Why did the strong third quarter growth come as such a surprise? Olga Bitel, Partner, Global Equity Strategist and Hugo Scott-Gall, Partner, Portfolio Manager, Co-Director of Research, Global Equity Team, discuss the broad expansion in the US economy, easing inflation and what to look for in a stock vintage market.
Hugo: Olga, what if I told you on January 1, 2023 that the third quarter gross domestic product (GDP) would be as strong as it is shown now? I mean, it was incredible. Would you have believed me?
Olga: Great question, Hugo. As we emerged from our New Year’s holidays in the winter of 2023, almost everyone expected a recession in the United States—and perhaps elsewhere. For the third quarter of this year, the consensus estimate from sell-side analysts who follow the stock market was for growth of just half a percent.
Instead, the American economy beat that number tenfold. This is well outside the normal range of forecast error.
Why did this happen? I think analysts underestimated the deep disinflation that the US economy was already experiencing and how much of a tailwind this would add to consumers for their real purchasing power and real incomes.
Inflation was perceived to have been contagious. There was much discussion about the US Federal Reserve (Fed) being behind the curve and needing to do more to tackle inflation. At the same time, there was widespread belief that the Fed’s action would send the US economy into a recession. So not only did the analysts get the growth aspect wrong, but also the inflation projection.
As of June, we saw year-over-year inflation in the United States that was in the 2% range, and we’ve mostly stayed in the 2-2.5% range since then. Of course, this means a significant increase in real purchasing power, because wage growth is slowing, but it is still slightly above the rate of inflation. This produces tremendous energy for consumers and consumption is 70% of GDP.
Low inflation and strong growth: It doesn’t get any better than this, Hugo.
Hugo: Why exactly was he so strong? Is this related to the large amounts of fiscal stimulus the US government has pumped into the economy? Or is it more about the ongoing aftershocks of COVID? Or is it actually more about the constant growth engine, the underlying innovative pulse of the American economy?
Olga: The innovative ability is certainly there. We only have to look at Nvidia (NVDA) earnings growth over the past few years, though most of the chatter has focused on the multiple — what investors are willing to pay for that growth.
But the most interesting story, from my perspective, is that what we’ve seen lately is a classic expansion story. In the last quarter, US consumers were responsible for almost 3% of the increase. More cyclically, inventories increased a little and government spending increased a little, but the story here, right now, is really consumption.
In terms of fiscal spending, there is a lot of ink being spilled over the large size of the US government deficit, especially at a time when GDP growth is very strong. While on the surface this is a worrying trend, I would argue that the composition of that fiscal deficit really matters for the trajectory of GDP.
When the government is spending money that goes to consumption and there is no investment in future skills, after a few years GDP growth will not be able to remain high without the funds. That would be a bad use of government cash, and investors would be right to be concerned about it.
However, this is not what is happening. What is driving fiscal deficits in the US is a series of industrial policy actions. The Inflation Reduction Act (IRA) and the CHIPS and Science Act were intended to improve the investment climate in the United States and encourage through tax cuts and various other subsidies corporate investment in new technologies.
As a result, the deficit is not driven by excess government spending, because spending isn’t growing as fast, but by a lack of taxes—specifically, corporate taxes that will be missing as a result of subsidies. This kind of deficit should certainly lead to stronger GDP growth in a few years through investment and innovation.
Hugo: Right. We are talking about increased capital expenditure and not operational expenditure.
So we have good growth and a good reinvestment rate. I heard someone say on a podcast the other day that nominal GDP of 5% plus pays the bills. There is enough growth around for everyone to provide it.
When you see the 10-year US Treasury note yielding 5% and not too long ago it was yielding less than 1%, that clearly has a lot of implications. But we need to understand why it is where it is. Can you look at it and say is it good or bad, or does it just depend?
Olga: Ultimately, despite all the hype, the US 10-year yield, which is arguably the world’s most widely used benchmark for interest rates, is a function of two things. It is a function of US economic growth and it is a function of inflation.
As we talked about earlier, inflation is set between 2% and 2.5%. So when analysts were trying to figure out where the rest of the shortfall in yield was, it had to be growth. In September, as we neared the end of the quarter, it was becoming clear that US GDP growth would come in well above expectations. The Atlanta GDPNow forecasting model, which has a pretty good short-term track record, was predicting this, and so were a host of other indicators.
As we look further, is the US a 5% grower? Almost certainly not. Is it closer to 2%? Most likely. That would be a very respectable rate in an expansion.
But what if I told you that looking five to seven years out, the United States could average 2.75-3% growth? This is a material acceleration over the rates we saw in the last decade. By itself, it would guarantee higher interest rates for a longer time in a positive way, without inflation being stronger than 2-2.5%.
Hugo: When you think about the relationship between real GDP and real interest rates, what does that mean for stocks as an asset class? How do you think the interaction of multiples on stocks versus alpha – excess return – on total shareholder returns? Is it possible that there is too much earning power that can be underestimated?
Olga: For some parts of the stock market, this will become much more challenging than it has been in the past decade. If your free cash flow yield is now significantly below 5%, you are no longer as attractive as you were when you could be used as a proxy for bonds. We’ve already seen this play in significant downward pressure on multiples in some pockets.
At the same time, for growth to be in the 2-3% range, it must be very broad indeed. In your opinion, one’s earnings growth is accelerating. Maybe it was too low before; it was probably relatively underrated. But it’s no coincidence that we’ve seen a number of companies where earnings growth is doubling on a one-year perspective. Of course, those companies will be rewarded with higher multiples, almost regardless of their initial multiple.
For other stocks where earnings growth is stable, they will need to become a source of funds. Strong growth is very good for stocks in general, but under the hood we’re already seeing a significant shift in the distribution of winners and losers.
This is the exciting part about investing in an expansion. This is what people call a bull market.
Hugo: Yes, and what they really mean is: You need to know where the growth is. Therefore, it is too simplistic to say that higher interest rates are bad for stocks. Because we need to understand what is causing the higher interest rates: growth. And if there is growth that could be good for stocks, you just have to make sure you have the right ones. Is this too simple a message you are giving?
Olga: That is exactly right. After all, interest rates are a function of growth. Everything we just talked about comes back to economic growth. Where is? Who leads the economic activity and who lags behind? Determining who will be tomorrow’s winners is the challenge, but the question is always the same. It is only the answer that changes.
Editor’s note: The bullet points for this article were selected by Alpha’s research editors.