Manufacturing activity contracted for the second consecutive month in September as tariffs hurt exports, and recession worries have resurfaced.

Within the United States, the messages have been mixed, at least in terms of the headline data. U.S. manufacturing activity tumbled to a more than 10-year low in September and set various alarm bells ringing. The Institute for Supply Management's (ISM) closely watched manufacturing index dropped to 47.8. It was the second successive reading below 50, a level which indicates contraction in the manufacturing sector. Financial markets fell on the news.

However, a separate survey of manufacturing from IHS Markit showed factory activity increased in September. This tells us something. The ISM manufacturing index is made up of disproportionately large companies, which are feeling the impact of the trade war on their global operations. The Markit PMI survey covers more small and medium-sized companies that are focused on domestic industries. The ISM index just told us what we already knew — that globally integrated manufacturing is suffering under the impact of President Trump's trade war.

As we have said in the past, uncertainty over what will come next — uncertainty that Trump seems to view as a negotiating strength — will weigh on the economy. The weakness in the manufacturing sector will affect investment.

Hiring stays steady

The labor market report didn't really change much at all. Employers added 136,000 jobs in September, and the jobless rate fell to 3.5%. Our preferred index — which aggregates people employed, hours worked, and wages — shows a gradual easing trend. The details in various sectors of the economy vary quite a lot. What is happening in "trade" and "construction" is quite different from what is happening in "leisure" and "health." Overall, even though the aggregate quit rate rose, the Atlanta Federal Reserve's wage tracker looks broadly stable. If you look at the number of job openings, or the number of people with more than one job, you come away with a late cycle feel. But the key message is one of gentle weakening.

The main question for the outlook is whether the trade difficulties in the globally integrated sectors of the economy will worsen and generate more problems in the wider economy. In September, the ISM non-manufacturing index produced a negative surprise — it was the weakest reading since 2016. However, the index held above 50 and again sent a somewhat different message than the IHS Markit services index. We need to keep an eye on the underlying story and look at the whole rather than just at one or two data points.

U.S. manufacturing and non-manufacturing slows

No recession in the cards

So, our assessment of the U.S. economy is unchanged. The economy is decelerating modestly, with strength in housing helping to offset, in part, the weakness from the global trade war and the passing of the fiscal stimulus. The United States is not heading unavoidably into a recession. Something more needs to happen to generate recessionary pressures. That includes a worsening of the trade war, a policy mistake by the Trump Administration or the Federal Reserve, and a significant slowdown in the labor market. The fragilities and risks are obvious, but recession is not our central scenario.

The economy is decelerating modestly, with strength in housing helping to offset, in part, the weakness from the global trade war and the passing of the fiscal stimulus.

A divided Fed

All of this brings us back to the Fed. The central bank in September cut its main interest rate — for a second time this year — by another 25 basis points to a range of 1.75% to 2.00%. But the Fed's statement and the dot plot were a little more hawkish than markets had expected or hoped for. The policy-setting Federal Open Market Committee (FOMC) was deeply divided as well. The dot plot — a visual representation of where policymakers think rates will be over the short, intermediate, and long term — suggests a division between a large minority who expect to cut rates further in 2019 and a small majority who do not.

Fed chair Jerome Powell has downplayed the division at the FOMC and stressed data dependence. Recent comments from FOMC officials suggest there is a possibility the Fed will lower rates further this year. The strength in the housing market will empower those who think the central bank should pause, and the labor market report won't do more than confirm pre-existing views. On the other hand, only one or two of the centrists on the FOMC need to flip; the ISM manufacturing data may be the catalyst.

Next: Policy twists and turns

More from Macro Report
Download the Macro Report (PDF)

Global growth will remain sluggish this year as protectionist tariffs continue to rattle manufacturers, businesses, and financial markets.