The huge American economy, driven largely by consumer, business, and government spending, amounts to more than $21 trillion in goods and services each year; however, its health can change based on external shocks, such as trade decisions, and public policy, such as changes in the tax code. This is reflected in the uncertainty shadowing the third-quarter economic report.
The Federal Reserve now has a wait-and-see policy with respect to future economic data and how it will affect the agency’s future decisions on adjusting rates. Economists want to see updates on trade policy and more economic data before predicting a rebound in global growth. Tepid manufacturing figures remain a concern, so analysts are looking ahead to upcoming data points and trade signals that could give markets even more momentum or reignite worries about the bifurcation in the economy.
Helping matters, the unemployment rate remains at a half-century low, the stock market is at very high levels, and the housing market has recently shown signs of rebounding. Consumer spending remains a linchpin for the economy.
The GDP and the Fed’s Moves
Gross domestic product (GDP) rose at a seasonally adjusted annual rate of 1.9% in the third quarter 2019 compared with a 2.0% rate in the second quarter 2019. Additionally, the four-quarter average growth rate has fallen to just 2.0%, dropping below the long-term average of 2.3%, which has been the average growth rate since the recession ended. The New York and Atlanta Feds were forecasting a range of 1.8%-to-1.9% for the quarter. The quarter was boosted by government and consumer spending, residential investment, and exports. Still, business spending declined for the second quarter in a row. Investment in structures dropped sharply, particularly those related to the petroleum and natural gas industries. The Commerce Department report showed that the divergence between relatively solid consumer spending and falling business-investment spending continued from the second quarter into the third.
Hours after the GDP announcement on October 30, the Fed cut interest rates by 25 basis points to a range of 1.5%-to-1.75% in a bid to spur growth. The Fed also hinted that there might not be any more interest-rate cuts on the horizon, as officials plan to monitor the economy going forward. “Weakness in global growth and trade developments have weighed on the economy and impose ongoing risks,” said Fed chair Jerome H. Powell.
Fed officials also recently began buying $60 billion a month in short-term Treasury debt to arrest recent volatility in money markets, reversing a two-year campaign to shrink the central bank’s $4 trillion asset portfolio. The officials have said the purchases are technical in nature, but they have contributed to lower borrowing costs.
The Fed can currently make six more quarter-point rate cuts before reaching zero. However, once they hit the one-percent level, any additional cuts could reduce investment rather than increase it. Households and businesses will likely recognize that the only reason the Fed would be cutting rates so low (below the 1% level) is that the economy is in trouble. Who borrows a lot of money when the economy is faltering? The next and final meeting of 2019 is December 10 and 11. The first meeting of 2020 is January 28 and 29. We don’t expect the Fed to make any moves in December.
Manufacturing Numbers Indicate Weakness
The Institute for Supply Management (ISM), a nonprofit professional association based in Arizona, released its highly anticipated manufacturing purchasing managers index (PMI) in October, and it came in at 48.3%, compared with a 47.8% reading in September. Still, this was below economists’ expectations of 49.1%. Any number below 50% represents a contraction in the industry.
This weakness was broad-based. All the components of the index remained below 50%, although new orders, employment, and inventories shrank at a slower rate. The production index was only 46.2% in October, compared with the September reading of 47.3%. According to ISM, the backlog-of-orders index was 44.1%, contracting for the sixth straight month, versus the September reading of 45.1%.
The sector showed its first contraction in a few years in August, ending a 35-month expansion period where the PMI averaged 56.5%. This contraction shows the challenging environment U.S. manufacturers are facing. One thing to keep in mind is that the gross output of manufactured goods comprised just 29.3% of U.S. GDP in 2018, but according to Goldman Sachs, goods-producing firms make up 44% of the S&P 500 index market capitalization.
Employment Growth Strong, But Slowing
The U.S. labor market remains a bright spot. While the pace of hiring is slowing, November’s better-than-expected employment number, along with upward revisions to hiring numbers in August and September, were the latest signs of strength from domestic employers.
Employment grew by a seasonally adjusted 128,000 jobs in October. Payrolls were revised higher by 51,000-plus in August and 44,000-plus in September. The unemployment rate ticked up in the third quarter to 3.6% and wage growth remained steady, up 3% from a year earlier.
Employers added an average of 167,000 jobs to payrolls each month this year. That is a slowdown from the 223,000 jobs added each month on average last year, and on pace to be the worst year for job creation since 2010. But job growth remains strong in areas of the economy — such as health care, business services, and hospitality — that serve U.S. consumers and are generally shielded from global trends and trade disputes. Health care and social services added 34,200 jobs in October, business services added 22,000, and hospitality, including restaurants, added 61,000.
Consumers Buoy Economy
Consumer spending moderated to a 2.9% annual rate in the third quarter from a 4.6% rate in the second. From a year earlier, consumer spending increased 2.5% in the third quarter, roughly consistent with the pace over the past year. Consumers are the lifeblood of the U.S. economy, as their spending accounts for nearly 70% of output. The report showed their spending on big-ticket items, such as cars and appliances, had slowed but remained strong, while spending on services slowed.
The housing sector was a tailwind for growth as residential investment rose at a 5.1% annual pace. The boost, which followed six straight quarters of declines, likely reflected lower short-term interest rates propelling construction and improvements.
Business Investment Lags
Commerce Department data also offered evidence of slowing corporate demand. Nonresidential fixed investment — which reflects business spending on research and development, software, equipment, and structures — fell at a 3.0% rate. This is the biggest drop since the end of 2015. Business-investment data can be volatile from one quarter to another, but the weak number in the latest report suggests factors including political uncertainty and the outlook for trade tariffs are weighing on business spending decisions regarding new equipment and plants.
The decline in business investment is a sign that the 2017 tax law isn’t having the effects its proponents predicted and desired. The law cut corporate tax rates and allowed immediate deductions for capital investment. Raising the after-tax rate of return was supposed to encourage companies to spend on factories and equipment. After a jump in early 2018, investment has slumped. It has been dragged down by uncertainty over the trade war and global economy.
CEOs Worry
The Conference Board, a New York-based nonprofit research organization, released its quarterly measure of CEO confidence. A reading of more than 50 reflects more positive than negative responses. That measure was at 43 in the second quarter of 2019, which was unchanged from the first quarter, but declined to 34 in the third quarter of 2019. The 2019 third-quarter reading is the lowest since the first quarter of 2009, when the measure was at 30.
CEOs have grown more pessimistic about current economic conditions, with only 8% saying conditions are better compared to six months ago, down from 13% last quarter. Close to three-quarters of CEOs say conditions are worse, up from 42% in Q2. CEOs were also more negative about current conditions in their own industries compared to six months ago. Tariffs and trade issues along with slowing global growth are causing an increased degree of uncertainty.
Conclusion
Economists would typically expect that after businesses cut back on spending, they would start laying off workers to save costs, which would lead to decreased consumer spending. But as of yet consumers continue to prop up the expansion. Almost half of the third quarter’s growth could be attributed to residential construction and spending on recreational goods such as computers, bicycles, and books, as well as at grocery and liquor stores.
Existing funding for the government expires on November 21. Congress is expected to pass a temporary spending bill to keep the government running through Dec. 20, forestalling a shutdown. If there is a lack of progress in negotiations over spending levels between now and December 20, lawmakers pass another stopgap running into early 2020. None of this would be particularly good for the market.
As always, each individual portfolio should be looked at with respect to diversification and risk profile.
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