Consumer defiance pays off

July 25, 2024

Real GDP grew at a 2.8% rate in the second quarter, double the 1.4% pace of the first quarter. A pickup in consumer spending and a rebound in inventories accounted for 2.4% of the 2.8% surge. The question is whether it can remain there. Spoiler alert: A need to drain now replenished inventories, earlier rate hikes and the cumulative effects of inflation on price levels is expected to subdue growth again in the second half.

Consumer spending picked up across the board, after slowing in the first quarter. Discounting by big-box retailers, who tend to lead the trend for the industry, made a move to roll back prices to make up on volume what they would lose on margin. The gambit paid off as consumers came back and boosted their spending on everything from goods to services. Even vehicle producers sweetened incentives and saw an increase in sales, as dealer lots became bloated with inventories. A massive cyber attack on auto dealers at the end of June shifted some sales from late in the quarter to July. The rebound in goods spending was stronger than that for services, but both were solid.

The closely watched personal consumption expenditures (PCE) index, which the Federal Reserve targets for inflation, cooled to 2.6% in the second quarter. That is getting close to the Fed’s 2% target and is well below the 3.4% surge we saw in the first quarter. Core PCE, which excludes food and energy, was a little warmer, coming in at 2.9% in the second quarter, after rising 3.7% in the first quarter.

Home buying and building sagged under the weight of higher rates. Single-family housing starts were hit the hardest as new construction slowed and inventories ballooned. Existing home sales also slowed. That is where the bulk of sales occur. Inventories remain below the pent-up demand by millennial buyers entering into their peak home-buying years. The promise of rate cuts later this year has left them on the sidelines until they pull the trigger and buy.  Some of what were the hottest pandemic markets have chilled as prices have moved out of reach of local and first-time buyers, while insurance – if you can get it - and maintenance costs have soared. Wealthy buyers migrating to the sunbelt to arbitrage lower taxes bid up the costs of everything else, while insurers are pushing back against the increased risk of property damages in many of those same markets.

Business investment moderated, with investment in new equipment – information technology and transportation – held up better than that for new structures, which cooled outside of chip plants. Investment looks poised to slow further in the second half of the year as a repricing of loans made when rates were lower and the uncertainty surrounding the outcome of the elections causes firms to delay major investments. The policy landscape could change dramatically, depending on the trajectory of tariffs and retaliation on those policies by our trading partners.

There is considerable uncertainty over the extension of corporate tax cuts which are slated to lapse in 2025. Anti-corporate sentiment has intensified across the party lines, with the extremes of both political parties making for odd bedfellows in antitrust investigations and to push harsher legislation for big banks.

Inventories surged after draining aggressively in the first quarter. Retailers scrambled to get under the wire of new tariffs and hedge against the threat of port strikes. Shipping costs have already soared in response to attacks on boats in the Red Sea and the ongoing war in the Middle East. Those inventories will need to be drained in the third quarter. Some retailers got so far ahead of ordering for the back-to-school season and the holidays that Halloween promotions have already appeared online. That is a first for me.

Government spending picked up, after contracting in the first quarter.  A rebound in federal outlays, which had been held back due to budget battles and the continuing resolution in the first quarter, drove those gains. Spending by state and local governments moderated slightly. A shortfall in revenues across many states in fiscal 2024 is expected to take a toll on spending at the state and local levels as we get into the second half of the year, while budget battles are expected to flare again as we approach the elections.

The trade deficit widened, adding to the losses we saw in the first quarter.  Exports slowed, while imports picked up. Growth abroad has been dismal. The rise in imports partially reflects the restocking of inventories. A strong dollar and excess capacity abroad are expected to buoy imports relative to exports in the second half of the year. That should keep the trade deficit from adding much to growth, barring a major pullback by consumers.

Larger concerns of weakness?

The gains come as many worry that growth will not only slow, but we may be seeing cracks in the labor market. Those who have lost jobs are taking longer to find new ones, while the unemployment rate, especially among new college grads, has moved up.

The rise in overall unemployment is very close to triggering what is known as the “Sahm Rule,” an early recession warning. That has prompted many to plead for a July rate cut by the Federal Reserve to avoid a more damaging rise in unemployment. Claudia Sahm, who designed the rule, has argued caution on using her rule to the letter. Much of the increase in unemployment is due to more workers seeking work as opposed to a surge in layoffs.