The domino effect?
Heading into the final quarter of the year, economic growth in the U.S. appears to be softening. BBVA USA Research estimates 3Q19 gross domestic product (GDP) to be around 1.8% with 4Q19 coming in at 1.6%. Much of the deceleration is a result of weakness in the manufacturing sector and trade uncertainty which is impacting business investment and net exports. While growth in the second half of the year is likely to be tepid, a recession in the short-term remains unlikely. BBVA USA Research still anticipates economic growth in 2019 will be around 2.3%, above the long-term average of 2.0%.
Slowing global growth and the ongoing trade conflict between the U.S. and China have intensified the weakness in the U.S. manufacturing sector. For September, the Institute for Supply Management’s (ISM) manufacturing index declined for the second straight month to 47.8 from 49.1 - the lowest level since the end of June 2009. The sharp decline is concerning as any reading below 50 indicates a contraction. However, a separate survey from IHS Markit showed U.S. manufacturing activity rising to 51.1 in September from 50.3 in August. Even though manufacturing accounts for a small share of the U.S. economy, approximately 12%, its impact bleeds into other parts of the economy such as net-exports which have already been dampened by the stronger dollar, and business sentiment.
Business investment has cooled significantly throughout 2019. In the second quarter, business investment declined at an annualized rate of 1.0% - the steepest decline since the fourth quarter of 2015. Trade uncertainty remains a key driver of the decline in business investment. While a short-term truce between the U.S. and China appears to be in the works, it is unlikely it would make a difference as companies are unlikely to commit to new investments until a deal is finalized. The trade standoff is not the only headwind business investment faces: the stimulus from corporate tax cuts has all but faded, and labor costs are rising. Easier monetary policy and stimulative fiscal policy should prevent a sharp decline in investment, but softness in these sectors is likely to continue into 2020.
Weakness has also begun to trickle into the service sector, which up until now has been unruffled by the trade war. In September, ISM’s nonmanufacturing index slipped to 52.6 – its slowest pace in three years. While service-sector activity is still in expansionary territory, it is a significant decline from 56.4 in August. Still, the service sector is not expected to slip into a contraction as long as consumer spending remains robust and the labor market remains strong. An escalation in the trade war could cause the softness in nonmanufacturing to continue if sentiment continues to be pulled down.
Can you see the light?
Relative strength in consumer spending has kept the U.S. economy afloat this year. Rising household incomes and a solid job market have encouraged consumers to go out and spend more even as sentiment has waffled. Retail sales, which is a measure of purchases at stores, online retailers, and restaurants, rose to one of its highest levels for the year in July at 0.7% on a monthly basis. Separately, consumer spending, which accounts for more than two-thirds of economic output, rose 0.7% in July on a monthly basis. Spending in August, however, was tepid, rising only 0.1% from a month earlier. Much of the slowdown can be attributed to lower energy prices and declining interest rates. Meanwhile, purchases on long-lasting consumer goods, such as household durables and cars, picked-up; this usually occurs when consumers are confident about their future prospects. While the decline may suggest the headwinds facing businesses and manufacturers are starting to impact the consumer beyond sentiment, consumers remain on solid footing.
The housing market is also showing potential signs of life, boosted by lower mortgage rates. For much of the summer lower mortgage rates appeared to only lead to a pickup in refinancing, but lately data regarding new construction and homes sales has picked up meaningfully. The National Association of Realtors reported pending homes sales increased 1.6% in August from a month earlier and were up 2.5% from a year earlier. Sales of newly-constructed homes increased 7.1% in August. Compared to a year earlier, new-home sales were up a whopping 18%. Similarly, existing home sales rose 1.3% in August to an annual rate of 5.49 million. Meanwhile, housing starts in August rose to their highest level since 2007, an annualized rate of 1.36 million – a 12% increase from July. The rebound in demand for housing is likely to remain throughout the fourth quarter as affordability is likely to continue offsetting some of the risks from the trade war and global growth uncertainty.
The labor market should also continue to serve as a tailwind to the economy. Employers added 136,000 jobs in September, while payrolls for August and July were revised upwards. According to the Labor Department, over the past three months, job gains have averaged about 157,000 per month. The gains still suggest the labor market is solid, but this is slightly lower than the average gains for the year at 161,000 per month and an even bigger drop from 223,000 in 2018. The unemployment rate fell to a fifty-year low in September to 3.5% down from 3.7% in August. A broader measure of unemployment, the U-6 rate, which gauges those too discouraged to look for work and those who want to move from a part-time job to a full-time job, fell to 6.9% in September from 7.2% a month earlier – its lowest level since 2000. Even though job growth appears to be moderating, the ever-declining unemployment rate and slight uptick in wage growth should curb immediate fears of a recession.
The Fed’s insurance policy
While there are reasons to be sanguine, there are risks looming over the U.S. economy. The trade war remains unresolved, and the outlook for global growth continues to deteriorate. PMIs, which survey manufacturing activity, declined sharply in September for much of Europe and Asia. Data from the most trade-sensitive economies has been bleak. According to data compiled by IHS Markit, Eurozone manufacturing activity fell to its weakest level since October 2012. In particular, German manufacturers have suffered as export orders declined sharply and industrial production continues to weaken. The service sector isn’t faring much better. Unlike the Eurozone’s manufacturing sector, the service sector is not in a recessionary slump, but is weakening. IHS Markit’s index for the Eurozone’s nonmanufacturing activity was 51.6 in September, down from 53.5 in August, dragged down by a pullback in Germany. This is troublesome as Germany is the world’s fourth-largest economy; its central bank has suggested the country may have entered a recession. Europe also faces the additional risks of new tariffs on exports to the U.S. and a messy divorce with the U.K.
Concerns about the impact of sluggish global growth bleeding over into our domestic markets and weakening have encouraged the Federal Reserve to cut short-term interest rates twice this year. Most recently, the Fed cut short-term rates by a quarter of a percentage point in September to target a range of 1.75% to 2.00%. Even though Fed Chairman Jerome Powell continues to cite an overall favorable outlook for the U.S. economy, it is likely that the Fed may implement an additional “insurance” cut this year to prevent the global economy from pulling the U.S. out of its expansionary phase. Interest-rate futures markets are already pricing in over an 80% probability of another quarter percentage point cut at the Fed’s October meeting. There is a 50% probability of are anticipating at least two more cuts this year.
While Fed officials have left discussions about the future path of interest rates open-ended, persistently low inflation further supports the outlook of at least one more interest rate cut this year. In September, consumer prices, gauged by the CPI index, rose a seasonally adjusted 0.1% from a month earlier and 1.7% from a year earlier. Core prices, which exclude volatile food and energy categories, were up 2.4% for the year. More importantly, the Fed’s preferred measure of inflation, the core PCE index, rose 1.8% on a year-over-year basis in August, undershooting the Fed’s 2% target. The muted gain in core prices suggests inflationary pressures are still contained. However, rising tariffs against China and Europe pose an upside risk to consumer prices.
Overall, U.S. economic growth is slowing but not floundering. While risks to the manufacturing sector are surely rising, consumer fundamentals remain solid, and corporate balance sheets are still in decent shape. If there are proactive steps taken towards a trade agreement between the U.S. and China this year, manufacturing and business investment may begin to recover. Regardless, easing monetary policy domestically should be supportive to U.S. economic growth.
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