Global events continue to roil economic indicators and pull the market into fluctuations that are difficult to predict and are sometimes more related to perception than real activity. Still, the second-quarter reports give a somewhat clearer view, even if it is difficult to predict the prevailing wind and where it may take us. Divergent signals abound, creating a cloudy picture. Recent confidence surveys have found that people feel good about the economy now but are more nervous about the future.
The manufacturing sector continues to slow due to trade worries and slowdowns in international economies, while business investment is weakening. However, consumer spending, which accounts for more than two-thirds of the economy, is strong. The U.S. economy remains supported by low unemployment and rising incomes, but slowing global growth, a strong dollar, and those trade uncertainties weigh on the outlook. Government spending, which picked up in the second quarter after being depressed by the shutdown, also helped lift growth.
The U.S. economy slowed in the second quarter of 2019 as GDP grew at a 2% annual rate, down from 3.1% in the first quarter. Consumer spending rose at an inflation-adjusted annualized rate of 4.7% in the second quarter, up from its first-quarter pace of 1.1%, marking the strongest reading since late 2017. Consumers have continued to spend since the second quarter.
Many economists expect growth this year of about 2.3%, the average during the current expansion (which started in mid-2009 and in August 2019 became the longest on record). Federal Reserve officials’ median projection in June was 2.1% growth from the fourth quarter of 2018 to the fourth quarter of 2019. However, the Federal Reserve banks of Atlanta and New York have growth estimates for the economy in the third quarter of 2019 that are below 2%. (The third-quarter release of GDP numbers will arrive on Oct. 30).
Global trade has stalled as concerns over rising trade barriers have taken effect. Turbulence from both has spilled over to corporate earnings, with the outlook remaining uncertain for the multinational companies that make up the major stock market indexes. It appears that companies are willing to absorb some of the costs of the tariffs and supply-chain disruption, as well as the reduced profit margins that result. Earnings growth for the S&P 500 for 2019 are expected to be below 2%, down from 22.7% in 2018 and 11.8% in 2017.
The labor market is very tight. Nonfarm payrolls in August increased by 130,000, below the consensus of 150,000, and the prior two months were revised down by 20,000 jobs. The three-month average increase of 156,000 was the slowest in almost two years. That trend is in line with forecasts for a gradual slowing of job gains as the labor market tightens, but it could also be a sign that the economy is losing steam. Hourly wages were up a strong 0.4% and a solid 3.2% over the year, which is enough to keep worker earnings above the inflation rate. With hours worked rebounding, weekly earnings surged 0.7% each month of the quarter and have risen 2.9% over the year.
However, manufacturers added 3,000 employees to their payrolls in August, another sign of slowdown. So far this year, manufacturing payrolls have grown by only 44,000, compared with growth over the same period in 2018 of 170,000 and in 2017 of 91,000. Manufacturing overtime dipped to 3.2 hours a week, the lowest level since April 2017.
The prospective risk is that manufacturing’s weakness starts to bleed into the consumer services side of the economy. This may already be underway, with the latest services Purchasing Managers’ Index (PMI) from Markit falling to 50.9 (which denotes an expansion, but just barely). The slide coincided with a weaker manufacturing reading, which did dip to slightly below the 50 line. This weakness into services could be exacerbated by the fact that the next two rounds of tariffs on Chinese imports are a direct hit to consumer goods.
Since consumers are the only broad shoulders left in the economy, businesses’ drive to combat declining profit margins by controlling costs may turn out to be self-defeating; households may not have the money to spend. The concern among economists is that future weakness in profits at American companies could spell trouble for the labor market if boardrooms slow their hiring or lay off workers to cut costs.
Businesses took a more cautious approach in the second quarter, with a key gauge of their investment declining for the first time since early 2016. Nonresidential fixed investment — which reflects spending on software, research and development, equipment, and structures — fell at a 0.6% rate, compared with a 4.4% rise in the first quarter. Businesses also drew down inventories in the second quarter rather than replenishing stock shelves, which subtracted 0.85% from the quarter’s overall GDP growth rate.
However, U.S. corporate profits rebounded in the second quarter as companies cut investment. A broad measure of corporate earnings — after taxes, without inventory valuation and capital consumption adjustments — rose 4.8% from the prior quarter. That came after corporate profits, which are often volatile on a quarterly basis, dropped 1.5% in both the first quarter of this year and the fourth quarter of 2018. Looking over a longer period, corporate profits were up a more muted 1.7% in the second quarter from the same period a year before. Residential investment, which includes housing construction, declined for the sixth consecutive quarter. Trade itself was a drag on growth, as exports fell at a 5.2% rate while imports rose slightly, expanding the trade deficit.
The Institute for Supply Management Manufacturing Index (PMI) dropped 2.1 points in August, its fifth monthly decline in a row, to 49.1, the lowest level since January 2016, and its first reading below 50 since August 2016. The consensus was for a modest 0.2-point pullback to 51.0. The report — coming after data pointing to contracting factory activity in the U.K., Germany, Japan, and South Korea — fueled fears that a manufacturing slowdown elsewhere in the world had reached the U.S. Germany’s PMI for manufacturing recorded an eighth straight monthly decrease in output and the steepest rate of decline since July 2012, with the flash reading for September at 41.4, falling from 43.5 in August.
The tariff dispute, along with cooling global economic growth, has contributed to a stagnation in total U.S. exports to the world and a widening of the trade deficit. U.S. farmers lost one of their biggest customers after China officially cancelled all purchases of U.S. agricultural products. China’s exit adds to a devastating year for farmers, who have struggled through record flooding, an extreme heat wave that destroyed crop yields, and trade-war escalations that have lowered prices and profits this year. Agriculture exports to China dropped by more than half last year. In 2017, China imported $19.5 billion in agricultural goods, making it the second-largest buyer overall for American farmers. In 2018, that dropped to $9.2 billion as the trade war escalated, according to the United States Department of Agriculture. That figure has continued to drop, with exports to China in the first half of 2019 sinking to $1.3 billion.
The U.S. economy has nonetheless expanded faster than other advanced economies in 2018 and 2019, while global growth has cooled. This has boosted American appetite for imports and depressed foreigners’ demand for U.S. exports. Imports to the U.S. rose 1.5% to $1.568 trillion in the January-to-June period, a rise from a year earlier. Exports, meanwhile, were virtually flat in the first half of the year at $1.252 trillion. Excluding services, shipments of goods produced by American farmers and manufacturers fell, as China reduced purchases from the U.S. while other economies slowed.
Those trends illustrate an 83-year-old economic principle that says tariffs on imports ultimately end up acting as a tax on exports. The upshot: America’s overall trade gap widened 7.9% in the first half of 2019 from a year earlier, to $316.33 billion, despite tariffs aimed at narrowing it.
Slow growth abroad is impacting our financial markets as well as threatening to weigh on U.S. economic prospects. In Germany, with a dominant export market, the yield on 10-year government bonds is negative and hovering at record lows. Negative-yielding debt is spreading internationally and is adding to the drag on U.S. real interest rates.
Signs of a global slowdown have sent yields on U.S. long-term bonds tumbling in anticipation of low inflation and Fed rate cuts to stimulate economic activity. Rate cuts are meant to spur growth by reducing the cost of borrowing, thus making it cheaper for businesses to invest and for consumers to purchase big-ticket items like homes and cars. One or more Fed rate cuts may prop up valuations for now but are not a silver bullet against the chronically low interest rates that erode income. At the FOMC meeting on Sept. 17 and 18, the Federal Reserve instituted the 25-basis point cut in rates that the market expected. Notes from the meeting showed that although the Fed sees no further rate cuts in 2019 and 2020, members of the FOMC were divided on what actions should be taken moving forward. The next FOMC meeting is scheduled for Oct 29-30.
There is little likelihood of rate cuts making much difference to future economic performance in the U.S. The challenge is that the U.S. economy’s deceleration from 3% to 2% real GDP growth was due to (a) the wearing off of the December 2017 tax cut that temporarily raised growth in the first half of 2018, and (b) the trade war slowing business investment due to the massive corporate uncertainty over tariffs and supply-chain impacts that could lower corporate profits.
Inverted yield curve has dominated recent headlines. An inverted yield curve means that a short-term U.S. treasury is paying a higher interest rate than long-term U.S. treasuries. Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession.
When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall. In a deviation from most past episodes, the curve inverted this time because long yields fell below shorter-term yields while in the past, the Fed has raised short-term rates above long-term yields. That said, an inverted yield curve, when persistent (and regardless of why or how it inverted), does crimp or eliminate the spread banks can earn by borrowing short and lending long — typically constraining credit availability, a common precursor to recessions.
The spread between the 10-year and the 3-month has sustained its inversion almost perfectly for exactly a quarter, and the spread between the 5-year to the 3-month has been inverted since February. The 10-year to 2-year also turned negative in August. We don’t see a looming recession, but we do agree there has been a growth slowdown.
As economic growth slows, manufacturing continues to weaken, and the trade dispute shows no sign of a resolution, the U.S. consumer continues to power the economy thanks to positive wage growth and a tight labor market. However, it’s prudent to be prepared for more bouts of volatility. Investors should make sure they are keeping a diversified portfolio with equity exposure equal to their risk tolerance.
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