reports on consumer spending that were already available.

Residential investment in new homes was also weak, declining 6.2% in Q3 on the heels of a 7.7% decline in Q2. That was also expected based on the monthly housing starts data, which was already known through September. The encouraging boost came from the parts of the report where we expected but were less sure it would transpire (exports and inventory investment). Exports surged at a 10% annual rate in this report, the fastest growth in nearly three years (see chart below). 

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Source: Bloomberg

Exports had been a drag on growth through most of 2015 as the impact of the appreciating dollar in 2014-15 made U.S. products more expensive to our trading partners. The weakness continued in 2016Q1 before a small recovery in Q2 and now a surge in Q3. The impact of the stronger dollar is now fading, but we do not expect double digit figures for exports going forward.

The other (cautiously) expected contributor to growth was a reverse in inventory investment. This notoriously volatile component of GDP took 1.2% off of growth in Q2 and then bounced back in Q3 to add 0.6%. The chart below shows total GDP growth and GDP growth when removing the impact of the inventories component. Excluding inventories, you can see that growth was not as weak as the reported headline figure in Q2, nor was it as strong as reported for Q3.

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Source: Bureau of Economic Analysis

Elsewhere in the report, the Personal Consumption Expenditures (PCE) core inflation measure was up 1.7% y/y in 2016Q3. We will get the September monthly data on Monday, October 31, but with today’s 1.7% for the full quarter we already know it will come in around 1.7% y/y in the monthly data as well.

Core narrative
Today’s report is very supportive of our core narrative of continued economic growth in the U.S. economy. Going forward, we expect growth to continue, but the underlying details are expected to change. With wages rising in a tight labor market and hiring slowing down, we expect less growth in consumer spending and more capital expenditures by firms. Net exports should continue to improve as well. If either capex or exports fall below our expectations, growth would come in below our forecasts. On the inflation front, we expect the continued firming in core inflation to keep the Fed on track with their December rate hike and two hikes next year.

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