A Yearend Surprise for Growth?


By Michael Englund Could the U.S. economy be growing at a faster pace in the fourth quarter than most experts expect? Based on data reports released Nov. 17, it's clear that the monthly indicators for factory sentiment and production -- as well as production as gauged by employment and inventories -- are accelerating. The Empire State index -- a survey of manufacturing conditions in New York - posted a much stronger-than-expected reading for November, while an update on business inventories in September showed surprising growth.

So why are economists still sticking to their consensus view that the rate of growth in U.S. gross domestic product will slow sharply to "only" around 4% in the fourth quarter? Sure, a cooling in productivity growth from the third quarter's colossal 8.1% rate is inevitable. But we at MMS International believe it's likely that GDP growth in either the fourth quarter or the first quarter of 2004 will still substantially outpace the consensus forecast.

Though we're sticking with our 5% GDP forecast for the fourth quarter and a 5.5% pace for 2004's first quarter, it remains possible that growth will be even more robust in the fourth quarter than in the third. That would be a surprisingly strong showing, as the third quarter is poised to be revised upward to near 7.8% from the originally reported 7.2% gain, given the big September turn in the retail inventory cycle.

INVENTORY REBOUND. The sharp acceleration in inventories reported for September suggests that the revival under way in the factory sector is being seen across the wholesale and retail levels as well. Previous factory data revealed inventory liquidation through September -- despite increasing production -- as sales growth outpaced output.

However, previously released wholesale-inventory data showed badly needed gains in September, following big liquidations since March. And the September retail-inventory data, released for the first time on Nov. 17, revealed a sharp turn in inventories, as retailers started to scramble for the holiday season.

In short, the inventory data indicate that the third-quarter turnaround for factories filtered through to wholesale and retail production levels as early as September. That makes a continued inventory turnaround and acceleration in activity likely during the fourth quarter.

PUZZLING RESPONSE. With this inventory rebound now established, along with evidence in the revised employment statistics that average hours worked started a clear upward climb in August, why is the market soft-pedaling expectations for the fourth quarter? Of course, back-to-back 7.8% gains in GDP would be historically unusual. That would be the biggest two-quarter gain since 1978, which proved to be a sizable but temporary bounce in the middle of a prolonged recession. Nevertheless, the signals for more robust growth are present.

Indeed, we at MMS International were a bit puzzled that the bond market didn't respond more negatively to the Empire State and inventory data released Nov. 17, as mounting evidence of a strengthening economy may prompt the Federal Reserve to reassess its aim to keep policy accommodative "for a considerable period."

Though the Empire State index is too volatile and targeted to use as a national gauge of factory activity, it's useful as a predictor of other widely followed factory-sentiment indicators. It now appears that the Philadelphia Fed index, the Chicago purchasing managers' survey, and the Institute for Supply Management manufacturing data are poised for outright increases in November from already robust October levels.

CLEAR PICKUP. All the factory-sentiment indicators have posted steady improvement since the start of the third quarter, providing a good leading signal of a commensurate acceleration in factory hours worked and production. We now expect the Philly Fed index to surge to around 34 in November from 28 in October, while the Chicago purchasing index rises to a range of 56 to 57 from 55, and the ISM index rises to 58 from 57.

Industrial production is likely to post a 0.5% gain in November, which should leave growth in the index edging higher, to a range of 4% to 5% from the third-quarter's already solid 4% clip. All the factory data imply a clear acceleration in activity in the fourth quarter.

The bottom line is that economists tend to be more cautious than traders, and we at MMS believe the market should remain ready for big GDP gains in both the fourth quarter and the first quarter of the new year. Englund is chief economist for MMS International


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