Authored by Andrew Sheets, Morgan Stanley Chief Cross-Asset Strategist
Next week the US Department of Commerce reports its advance estimate of 2Q GDP. It’s likely to be a whopper. Our US economics team expects it to register at +4.7%, and given the unusually large number of moving parts at work this quarter, a 5-handle is possible. A few days later, the June reading of US PCE could show a slight downtick in core inflation. Robust growth and modest inflation; what could be better?
Try not to get carried away. Amid the inevitable cries of ’Goldilocks’, a more important story lies below the surface. An unusually large number of one-off factors appear to have boosted 2Q GDP, many of which are directly related to escalating trade concerns. As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled. If these trends are one-time adjustments (and our economists believe they are), the ‘payback’ in 2H could be significant. Enjoy the 2Q GDP number, which may be the last best print for a while.
2018 has seen a steady increase in trade tensions, and trade actions, between the US and its trading partners. The US slapped tariffs on washing machines and solar panels in January, on steel and aluminum in March, and on US$34 billion of goods from China on July 6. In response to these measures, China and the European Union have announced countervailing tariffs of their own.
For Michael Zezas and our US public policy team, this fits with a narrative of continuing escalation in trade tensions, a trend we expect to persist until it comes up against greater political or market pressure. As we have yet to see either, companies are facing this new backdrop with a familiar mantra: ‘Hope for the best, prepare for the worst’.
At least that’s what Ellen Zentner and our US economics team see when they peel back the US data. As Ellen noted in a recent NYT op-ed, countries have dramatically increased the volume of goods they import from the US, likely with a view towards securing goods before new duties are applied. If you don’t believe us, we’re open to other suggestions on why US soybean exports were up almost 9,400% annualised over the last three months, or why the export of crude and fuel oil surged by 244% over this period.
In aggregate, this ‘stockpiling’ in exports could be responsible for 1.5 percentage points of our 4.7% 2Q GDP estimate.
‘Stockpiling’ also appears to be at work for US companies, albeit to a more limited extent. The inventory build in 2Q is tracking at +US$38 billion, versus a +US$10 billion rate in the prior two quarters. And what’s more interesting is the areas where those inventories are building, which have material overlaps with trade: electrical goods, machinery equipment, motor vehicles and parts.
In total, our US economists see net trade and inventories making up 2.2 percentage points of our 4.7% US GDP estimate, the highest combined contribution since 4Q11. Their concern is that since they are one-off adjustments, both contributions are unsustainable and represent a pull-forward of demand that will need to be given back. US GDP was +4.6% in 4Q11, then averaged +1.6% for the next five quarters.
The latest round of trade tensions may also matter for inflation. Despite all the ink spilled on trade this year, the impact on end prices appears minimal. But this may be set to change. My colleague Guneet Dhingra notes that, so far, tariffs have focused on the components of production, which tend to take time to work their way into final prices. But when tariffs target consumer goods, the impact can be rapid. Remember those tariffs on washing machines? The ‘laundry equipment’ category of CPI is up almost 15% year on year.
Why does this matter? Of the US$34 billion in items targeted in the initial set of China tariffs, 3% were consumer goods. In the next US$200 billion set of proposed items, 33% are consumer goods – a much larger share of a much larger number. And if the tariff list expands to the remaining US$250 billion of Chinese goods, of which 60% are consumer goods, this will result in a more acute impact of incremental tariffs on CPI.
What does this mean for markets? While next week’s print will tempt with a narrative of strong growth and modest inflation, we think that 2H will follow a different storyline, with decelerating growth and rising inflation across major regions. More tactically, we’re also moving out of a July reporting period that has historically been supportive of risk into an August-September stretch that is usually one of the most challenging.