Recap
The U.S. economy slowed but still grew at a 2.1% rate in the second quarter as strong consumer spending offset a drop in business investment, keeping the decade-long expansion on track amid trade tensions and cooling global activity.
Persistent labor market strength and fresh equity market highs have supported the ongoing rebound in consumer confidence and spending. Industrial production was more or less flat in June, but manufacturing output rose a solid 0.4%. The U.S. factory sector appeared to have just avoided slipping into contraction territory and has likely already bottomed.
The trade détente between the U.S. and China has provided some reprieve, but the ongoing uncertainty along with slowing global growth and a stronger dollar will put a ceiling on the manufacturing rebound.
Residential construction has also likely bottomed; the recovery has been anything but inspiring. A full percentage point drop in mortgage rates has failed to breathe much life into the housing market, which has continued to grapple with affordability challenges.
Household balance sheets have generally remained strong, and real income has continued to grow at a decent rate thanks to further job and wage gains, along with low inflation. Consumer confidence rebounded in July to its highest level this year, suggesting Americans remain confident about the U.S. economy despite persistent trade tensions and slowing global growth.
Capital spending plans among manufacturers reached a two and a half year low in June. As such, a lackluster pace of business investment has been expected. Employment growth rebounded in June, allaying fears of a sharp deterioration in the labor market. While job growth has been expected to cool further in the coming months, it should remain strong enough for further tightening in the labor market. Yet wage growth has shown few signs of generating a burst in inflation. Core PCE inflation seemed likely to remain below 2% on a year-ago basis until early next year given solid productivity growth and low inflation expectations.
Despite a generally healthy economy, the Fed cut its key short-term interest rate by a quarter-percentage point to a range of 2% to 2.25%, in a bid to head off a possible recession spurred by global troubles and trade tensions. The move will likely ripple through the economy and financial system, nudging down rates for different financial instruments. Further cuts could occur depending on trade and global economic developments.
While a further escalation in trade tensions between the U.S. and China has been avoided, for now, the lack of a resolution has prolonged trade-related uncertainty. Growth indicators from around the world have disappointed, raising concerns that weakness in the global economy could continue to affect the U.S. economy. These concerns may have contributed to the drop in business confidence in some recent surveys and may have started to show through incoming data.
Gross Domestic Product
The U.S. economy grew at a 2.1% annual rate in the second quarter of 2019 keeping the decade-long expansion on track. Consumers were the key driver of domestic demand strength while the investment side of the economy was soft. Both nonresidential investment and investment in structures were down. Businesses also drew down inventories in the second quarter rather than replenish stock shelves. Trade itself was a drag on growth, as exports fell, while imports rose slightly expanding the trade deficit.
The divergent signals from strong consumer spending and weakening business investment in the second quarter have left a mixed picture. The economy has remained supported by low unemployment and rising incomes, but slowing global growth, a strong dollar, and trade uncertainties have weighed on the outlook.
Manufacturing
Manufacturing industries around the world have undergone a synchronous slowdown. In fact, in China and the Euro area, the manufacturing sector has been in contraction, while in the U.S., the pace of expansion has decelerated.
U.S. manufacturing activity has slowed in recent months as global developments such as rising trade uncertainty and softening global growth constrained foreign demand. Domestic conditions, on the other hand, appeared more stable and do not seem to be weighing heavily on manufacturing activity. Indeed, within manufacturing, sectors with lower degrees of export-intensity have either avoided contraction or experienced a much more muted slowdown so far in 2019. The role of the exchange rate cannot be ignored. The real effective exchange rate of the US dollar has appreciated by almost 7% over the course of 2018, weighing on manufacturing shipments.
Any further deterioration in global growth could bring manufacturing activity to a level that becomes a risk to the broader U.S. economy. Softness in the U.S. manufacturing sector has been particularly concerning as it could be a harbinger of a broader economic slowdown. In the current context, manufacturing weakness has appeared less related to domestic issues, and more related to global factors. Specifically, elevated trade uncertainty and slowing global growth. Indeed, the deepest declines in manufacturing shipments have been concentrated in sectors that are relatively more export intensive. Shielding against this outcome has been a key reason for the Fed’s pivot to insurance rate cuts.
While external conditions have worsened, U.S. domestic demand has remained healthy. As in previous episodes, most recently in 2015- 2016, resilient domestic demand could likely put a floor on U.S. manufacturing activity.
Housing Market
Housing starts fell 0.9% in June largely due to a sharp decline in volatile multifamily starts. Residential building permits, which have signaled how much construction is in the pipeline, dropped 6.1% in June. That was the biggest monthly drop since early 2016. Lower mortgage rates have not spurred the home building industry to increase construction, as a lack of skilled workers, material costs and land zoned for building have continued to hamstring production. The overall housing sector has struggled with high prices and low inventory, even with a strong labor market, low borrowing costs, and rising incomes.
Federal Reserve
As expected, the Federal Reserve Bank cut interest rates by a quarter-percentage point to a range between 2.0 and 2.25%. It was the first reduction since 2008. The Fed also decided to end the runoff of their $3.8 trillion asset portfolio two months earlier than previously planned. The pre-emptive strike to lower rates has partly been about fears of an immediate pullback in growth and partly been about an inability of central banks to generate more inflation.
In a low-interest rate world, the Fed has less ammunition to combat a slowdown and therefore needs to act more quickly when risks become elevated. With the policy setting now at 2.0-2.25%, the Fed has considerably more scope to guard against emerging risks. The Fed left the door open for further monetary stimulus and it has been expected this would come in the form of one more insurance cut in September or October.
United Kingdom
It was a busy month for the United Kingdom, with a mix of Brexit headlines and data points providing mixed signals for the U.K. economy and currency. The British pound has slipped closer to its lowest sustained level against the dollar in more than 34 years, due to rising investor fears of economic disruption should the U.K. quit the European Union without a deal to smooth its exit. The pound has also fallen heavily versus the euro. The currency’s drop has underscored investor anxiety about Brexit, particularly one without a divorce deal in place.
Those worries have grown in recent days as members of the new U.K. government, led by Prime Minister Boris Johnson, have suggested that a departure without an agreement is the most likely option. It was thought that Boris Johnson could soften his stance once he was in power, but now a no-deal Brexit is a very real possibility. The probability of a no-deal Brexit appeared to be between 35% and 45%, up from 20% to 30% at the start of July.
While the pound has tracked Brexit concerns, U.K. stocks have remained largely impervious because many of the largest companies trading in London have been international businesses whose fortunes were not linked to the British economy.
Meanwhile, U.K. data were generally quite strong and consistent with an economy showing resilience in the face of persistent uncertainty. Retail sales rose in June, while wage growth was firmer than expected in the three months through May. This, coupled with generally contained core inflation, would be likely to support the ongoing resilience in U.K. retail sales. The Bank of England has a relatively accommodative policy stance with its policy rate at 0.75%. While current economic conditions might otherwise warrant a rate cut, Brexit uncertainty and the threat of a no-deal exit would probably be too concerning for the central bank to raise rates for now.
European Central Bank
The underwhelming performance of the Eurozone economy has been characterized by sluggish GDP growth and stubbornly low inflation, which remained well short of the European Central Bank’s (ECB) target goal of “close to, but below” 2%.
It is against this backdrop that the ECB has sent fairly strong signals that a broad package of easing measures is likely to be delivered in September. A rate cut is highly likely, and it has been expected the central bank will announce a new program of asset purchases focused on sovereign bonds. This would represent a significant policy shift aimed to insulate the wobbling Eurozone economy from global headwinds ranging from trade tensions to Brexit.
This policy shift has reflected the broader theme of global central banks – not just the Fed – shifting in a more dovish direction, a theme which has factored a soft landing for the global economy. Central bankers, from Asia to Europe, have been eager to act early to safeguard the long economic expansion because they appear to have limited policy space to counteract any recession with interest rates already low. Meanwhile, the euro will remain on the defensive for now.
China
China’s economic growth decelerated to its slowest pace in decades, weakened by trade tensions with the U.S. and businesses that held back from making big investments despite encouragement from Beijing. The economy grew by 6.2% in the second quarter, down from 6.4% in the period before, its slowest pace since 1992. Investments remained weak on a quarterly basis, even though the month of June saw the beginning of a potential recovery as Beijing encouraged banks to lend more. Exports fell in June from a year earlier after trade talks with Washington broke down and President Trump applied higher tariffs to Chinese goods.
Policymakers in China have planned to stabilize the economy in the second half through additional tax cuts and efforts to boost infrastructure investment. Meanwhile, sentiment has been weighed down by uncertainty in the U.S.-China trade dispute as exports have fallen. Beijing may be forced to further loosen monetary policy, even though that could push up debt levels. Also, cutting banks’ reserve requirement ratios or cutting benchmark interest rates would risk pressuring the value of the Chinese yuan, an undesirable outcome for Beijing during trade negotiations.
Outlook
The outlook is for U.S. economic growth to remain solid, labor markets to stay strong, and inflation to move back up over time to the Fed’s 2% objective. There are several pillars of strength for the U.S. economy beyond historically low unemployment and a record 106 straight months of job gains. American household spending and incomes both rose at solid rates in June, consumer confidence remained relatively strong and the stock market touched a record in recent weeks. However, uncertainties about the outlook have increased in recent months. The manufacturing sector in the U.S. is steadily decelerating and the erosion is happening on a quicker and larger scale internationally. Trade tensions are a major source of pain here. With each passing month where business confidence erodes and investment intentions become sidelined, the biggest concern becomes one in which the global economy is on a moving train that cannot be easily halted by the central banks.
In particular, economic momentum appears to have slowed in some major foreign economies, and that weakness could eventually affect the U.S. economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent in the coming months.
Sources: Department of Commerce, Department of Labor, Bloomberg, Morningstar, European Central Bank, People Bank of China, Bank of England, the Conference Board, The Institute for Supply Management
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