US: Busier than a French Highway in August

Dan North
Dan North Chief Economist North America

It’s been an exceptionally busy week for economic news. But it all points to a slowing economy.

Tariffs

  • On Thursday President Trump announced plans to impose a 10% tariff on the remaining $300B of imports from China, beginning September 1st.
  • In theory, if the tariffs currently in place are being passed through entirely to the consumer, it is costing the average American family $700-$800 per year.
  • However those tariffs did not target consumer products so much. This new round of tariffs will affect consumers even more as they will be imposed on apparel, toys, and electronics such as cell phones. In fact, 69% of total US imports of consumer products from China will be targeted by the new tariffs.
  • As a result total tariffs on Chinese imports could in theory cost the average family about $1,000 per year – effectively a tax on consumers that will slow the economy. (In practice, the cost won’t be that high to consumers since importers will absorb some of the increased cost, and a weakening Chinese currency will soften the blow.)
  • But there is no doubt the uncertainty caused by the situation is hurting the economy.  Q2 business investment was down sharply, most likely over trade concerns. Earnings reports and business survey responses are all heavily laden with comments about trade uncertainty.
  • Fed Chair Powell must feel somewhat vindicated as Wednesday’s cut was intended as “insurance” against the possibility of this very move (although it still doesn’t get him off the hook for the “mid-cycle adjustment... not the beginning of a series of cuts...” botch-up).
  • The tariffs make a September cut very likely. According to the Fed Funds futures market, the probability of a September cut spiked after the announcement and is now above 95%.

Employment report

The July employment report was mostly solid, showing job gains of 164k, about as expected.  However job gains from the previous two months were revised down a total of 41k jobs.  As shown in the chart, the trend in job growth is clearly slowing.

The unemployment rate was unchanged at 3.7%, the participation rate ticked up a notch, and the labor force grew for the third straight month. Wages ticked up +0.1% y/y to +3.2% y/y.  Wage growth has ranged between 3.1%-3.2% for five straight months, and remains below February’s peak of 3.4%.

Manufacturing added +16k jobs which although is an improvement over the past several months, is still somewhat below trend. However another piece of data we don’t normally pay much attention to in this report is confirming the weakness in the manufacturing sector. Specifically, average weekly overtime hours in the manufacturing sector are plummeting at a -11.1% y/y rate, the worst of the entire 10 year recovery.

ISM

Similarly, the July ISM manufacturing report was alarming as it slipped from 51.7 to 51.2, the lowest in three years. Below 50, the index indicates a contraction in manufacturing.  The report was full of weaknesses as six of the ten components fell, and only four components remain above 50. Backlogs and export orders are at the lowest in over three years. Except for last month’s 50 reading, new orders are at a three year low of 50.8. Of 18 industries, only nine reported expansion, a very low number. Comments from respondents almost all reflected economic weakness or tariff concerns. It would appear that the manufacturing sector is near recessionary territory.

Note that as shown in the chart below, the ISM index does lead the economy by one to two quarters with a strong statistical significance, and right now it is clearly suggesting a downturn.

Personal Consumption Expenditures (PCE) and Disposable Personal income (DPI)

Last Friday the Q2 GDP report came out and showed that Personal Consumption Expenditures (PCE) were strong in the quarter. Since PCE, also known as the consumer, was heathy, many were asking why the Fed was considering raising rates. There are two problems with this reasoning. First, while GDP is our broadest measure of economic health, it is by nature backward-looking – it tells us what happened in April, May, and June. It’s useful to know, but the Fed really has to look into the future (using leading indicators like the ISM above, and the yield curve, below). Secondly, on a more granular monthly basis, consumption is modest at best. Sure, it’s positive, and it’s not bad, but it’s in a downtrend and is below the long-term average.  Disposable (after tax) personal income is reasonably strong, but since we are not getting a tax cut this year, its growth has returned to a more normal rate.

The Fed

The Fed cut rates 25 bps on Wednesday, fending off critics who, as noted above, thought the economy was just fine (today). The Fed justified its action by expressing concerns over “uncertainties about” the outlook – in other words the threat that trade tensions would rise. Bang, the next day trade tensions rose, and the Fed was vindicated - at least for that part. But Fed Chair Powell did botch the press conference when he characterized the cut as a “midcycle adjustment” and “not the beginning of a long series of rate cuts”, which was contrary to expectations of both economists and markets. In a sense Trump’s new tariffs smoothed over that botch too because they make a cut in September a virtual certainty. According to the Fed Funds futures market, the probability of a September rate cut was about 70-75% before the botch, the botch drove it down to around 50%, and the tariffs drove it back up to virtually 100% today.

Interest Rates

The new round of tariffs have raised fears in the financial markets, driving investors to but US Treasury securities, bidding up the price and down the yield.  Falling long-term yields can indicate concerns over uncertainties or slowing economies, both domestically and globally. The yield on the 10 year Treasury note dropped from 2% to below 1.9% on the tariff announcement. At its current yield of 1.87% it is the lowest since November of 2016. And as the 10 year dropped, the yield curve inverted more, again suggesting the possibility of a recession in 2020. Except for one day, the yield curve has been inverted for over two months. 

So on the one hand we do have income and consumption doing reasonably well, and that is great because consumption drives about 70% of all economic activity.  But we also have a new round of tariffs and a brewing trade war, a downtrend in hiring, a near recession in manufacturing, falling yields, and a deepening yield curve inversion. Therefore, our scenario of decent economic performance for most of this year, two Fed cuts this year, two more in 2020, and the distinct possibility of a recession in 2020 remain intact. Sorry. But at least you know.

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