Recap
At over a decade long, the U.S expansion is now the longest on record. Notwithstanding pockets of weakness in trade-exposed sectors like manufacturing and agriculture, the economy is performing well. Underlying demand is proving fairly resilient. Job growth remains solid, even in the face of cutbacks in capital spending, disruption in supply chains, Boeing problems with the 737 MAX and strike settlements at General Motors.
The strength in the labor market has been reflected in solid growth in consumer spending and in the stock market, which, after a scare, late last year, have pushed to all-time highs. Households are in a relatively strong position today, with consumer confidence remaining near its high for this cycle and the saving rate currently running at 8.3%. Wages and salaries have risen at a 4.0% annual rate over the past three months. Moreover, wages have risen fastest at the lower end of the income spectrum, where workers tend to spend a larger portion of their take-home pay.
Worries about an impending recession have diminished considerably since last summer when the yield curve briefly inverted sending financial markets into a frenzy and sparking fears that this record-long business expansion was near its end. Most of the concerns stemmed from the trade war with China, which slowed global economic growth and led to a pullback in manufacturing orders and output. The Federal Reserve has been proactive, cutting the federal funds rate by a quarter percentage point three times this year and providing liquidity to the short-term funding markets by expanding its balance sheet with purchases of short-term Treasury Bills.
Still, trade disputes have raised uncertainty and slowed investment. Progress toward a preliminary trade deal between China and the U.S. has been an unambiguous positive for the outlook on this front. Even so, with low unemployment and an aging population, finding skilled workers will remain a headwind to business expansion. As a result, economic growth should slow over the next several years relative to the past.
Business activity in some of the world’s largest economies has remained sluggish as 2019 draws to a close, amid signs that a long slowdown in manufacturing has spread to the services sector. Across the globe, factories have been hit by rising tariffs and slowing investment spending as businesses have opted to wait out a lengthening period of unusually high uncertainty about future trade relations between the world’s leading economies.
A fracturing of the global economic system meant that robust rates of economic growth are no longer an absolute certainty. Ongoing trade tensions and geopolitical uncertainties have contributed to a slowdown in world trade growth, which has more than halved since last year. This has in turn depressed global growth to its lowest level since the great financial crisis.
Retail Sales
Retail sales rose by 0.3% in October, rebounding from a 0.3% decline in September. Gains were concentrated in autos & parts dealers and gasoline stations. The increase in retail sales suggested consumers have continued to hold up well, despite lingering global trade tensions and a broader slowdown in the manufacturing sector across the U.S. and Europe. A still-robust job market and solid wage gains should continue to underpin spending. The prospects of some resolution on the trade front could also boost consumer confidence and help to raise consumer spending.
Small Business Optimism Index
Although manufacturing has weakened, some improvement in small business confidence was reported. The NFIB small business optimism index increased in October, with businesses signaling they would move forward with capital outlays in the months to come. This has been a good sign for sputtering investment, which has contracted in the last two quarters as economic policy uncertainty spiked.
Price Level
Although trade uncertainty has made its way through the U.S. economy, it has yet to show up in overall price pressures. Indeed, despite the imposition of tariffs on many imported consumer goods from China in September, goods prices, which have carried the burden of the tariffs on aggregate, only rose by 0.3% on a year-over-year basis. In addition to the rising U.S. dollar, other forces may be counteracting the price increases implied by tariffs. Elevated inventories for some consumer products have likely put downward pressure on prices. There have also been indications that importers are absorbing tariff impacts by compressing margins, the latter demonstrating how some U.S. firms have shouldered the burden of the trade war.
Housing
The housing market has perked up recently, thanks to lower mortgage rates and more concerted efforts on the part of builders to develop entry-level homes. Residential investment rose at a 5.0% annual rate in the third quarter, marking its first positive contribution to economic growth in six quarters. The pickup in new and existing home sales and new home construction likely has some legs to it. Lower interest rates have boosted housing affordability and businesses, and workers have increasingly migrated to lower-cost metropolitan areas, where residential development is more feasible. Demographics are also turning more positive, with a growing number of Millennials reaching their late thirties each year, which has boosted household formation.
While the underlying fundamentals for housing have turned positive, there have been limits as to how much home sales and new home construction can ramp up in the short-term. Inventories of new and existing homes have remained near historic lows and affordability has remained a major challenge across most of the nation’s fastest-growing metropolitan areas. Moreover, construction labor remained scarce across much of the country and there has still been quite a bit of resistance to residential development, particularly in areas of the country where economic growth has been the strongest.
Manufacturing
American manufacturing faces a tough road. Weak foreign demand and elevated trade uncertainty have conspired to suppress activity in the sector. The ISM manufacturing index has been in contraction territory for some months. The state of the manufacturing sector has fueled fears that the contraction will spill over to other sectors, ultimately causing an economy-wide recession. This is unlikely. Manufacturing has not been the driver of economic growth that it once was. It has accounted for a small and decreasing share of overall economic activity and an even smaller segment of employment.
Still, the slump in manufacturing has been a symptom of a broader global demand slowdown and sentiment shock caused, in part, by trade conflicts. There is a risk that what ails manufacturing could spread to the rest of the economy, but so far, the signs appear to be of an economy that is maintaining its resilience.
The key metrics to keep an eye on: one, the ISM manufacturing index – the nascent sign of stabilization in October corroborates the story of a floor in domestic demand observed in other indicators; two, manufacturing job growth – outside of the strike at GM, manufacturing jobs appeared to have held up in October; three, service-sector employment as a sign of the American economy’s overall resilience.
Non-manufacturing
The ISM non-manufacturing index climbed to 54.7 in October from a three-year low of 52.6 in September. The multi-year low of the non-manufacturing survey was especially concerning, indicating outright contraction at the fastest rate since 2009. The manufacturing survey still indicates contracting activity, but the greater worry has continued to be manufacturing weakness spilling over into the much larger service sector. That remains a risk, but the spread between the two rose in September and healthy consumer fundamentals pointed to continued resilience.
Business Investment
While the housing market has recently emerged as a bright spot, business investment has been a drag on growth. Since last year, businesses have found themselves in a deep fog of economic uncertainty brought about by volatile policymaking and the U.S.-China trade war, making them reluctant to commit to new investment projects.
Equipment spending – the largest component of business investment – has borne the brunt of the uncertainty impact, with the rise in uncertainty reducing equipment investment by an estimated 4% in the last eighteen months. The resolution of the trade war could help boost investment. However, a sustained improvement would only be possible once firms are convinced that policy-making will not be as volatile as it has been over the last few years.
Trade
In October, there were signs of a de-escalation in trade tensions between the U.S. and China; both countries agreed to lift the same proportion of tariffs simultaneously on one another in stages if the two countries reached a phase-one trade deal. Since then, there have been few signs of progress. Both sides have remained divided over core issues—including Beijing’s demand for removing tariffs and the U.S.’s insistence on China buying farm products.<
A trade deal is not necessarily expected in the coming weeks and there could be a U.S. political battle over the president’s call for a truce in the China trade war. Looming now are plans by the Trump administration to impose 15% tariffs on Chinese products on December 15.
Any trade deal between these two countries should help U.S. equities. Equity markets have continued to hang on every murmur on the trade war, which has remained perhaps the most significant risk to the economic outlook and has caused business investment to falter.
However, caution should be used in reading too much into the recent optimism about a trade deal, for as long as core issues remain unaddressed, a re-escalation in the trade war remains a distinct possibility.
Yield Curve
Yields on longer-term U.S. government debt have climbed above those on shorter-term treasuries in recent weeks - a sign investors expected no immediate pullback in growth and inflation. That stands in contrast to earlier in the year, when longer-term yields fell below their shorter-term counterparts, leading to an inverted yield curve. The reversal gives comfort to investors because an inverted yield curve has proven to be one of the financial markets’ best predictors of recessions.
The change in the yield curve has been the product of recent interest rate cuts by the Federal Reserve and improvement in U.S.-China trade relations. Taken together, the developments have bolstered expectations about the durability of the record economic expansion, helping power stocks to records. That has pushed up long-term yields, which have been particularly sensitive to the outlook for economic growth and inflation.
Global
Recent data from key international economies has offered investors little respite from concerns about slowing global growth. Chinese GDP growth softened further in Q3 to the slowest pace in decades, while Eurozone Q3 GDP data released showed the region’s economy grew a paltry 0.2% (not annualized) during the quarter. October sentiment figures from China and the Eurozone have suggested both economies may have lost further momentum going into Q4, hardly an encouraging sign. The European Central Bank (ECB) made no changes to monetary policy at its October meeting, the final meeting for Mario Draghi. However, the central bank is expected to cut rates an additional 10 bps at the December meeting, the first for newly appointed ECB President Christine Lagarde, as growth and inflation continue to languish in the Eurozone.
On the Brexit front, Prime Minister Boris Johnson turned matters back over to the people of the United Kingdom as he successfully put forth a bid to hold an early general election on December 12. Current polling has suggested his Conservative Party will win a majority, allowing them to pass PM Johnson’s recently negotiated Brexit deal and move on to longer-term trade talks with the European Union. Still, a lot could change in the coming weeks, and there is a significant risk that the election will merely result in more gridlock and dithering rather than a path forward to the next stages of the Brexit process.
Outlook
The economic cycle is maturing and concerns have been raised about its sustainability. However, warnings about an imminent downturn are not supported by the data. Consumer fundamentals remain sound and there is little evidence of excesses in household leverage that would hasten a downturn. The key risk lies on the business side of the economy, where global trade and policy uncertainty is weighing on investment and contributing to the economic slowdown.
While the risk of recession has subsided, a cautious forecast for the current quarter seems prudent. Following a 1.9% annualized growth rate in Q3, real GDP is likely to rise at a 1.5% pace in the current quarter. Much of the shortfall in headline GDP growth stems from a reduction in inventory building. Capital spending is also expected to slow as businesses cut back on equipment purchases and energy exploration moderates further. Trade is also likely to exert some additional drag on growth, as imports grow faster than exports.
Consumer spending is likely to remain a lynchpin of growth, but at a more subdued rate than the past several years. Investment, meanwhile, is likely to be muted, reflecting heightened global uncertainty and the broader moderation in demand growth.
If the headwinds from the trade war truly subside, the economy could be headed for better days. Capital spending, which is where much of the weakness is centered today, tends to follow consumer spending and homebuilding. Both look set to remain solid in the coming quarters.
Sources: Department of Labor, Department of Commerce, Institute for Supply Management, Morningstar, Bloomberg, National Federation of Independent Business
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