The economy is showing signs of weakness amid the ongoing trade dispute and a slowdown in globally integrated manufacturing activity.
The dynamics of the U.S. economy have become a little clearer over the past few months. The manufacturing sector — especially globally integrated manufacturing — is slowing. This provides the latest sign that the global manufacturing pullback is weighing on the economy. The readings of two manufacturing indexes differed in August. The IHS Markit U.S. Manufacturing Purchasing Managers’ Index was at 50.3 in August, down from 50.4 in July. The Institute for Supply Management’s (ISM) manufacturing index, a widely watched gauge of factory activity, fell to 49.1 in August from 51.2 in the prior month. Readings below 50 are a sign of contraction. The slight gap between these two measures suggests the domestic industries are doing better than globally integrated ones. In addition, the gap between manufacturing and the U.S. service sectors has widened, indicating that nonmanufacturing is still fueling the broader economy.
August tweet storm
President Trump escalated the trade war with China with a blast of angry tweets in August. The big problem with Trump’s trade war and his negotiating style is that today’s tariff is X% on one list of products and tomorrow it is Y% on a different list. Who can be confident about a global supply chain under these conditions? Trade policy uncertainty is already affecting business investment. Capital expenditure has been weakening, according to Morgan Stanley’s Capex Plans Index. And, various regional surveys by the Federal Reserve have also shown that the trade uncertainty has affected corporate behavior.
The big problem with Trump’s trade war and his negotiating style is that today the tariff is X% on one list of products and tomorrow it is Y% on a different list.
The key issue for the economy is whether it muddles along at a 1.5%–2.0% growth rate or whether that growth rate erodes. The winter months could bring us closer and closer to a recession. We are clearly not in a recession now. What factors could cause a recession? The slowdown in the globally integrated manufacturing sector has left the economy dependent on consumer spending. While consumer spending has remained strong, the dependence on a single factor increases the economy’s vulnerability.
The channels to worry about are the services sector and the labor market. If these weaken, consumers will retrench, and the outlook will get a lot worse. The labor market appears to be flagging; the economy added 130,000 jobs in August, below what analysts had expected. Private sector hiring was also lower than expected. But wages rose at a healthy clip. Job creation in the service sector has also been steadily weakening. Overall, the data point to a trajectory of sluggish growth. But risks to the outlook remain.
Financial markets look to the yield curve
For the financial markets, the question is, once again, how to think about the inverted U.S. Treasury yield curve. As of early September, the yield between the two-year note and the benchmark 10-year bond had a positive slope. However, the yield curve was inverted for many other maturities. We don’t view inversion as a reliable predictor, nor as an inherent cause, of a recession. But it is a problem for the financials sector because of the way leverage is financed. It is also a sign that one key risk metric is priced very oddly. We can’t imagine that equity markets would do very well in the face of persistent inversion. If the inversion persists, the Fed will need to respond by becoming more dovish or risk making a policy mistake that weakens the economy.
The shape of the yield curve hasn’t changed enough to influence the economic models that put a lot of weight on inversion; they still suggest a recession is certain. Our preferred models are not yet telling us to be worried. Recession probabilities are ticking a little higher, but they are low enough to be consistent with continued slow growth. It’s important to clarify what these models measure. They are built to find information in factors that in the past were early indicators of recessions. In this sense, they aren’t forecasting models; they try to see if current conditions are consistent with a looming recession. And they are telling us that these conditions are not. The yield curve model is different because it is possible the inversion could cause a recession. We don’t believe it, but there are conditions, like those today, under which an inappropriate policy response would result in a recession.
Our view is that the chances of a recession in early 2020 are a little below one-third. We think it possible that a combination of global weakness, further missteps by the Trump Administration on trade, a slow-moving Fed, or a geopolitical shock could weaken asset markets to the point that a recession happens. In other words, we do not think that a recession next year is inevitable. With the right policy moves, it can be avoided. But a slowing economy is vulnerable to policy mistakes.