Art Micheletti, CFA, Economic Consultant
September 30, 2019
The U.S. economy slowed earlier this year and appears to have deteriorated further in the third quarter. For the quarter ending June 30, the economy slowed to a 2.0% annualized rate and the year-over-year pace slowed to 2.3%. This was down from the first quarter’s 3.1% growth rate and 2.7% year-over-year. The U.S. has remained on a slow growth path but, notably, is growing faster than most countries and regions.
The economic consensus forecast from both the Atlanta Fed GDPNow forecast and the New York Fed NowCast model predicts 2% growth again in the third quarter. The New York Fed Recession Probability Model increased once more in August to 38, a level consistent with prior recessions. In addition, the Organisation for Economic Co-operation and Development (OECD) Leading Economic Index for the U.S. has continued to trend lower, pointing to sub-2% growth in the fourth quarter, as does the Goldman Sachs Current Activity Index. Also pointing to economic weakness is the inverted yield curve, with short-dated U.S. Treasuries currently yielding higher than long-dated Treasures.
We continue to expect slow growth as long as consumers support economic activity. Consumer spending has been augmented by a decline in savings and an increase in consumer credit. Employment growth has remained steady (1.5% year-over-year growth), while hours worked have been flat and hourly wages have trended higher at 3.2%. The number of people working, plus wages and the hours worked, gives an indication of nominal consumer income. Assuming 2% inflation, real income growth is around 2.5%.
Housing has long been a drag on GDP growth but is now likely to become a contributor. The sharp decline in mortgage rates is expected to provide support for economic growth ahead.
The manufacturing sector has continued to trend lower; the ISM Manufacturing Index fell into negative territory to 47.8 in the third quarter, consistent with weaker production and GDP growth. Durable goods orders have trended lower, indicating further cuts in production.
Capital goods orders are also deteriorating, with year-over-year growth of only 0.6%. Capital expenditures have been disappointing, as cash flow and borrowing have gone to dividends and share buybacks rather than investment.
In addition, inventories have remained high (relative to sales) and inventory accumulation has helped stabilize current growth at the expense of future growth.
The trade deficit has continued to deteriorate. Barring a swift resolution to trade disputes, it is possible the worst of the trade war impact may yet be ahead of us.
The biggest long-term problem for the U.S. economy is the increasing accumulation of debt. The budget deficit is back above $1 trillion, corporate debt is near its record high, and the consumer continues to buy on credit. Moreover, debt accumulation has become a global phenomenon. Debt has been kept manageable by the suppression of interest rates by central banks and the massive printing of money. Central banks are leaning heavily on the scale of interest rate policy. In a free market, without central bank influence, rates should be moving higher (not lower) as debt climbs.
There is currently $17 trillion in negative-yielding global debt outstanding. Bond investors are paying for others to hold their funds. The only reason an investor would do this is if they expect even lower rates and expect capital appreciation in the short run. One thing that is clear, is that central banks have less fire power at this level of rates than after the Great Financial Crisis. While central banks have shifted to become more accommodative, how long will investors tolerate low/negative yields before revolting? If, as we have seen recently, a small increase in interest rates was sufficient to slow growth, what happens if central bankers lose control of monetary policy and rates spike?
For now, financial markets are hoping for more liquidity and prospects of a resolution to the U.S.-China trade dispute. Markets are currently swinging about on prospects of more rate cuts, central bank liquidity, and daily headlines regarding trade. The other big drivers have been the current impeachment efforts and concerns about oil production, as the world’s largest oil facility was attacked in Saudi Arabia.
One thing that is clear, is that central banks have less fire power at this level of rates than after the Great Financial Crisis.
As noted, we continue to expect slow growth and low inflation, but there are a number of risks to this outlook and flexibility in both directions will be critical going forward.
Global growth shows continued signs of deterioration and has remained on a slow growth path, with most international economies growing at a slower pace than the U.S.
Europe reported annualized growth of 0.8% for the second quarter, with the UK reporting negative growth of 0.8%. Year-over-year GDP in Europe was up 1.2%. Not surprisingly, the growth outlook for the third quarter is for continued anemic growth.
The European Commission (EC) Business Climate Indicator, a measure of business confidence, fell below zero in September. GDP growth tends to follow.
Retail sales fell 0.6% to start the third quarter, and the year-over-year pace slowed to 2.2%.
New car registrations continued to deteriorate through the first half of the year.
New factory orders remained in a downtrend and have led industrial production lower. The manufacturing sector in Europe is continuing to deteriorate as the IHS Markit Purchasing Managers Index (PMI) for Europe stood at 45.7 in September, well below the 50.0 level that indicates contraction.
Construction activity continued to deteriorate in third quarter and, in September, the PMI Construction Index also fell below 50.0.
The EC trade balance with non-euro countries flattened year-to-date, with imports and exports decreasing as well. This could be a reflection of deteriorating economic conditions and the trade war. Notably, Germany and Italy accounted for all of the surplus.
Like the U.S. Federal Reserve, the European Central Bank (ECB) has been sounding more dovish and, after only modest growth in its balance sheet over the last year, the ECB appears ready to step on the gas pedal again. With the Eurozone overnight rate at 0% and the cost of capital to banks zero, how much more incentive do banks need to lend? This liquidity flow is likely to find its way into financial markets.
Europe is still dealing with the uncertainty of Brexit, with the daily news flow triggering rallies and pullbacks.
Japan reported growth of 1.2% annualized in the second quarter and 1% year-over-year. Japan’s GDP growth rate is up from zero the third quarter of last year. While still weak, Japanese growth has gone from bad to less bad.
Japan’s Leading Indicator Diffusion Index continued its deterioration through August; economic growth should follow.
Japan’s real income and household spending have both slowed, falling to a 0.9% and 0.8% year-over-year pace in August. Household real cash wages (no benefits) are falling at a 1.7% rate.
Retail sales jumped 4.8% in August, pulling the year-over-year growth pace to 2.0%.
Japan’s IHS Markit Manufacturing PMI deteriorated, falling to 48.9 in September. However, the Services PMI stood above 50.0, bringing the Composite PMI to 51.5, consistent with 1.0% growth.
Industrial production fell 1.2% in August and the year-over-year rate slowed to -4.7%.
Capital expenditure growth fell to 1.9% year-over-year in the second quarter and was decelerating heading into the third quarter.
Japanese inventories have been growing and helped support third-quarter growth. These inventories appear to be unwanted (relative to sales) and will eventually have to be worked down, likely creating a drag on growth.
The Japanese trade deficit remained in a down trend into the third quarter, with both exports and imports deteriorating.
Amidst anemic growth and near-zero inflation, the Bank of Japan is likely to remain accommodative.
After twice postponing another increase, on October 1, Prime Minister Shinzo Abe raised Japan’s consumption tax from 8% to 10%. The prior hike in 2014 (from 5% to 8%) weighed heavily on the Japanese economy with GDP contracting two quarters in a row that year. In contrast, impacts this time are expected to be more muted; most of the proceeds of this tax hike are being put back into the economy, including the funding of free preschool education.
Chinese quarterly GDP growth increased from 5.6% to 6.4% in the second quarter, but the year-over-year pace slowed to 6.2%. This represents the lowest level in three decades. One year ago, China was growing at a 6.8% year-over-year pace; and now, in the third quarter, the economy appears to have deteriorated further. The consensus economic forecast is for 6.2% growth in 2019, declining to 6.0% in 2020.
The trade war between China and the U.S. continues to weigh on Chinese economic activity; resolution will be a critical factor in getting China back on a stronger-growth path. China’s trade surplus has actually improved over the last year despite the tariffs. Unfortunately, this improvement has resulted from imports having fallen faster than exports, reflecting weak demand both domestic and overseas.
China’s currency fell to an eleven-year low in August. China has been allowing the yuan to drift lower in an effort to offset the negative impact from U.S. tariffs.
While having risen slightly to 49.8 in September (from 49.5 in August), China’s official Manufacturing Purchasing Managers Index has stayed below the critical 50.0-mark for five months in a row. Output and orders continued to slow.
The domestic economy is deteriorating. Electricity demand is falling and was relatively flat year-over-year as of September 30. Containerized shipping volume and freight rates are also relatively unchanged. Auto sales have been falling and retail sales are trending lower.
China’s capital spending growth continued to deteriorate and, in August, fell to a 5.5% growth rate.
Credit growth continued to accelerate in September, as Chinese authorities have been using monetary and fiscal policy tools to support growth.
China’s banking system remains under pressure, with non-performing loans continuing to trend higher.
Unlike most countries and regions, Chinese inflation is accelerating. Inflation climbed to a near six-year high in September (3% year-over-year). Nearly half of the September increase was attributable to a quick rise in pork prices, up 69% from one year ago. Surging food costs tend to get the attention of citizens and, if sustained, could lead to social unrest.
Unlike most countries and regions, Chinese inflation is accelerating.