U.S. 2Q18 GDP Advance Report

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1 Contacts Felix Boni Chief Credit Officer Jordy Juvera Economics Associate Cynthia Pérez Economics Analyst HR Ratings comments on the strong 2Q18 GDP report and the implications in terms of growth, business investment, consumer spending and trade, including its impact on lowering inflation. General Comments US GDP grew a very strong 4.06% in 2Q vs. 1Q driven by nonresidential (or business) fixed investment, trade and consumer spending. Reducing growth was the reduction in inventory change (in this case a decline in inventories) and continued weakness in residential investment. Government spending increased although its relative contribution to GDP was weak except for the strong increase in defense spending. We comment in some detail on the impact of the smaller trade deficit. Quarterly details are seen in Table 1 below which also shows the relative contribution of each component to the absolute change in GDP 1. Table 1: Quarterly Evolution of US GDP in Real 2012 Dollars Billions Annualized change vs. Immediately prior period Abs. Chg. Bns. Part. in Chg. Mar-18 2Q vs. 1Q 1Q vs. 4Q Gross Domestic Product 18, % 2.29% 2.22% 4.06% n.a. Personal consumption expenditures 12, % 3.92% 0.52% 3.99% % Goods 4, % 6.85% -0.61% 5.92% % Durable goods 1, % 12.65% -2.03% 9.31% % Nondurable goods 2, % 3.98% 0.12% 4.23% % Services 8, % 2.61% 1.04% 3.12% % Gross private domestic investment 3, % 0.78% 9.57% -0.48% % Fixed investment 3, % 6.23% 7.96% 5.41% % Nonresidential 2, % 4.85% 11.51% 7.35% % Residential % 11.12% -3.40% -1.06% % Change in private inventories (28) n.a. n.a. n.a. n.a % Net exports of goods and services* (850) -0.68% 27.71% 1.39% % % Exports 2, % 6.65% 3.55% 9.26% % Imports 3, % 11.77% 2.98% 0.47% % Government consumption & investment 3, % 2.38% 1.54% 2.14% % Federal 1, % 4.07% 2.64% 3.45% % National defense % 2.94% 3.01% 5.53% 9.8 5% Nondefense % 5.71% 2.12% 0.58% 0.7 0% State and local 1, % 1.38% 0.89% 1.36% 6.5 4% Residual 10 n.a. n.a. n.a. n.a % GDP less change in inventories 18, % 3.39% 1.90% 5.39% n.a. Source: HR Ratings w ith seasonally adjusted data at annual rate from the BEA. *A negative number indicates a deficit in the balance of trade and thus statistically reduces GDP. Positive changes indicate a decrease in the deficit and thus a positive impact on GDP. Sustainability of Growth The strong quarterly number has given rise to substantial debate as to its significance including its sustainability and relationship to policy changes. In general terms, it does appear that the contribution of business investment has been strong and potentially enduring. Whether it is due to policy changes (less regulation) lower corporate taxes or other elements is debatable. What is less clear is the sustainability of the strength of consumer spending. The 3.99% is quite strong but it does come after a weak first quarter (0.52%) which in turn came after a strong 4Q17 (3.92%). For the first half of 2018, consumer spending advanced a moderate 1 This report represents a change in the base year from 2009 to Hoja 1 de 11

2 2.22% vs. the second half of 2017 at an annualized rate. For the four-quarter period (LTM) ending in the June quarter consumer spending increased by a moderately stronger 2.52% (see Table 2 below) against the same period ending in June Whether the June quarter s result represent an accelerated rate of growth that will continue, although possible, remains to be seen. This is especially the case for services which advanced at an unusually rapid rate in the second quarter of 3.12%. We believe it is relevant to note that the positive contribution to GDP of the strong quarter in trade (of $52.4bn in real 2012 dollars) was comparably offset by a similar ($58bn) decline in inventory change. These offsetting changes do not appear to be sustainable and are probably interrelated. Table 2: Last Twelve Months Evolution of US GDP in Real 2012 Terms (LTM) Billions Annual change vs. Prior year LTM Abs. Chg. Bns. Part. in Chg. Mar-18 2Q18 vs. 2Q18 vs. 4Q16 4Q16 Gross Domestic Product 18, % 2.22% 2.38% 2.56% 457 n.a. Personal consumption expenditures 12, % 2.53% 2.48% 2.52% % Goods 4, % 3.68% 3.87% 4.03% % Durable goods 1, % 6.85% 6.89% 6.84% % Nondurable goods 2, % 2.10% 2.36% 2.62% % Services 8, % 2.02% 1.85% 1.84% % Gross private domestic investment 3, % 4.79% 5.63% 5.63% % Fixed investment 3, % 4.83% 5.05% 5.26% % Nonresidential 2, % 5.26% 5.84% 6.20% % Residential % 3.34% 2.41% 2.09% % Change in private inventories 21 n.a n.a. n.a. n.a % Net exports of goods and services* (874) 7.94% 9.21% 8.69% 6.23% (51) -11.2% Exports 2, % 3.02% 3.45% 4.20% % Imports 3, % 4.56% 4.76% 4.72% (152) -33.4% Government consumption & investment 3, % -0.07% 0.14% 0.43% % Federal 1, % 0.72% 1.18% 1.45% % National defense % 0.65% 1.31% 1.42% % Nondefense % 0.82% 0.97% 1.48% 7 1.6% State and local 1, % -0.54% -0.47% -0.18% (3) -0.8% Residual 12 n.a n.a. n.a. n.a. (14) -3.0% GDP less change in inventories 18, % 2.22% 2.26% 2.49% % Source: HR Ratings w ith seasonally adjusted data at annual rate from the BEA. *A negative number indicates a deficit in the balance of trade and thus statistically reduces GDP. Positive changes indicate a decrease in the deficit and thus a positive impact on GDP. Measuring Growth Measuring and comparing relative rates of growth is not a simple exercise and can be done in different ways. For example, the average quarterly growth rate of the first half of 2018 for GDP was an impressive 3.14%. Breaking the 3% barrier has real significance, both economically and politically. However, if we compare the first half vs. the second half, annualized growth in GDP was a still strong but less impressive 2.70%. Likewise, the average growth rate during the four quarters that ended with the 2Q18 number was a strong 2.85%. However, growth in GDP was a moderate 2.56%. Relative economic performance: Obama and Trump There is also the issue of the performance thus far of the economy under President Trump vs. its performance under President Obama. First, there is the question of when we can assume that President Trump (or any incoming president) can take responsibility for Hoja 2 de 11

3 growth during his term, given the multiplicity of factors that explain growth. Second, in evaluating the Obama presidency how do we evaluate his first administration coming immediately after the 2008 financial crisis. Did this make for an easier comparison or should we assume that he needed more time to overcome the difficulties that originated in that crisis. For the Trump administration s record, the four quarters ending in June (beginning with 3Q17) might be a reasonable early evaluation. As stated above that was 2.56%. For the Obama administration one measure would be growth during his second administration, leaving aside how we evaluate the first term. Thus, from the LTM ending in 4Q12 through the LTM ending in 4Q16 the economy grew at an average annual rate of 2.18%. Rising Inflation There has been speculation that the strong growth reflected in the second quarter data increase the likelihood that the Fed will, indeed, make two additional interest the hikes by the end of the year. That likelihood might also be increased by the fact that headline PCE inflation was also revised upwards. Thus, YoY headline PCE inflation rose 1.80% and 1.89% for 4Q17 and 1Q18; this in contrast to Base 2009 reports of increases of 1.68% and 1.76%. Furthermore, the YoY headline PCE inflation accelerated to 2.16% in the second quarter. Overall GDP Growth In Graph 1 we show the evolution of GDP both in terms of LTM annual growth and in terms of annualized quarterly growth vs. the immediately prior period. Graph 1: LTM Annual and Quarterly Annualized GDP Growth (Base 2012) 6% 5% 4% 3% 2% 1% 0% LTM vs same period prior year. Annualized quarter vs. immediately prior quarter (1%) Source: HR Ratings w ith seasonally adjusted data from US BEA The graph shows how the Obama presidency ended () at the beginning of a downturn from strong LTM growth which reached a high of 3.23% in the September quarter. The growth also shows the exceptional strength of the second quarter which is even more impressive given that it does not come off comparably weak prior quarter which is often Hoja 3 de 11

4 case (e.g., 2Q14 and 4Q11). On an LTM basis, the change in direction beginning in 1Q17 is apparent. The longer term trend through 2Q18 does not appear to have been affected by the strength of the second quarter. Consumer Spending In Graph 2 we show the evolution of consumer spending from the same perspective shown in Graph 1 for GDP. The extreme volatility of the quarterly results is especially apparent. The revisions presented in the Base 2012 data compared with the numbers previously reported from the Base 2009 show spending weaker than they were originally reported as being, making a stronger rebound more likely. Thus originally, the Base 2009 information had shown that consumer spending in 4Q17 and in 1Q18 had advanced 4.04% and 0.86%. With the Base 2012 data, consumer spending rose a slightly more modest 3.92% in the fourth quarter and a much smaller 0.52% in the first quarter of Additionally, the new data base provides a substantially different picture of the personal savings rate, variations in which can have a major impact on consumer expenditures. In terms of the second quarter, for example, the personal savings rate fell from 7.16% in 1Q18 to 6.80% in 2Q18. We estimate that had the savings rate remained the same spending would have increased a still strong but weaker 3.42% instead of 4.0%. The level of and changes in the personal savings rate were substantially modified with the new data base. The level of savings has been revised substantially upwards, leaving more room for declines that would increase consumer spending. Thus, for the years the personal savings rate rose from and average to 6.10% to 7.55%. Additionally, the Base 2009 data show that in 2016 and in 2017 the personal savings rate fell by strong 20% and 44.4% relative to their average. In the case of the Base 2012 data, the declines were a much more modest 11.4% and 11.7% respectively. Graph 2: LTM Annual and Quarterly Annualized Consumer Spending Growth (Base 2012) 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% LTM vs same period prior year. Annualized quarter vs. immediately prior quarter 0.5% 0.0% Source: HR Ratings w ith seasonally adjusted data from US BEA Hoja 4 de 11

5 Business Investment Graph 3 shows the evolution of business investment on a LTM and quarterly basis. There we see a downward trend during 2014 and 2015 and the beginnings of an uptrend clearly visible by the second half of However, it is also possible to detect the possibility that the acceleration is peaking and could soon begin a slight downward trend from the currently strong LTM growth of 6.20%. Graph 3: LTM Annual and Quarterly Annualized Business Investment Growth (Base 2012) 23% 18% LTM vs same period prior year. Annualized quarter vs. immediately prior quarter 13% 8% 3% (2%) (7%) Source: HR Ratings w ith seasonally adjusted data from US BEA One might argue that the change in trend in LTM business investment beginning toward the end of the first year of the Trump presidency is due to the promise of regulatory change and that its continuation (albeit with moderating rates of acceleration) is due to corporate tax changes. One, however, could also argue that the change in trend is merely the cyclical pattern that business investment follows with policy only having a marginal impact. However, we would note that while the tax changes might be having a positive impact on business spending (and in some cases on consumer spending) the negative impact on the fiscal deficit is clear. Trade Comparative evolution of the deficits: real vs. nominal The trade deficit in real terms declined by a dramatic 21.3% in the second quarter. Although this kind of volatility is not exceptional (the deficit increased by 27.7% in 4Q17) it is unusual and, more relevantly, unlikely to be easily repeatable. The decline in the deficit was driven by the 9.26% rise in exports which was probably related to attempts to ship goods before the levying of higher tariffs in retaliation to the administration s trade policy. For their part imports increased by very small 0.47% which is inconsistent with the strong increase in Hoja 5 de 11

6 durable goods consumer spending and the strength of business investment and could be related to import restrictions. This imbalance is not likely to persist. Although the reduction in the trade deficit had a positive impact on GDP the net effect was largely nonexistent if we assume that the dramatic change in inventory change was significantly related to the surge in exports and the relatively negligible increase in imports. As we mentioned above, while the reduction in the deficit contributed $52.4bn in 2012 real dollars the decline in inventory change reduced GDP by $58.3bn 2. The evolution of the trade balance is seen in Graph 4, again presenting the information on a LTM and quarterly basis. However, in this case we present the absolute amounts rather than percentage changes. We do this given the extreme volatility of quarterly changes. However, as we shall see this presentation also gives us additional insight into the relevance of the trade sector when we compare real dollar to nominal dollar values. The graph clearly shows the decline in the deficit in the second quarter, representing, arithmetically, at least, a powerful addition to GDP. The graph also shows the dramatic increase in the deficit on an LTM basis beginning in the first quarter of This is despite the positive impact of fracking technology for reducing the petroleum deficit. Graph 4: LTM and Quarterly Net Exports in billions of constant 2012 dollars (450) (500) (550) (600) (650) (700) (750) (800) (850) (900) LTM Quarterly (950) Source: HR Ratings w ith seasonally adjusted data from US BEA However, the dramatic increase in the size of the deficit in real dollar terms is in large part related to an increase in the terms of trade 3. Thus, on a nominal term basis, the picture is quite different although we also see a rising trend in the deficit. The increase has been for a shorter period and more modest. The evolution of the deficit in nominal terms is seen in Graph 5 below. 2 During the thirty-two quarters since 2019, the change in inventories has been negative on only five occasions with the $28bn in 2Q18 by far being the largest. The change in the change in inventories of $58.3bn was exceeded only by the $88bn change in 3Q11. During the financial crisis of declining inventories were common. 3 In this case a decline in the price of imports in relation to the price of exports. Hoja 6 de 11

7 Thus, while in real terms the deficit decreased at an annualized rate of 21.3% in 2Q18 vs. 1Q18, the decrease in nominal terms was only 4.4%. Graph 5: LTM and Quarterly Net Exports in billions of nominal dollars (425) (450) (475) (500) (525) (550) (575) (600) (625) LTM Quarterly (650) Source: HR Ratings w ith seasonally adjusted data from US BEA A more direct comparison of the deficit in nominal and real terms is seen in Graph 6 below. There we show on an LTM basis the evolution of the deficit relative to GDP. In nominal terms the deficit is much smaller and has remained relatively constant at between 2.75% and 3.0% of GP. In real terms, however the deficit has grown rapidly relative to GDP increasing from around 3.25% in early 2014 to 4.78% currently. For the last two quarters. However, the LTM metric has remained relatively stable. This stability is somewhat consistent with the slight reduction in nominal terms of the LTM metric with the 2Q18 information. Hoja 7 de 11

8 Graph 6: LTM net exports as percentage of GDP in nominal and real terms (2.50%) (2.75%) (3.00%) (3.25%) (3.50%) (3.75%) Nominal Terms Real 2012 Terms (4.00%) (4.25%) (4.50%) (4.75%) (5.00%) Source: HR Ratings based on seasonally adjusted data from US BEA. Assuming that the second quarter reduction in the deficit was an oddity, it will be relevant to see what occurs in the third quarter. Does the deficit really matter? The intense polemic surrounding President Trump s trade policy has given rise to arguments over the relevance of the trade deficit. On the one hand, it clearly (by definition) has a negative arithmetical effect on GDP. One could also argue that it represents an opportunity cost relative to the domestic production that could have materialized in lieu of imports that met the demand. On the other hand, of course, is the argument that imports make the economy more competitive by facilitating the purchase of the best goods at the best price. In terms of intermediate and investment goods, imports make the economy more productive by reducing the costs and increasing the competitiveness of final products and improving productivity through the importation of capital goods. An interesting question is the implication of the use of the dollars that surplus economies have by exporting more than what they import. These can be used to invest in the deficit economy. They purchase, for example, government securities, facilitating fiscal deficits. This will generate a future income stream for the surplus economy and represent a burden on the deficit economy. Is this good or bad? If the deficit is used to finance productive investment the negative impact might be lessened. But if the deficit is generated by consumer spending? The deficit is also used to purchase control of deficit economy companies. This is a valuable source of financing although it too provides a future stream of dividend income. But does it also permit the surplus economy to obtain valuable technology giving it a competitive edge in the future? Or does the surplus economy bring its technology to the company it has purchased. Hoja 8 de 11

9 Trade and inflation Thus, the evaluation of the impact of deficits is not an easy task. However, what is somewhat more easily ascertainable is that trade appears to be having a positive impact on limiting inflation. A major consequence of which is lower interest rates. This is reflected in the difference in the nominal and real trade deficit. The deficit is higher in real terms because of the lower nominal value of rising imports. The higher real value reflects the fact that tradeable goods, especially imports, experience less inflation (indeed, deflation) than the economy overall. This is seen in an analysis of the deflators. Thus, in 2Q18 the deflator for imported goods was In contrast, the overall GDP deflator was This means that imported goods had experienced 20% less inflation than the economy overall since For their part, the deflator for goods exports was 94.3, significantly higher than imports but still less than the overall deflator. The deflation experienced by tradeable goods (especially imports) not only is an incentive for their purchase but also helps to keep overall inflation down. In the case of the consumer expenditures deflator, this reached 108 in the June quarter and was the result of for services and 95.4 for goods, with durable goods at an even lower 87.8, near the level for imported goods. Hoja 9 de 11

10 HR Ratings Senior Management Management Chairman of the Board Vice President Alberto I. Ramos Aníbal Habeica Chief Executive Officer Fernando Montes de Oca Analysis Chief Credit Officer Chief Operating Officer Felix Boni Álvaro Rangel Deputy Chief Credit Officer Pedro Latapí Public Finance / Infrastructure Financial Institutions / ABS Ricardo Gallegos Fernando Sandoval ricardo.gallegos@hrratings.com fernando.sandoval@hrratings.com Roberto Ballinez roberto.ballinez@hrratings.com Corporates / ABS Methodologies Luis Quintero Alfonso Sales luis.quintero@hrratings.com alfonso.sales@hrratings.com José Luis Cano joseluis.cano@hrratings.com Regulation Chief Risk Officer Head Compliance Officer Rogelio Argüelles Rafael Colado rogelio.arguelles@hrratings.com rafael.colado@hrratings.com Business Development Business Development Francisco Valle francisco.valle@hrratings.com Hoja 10 de 11

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