Economic sugar rush and other treats

Well, there's no denying that the third quarter GDP advance was pretty impressive, with growth coming in at an annualized 3.9% rate. I don't want to put a bearish spin on the numbers, so let's start with the positives:

1. Consumer spending: The 3% annual growth rate is very solid. Based on modest employment growth and rising compensation, it was strong across the board. There's no sign that consumers are slowing down due to lower home equity.

2. Investment: Residential investment is still dismal, contracting at a 20% annual rate. But nonresidential construction is going very strong (12.3% growth) and equipement and software investment posted its best showing since the 1st quarter of 2006.

3. Net exports: Real export growth was a blistering 23%, more than offsetting an uptick in imports.

4. Government expenditures: They made a positive contribution by rising 3.7%.

Now, let's look at the caveats:
1. Inventories grew very strongly, adding 0.36 to the 3.9% growth rate, which may be a modest drag on growth looking forward.

2. Residential investment will fall some more and nonresidential construction has grown at what looks to be an unsustainable pace, specially considering faltering corporate profit growth.

3. Export growth looks too high, although the dollar's fall will make net exports a key contributor to growth for the near future.

4. Federal defense outlays jumped 9.7%, also an unsustainable rate, although this variable is extremely volatile.

The end result is that the 3.9% growth rate will probably be revised down. However, the underlying rate is quite likely above 3% which is still a good result. Last year's 3rd quarter GDP advance orignally came in at 1.6% and ended up revised downwards to 1.1%.

Where does all this leave us looking forward? Yesterday's 25 bp cut in the fed funds rate certainly was a signal that a significant slowdown lies ahead. How deep will it be?

The most recent analyst survey, from The Economist, places 2007 GDP growth at 2%. This would imply, given the current numbers, a contraction of 0.3% in the fourth quarter. Ouch. Given the margin of error and the fact that this year's forecast might be raised a bit, my guess is that 4th quarter growth will come in flat. The Fed is buying insurance against the possibility of the coming slowdown becoming entrenched.

As to 2008, it all depends on the consumer. So far, they have shaken off the twin blows of rising energy prices and falling home values. It seems they believe these are temporary phenomenons and are set on waiting them out. This will continue until it stops and it's impossible to forecast when that will happen (if at all). The key, in my opinion, lies in the labor market. If job growth falters, things will get uglier very fast.