Fixed Investment - ECRI Leading Index Goes Negative

The ECRI leading index has been bearish on the American economy since late 2017.

Now that the stock market has had 2 corrections in 2018, ECRI can claim victory even though GDP growth has been strong in 2018.

It’s interesting to see media commentators and investors who have been bearish claiming victory on stocks as if the market is destined to go lower or at least stall out.

The market has been volatile lately, but most economic reports don’t suggest a recession is coming soon.

As you can see from the chart below, the ECRI leading index is now down 0.4% year over year.

If the index doesn’t spike, it will look even worse as the year progresses. Comparisons will get tougher. This index is a tool.

Tools are meant to be used, not followed mindlessly. I would find it interesting if this index shows sharply negative year over year growth. But I won’t be clamoring for a recession.

Fixed Investment - A Deeper Look At The Q3 GDP Report

As I mentioned previously, the GDP report was helped by inventory investment. And it was hurt by the trade data which is the opposite of Q2.

This was catalyzed by pre-buying of goods before the tariffs were implemented. Each round of tariffs catalyzes pre-buying.

It was easy to see that inventories were going to be built. And that export growth wasn’t going sustain that Q2 increase. Soybean exports exploded in Q2 and retracted in Q3. This impact didn’t change the fact that growth was very strong in Q2. And that Q3 growth was strong but weaker than Q2.

The chart below shows GDP growth without inventory and trade effects. Q3 growth fell to 3.1%. It’s interesting to see there haven’t been any negative growth quarters in this expansion without these factors.

Inventories are altered by supply and demand factors but don’t change long-term growth. It’s great to see strong export and import growth. However, tariffs make the data erratic.

Fixed Investment - Government Spending Increases

Government spending helped GDP by 0.56% as it grew at a 3.3% clip. This was the biggest help to GDP since Q2 2015 when government spending added 0.7% to growth.

That boost positively manipulates growth, but shouldn’t be thought of as a sustainable trend. You can clearly see the growth impact of the fiscal stimulus in the data.

Q1 GDP was helped by 0.27% and Q2 was helped by 0.43%. Generally, the economy shouldn’t be getting help from the government this late in the cycle.

If the government wants to smooth growth, a rational goal, it would pull back from spending late in the cycle. And then boost spending in recessions.

Because of transfer payments like unemployment insurance, there is a natural spending cushion during recessions even without a stimulus.

Currently, the government is spending $4.1 trillion which is increasing the deficit. Historically, we haven’t seen rates go up when the government has a large deficit. But 2018 looks like that’s changing. Treasuries didn’t spike during the October correction.

Fixed Investment - Weak Business Investment

Since trade was influenced by tariffs, it’s fair to say weak business investment was the worst part of the Q3 GDP report.

Business investment was only up 0.8%. That's much slower than the 8.7% growth in Q2 and the 11.5% growth in Q1.

Investors might be wondering if the stimulative effects from the overseas capital repatriation and corporate tax cut are waning. If businesses aren’t spending, it signals their outlook isn’t strong.

Profits are clearly available to spend more money expanding business. S&P 500 EPS growth has been above 20% all year.

The chart below breaks down the quarterly growth in spending on equipment, structures, and intellectual property.

Spending on structures hurt GDP by 0.26% which is the worst impact since Q4 2015 when it hurt growth by 0.7%. Spending on intellectual property helped GDP by 0.35%. While spending on equipment helped GDP by 0.03%.

Overall fixed investment hurt GDP by 0.04%. That's a sharp change from 1.04%, 1.34%, and 1.1% positive impacts in the last 3 quarters. This was the weakest impact fixed investment had since Q4 2015. That was the trough in the economic slowdown from late 2015 until early 2016.

In early 2016, investors feared a recession partly because of this weakness. To be clear, fixed investment hurt growth by 0.33% in Q4 2015. So the situation was worse than this quarter. However, it’s still disconcerting.

If the consumer would have slowed slightly from last quarter, many would have viewed this as a terrible report.

The consumer should power growth, but the amount it powered growth in Q3 was unsustainable. On the other hand, the strong labor market suggests there should be decent consumption growth.

Fixed Investment - Weak Residential Investment

As you can see from the chart below, residential investment fell 4% in Q3. That's consistent with the weak housing data I’ve reviewed.

Residential investment hurt GDP growth by 0.16% which was the worst since Q2 2017. That’s the 3rd straight quarter residential investment hurt GDP. This is the first 3 quarter losing streak since late 2008 to early 2009.

To be clear, this is a very slight weakness. While the streak in the financial crisis includes very sharp declines.

Either way, the housing market is looking weak. The September new home sales report shows sales fell 13.2% year over year.

Fixed Investment - Weak Hard Data

The trend where economic surprises were positive, but hard data surprises were weak has continued.

When analysts need to lower their expectations, investors follow their lead by selling stocks.

This divergence also occurred in 2017 which was a strong year for the economy and stock market.

Therefore, this divergence is far from a recession or bear market warning. Investors are concerned about any economic weakness. They fear the negative catalysts of a weakening fiscal stimulus and tightening Fed next year.

The weak business investment I discussed in this article only makes investors more nervous.