Over the last 12-18 months, there's been a continual grinding lower in the global economic data, primarily centered in the manufacturing sector. At first, it was only anecdotal in nature, with various Market PMI or US ISM reports noting concern among respondents about tariffs. That concern eventually lowered sentiment, which led to a drop in new orders and eventually purchasing activity. Traders started to pick-up on this development and acted: over the last three months, various measures of the belly of the treasury market have been inverted while the 10 year/3-month spread inverted about a month ago. This is starting to impact the US economy: industrial production has been weak since the first of the year while the pace of job creation is starting to slow.
Let’s look at this chain of events in a bit more detail, starting with the global manufacturing picture. Every month, Markit Economics publishes purchasing managers indexes from numerous countries. These are then compiled in a master, global index. Here is a chart of that data:
The report’s commentary says it all:
“July PMI data signal that the global manufacturing sector remained on a weak footing at the start of the third quarter. The PMI implies no growth in global manufacturing output with the deteriorating trend in international trade flows weighing particularly heavily on performance.
This is bolstered by other economic data. Japanese industrial production has contracted on a Y/Y basis in 7 of the last 12 months as has EU industrial production and UK industrial production. The IMF commented on this weakness in its latest global economic update.
This weakness has manifested in the US financial markets in two ways. First, various sections of the bond market have inverted, starting with “the belly of the curve:”
The left chart shows the spread between the 10, 7, and 5-year treasury and the 3-month bill. This part of the curve inverted about three months ago. The right chart shows the difference between the 7, 5, and 3-year treasury and 1-year treasury. This part of the curve inverted at the end of last year and has been remained so for most of 2019.
Then we have the “big one” — the spread between the 10-year and 3-month treasury:
This inverted about a month ago and is considered a “classic” recession signal.
Over the last three months, the financial markets have pick-up on the softening economic backdrop and have acted accordingly:
Performance Chart from Stockcharts.com of the (from left to right) IEF, TLT, IWM, SPY, OEF
The above performance table shows the 3-month performance of five ETFs: (from left to right) the IEF (7-10 year treasury); the TLT (20-year treasury); the IWM (the Russell 2000); the SPY (the S&P 500); and, the OEF (the S&P 100). The treasury market has clearly out-performed equities. Among stocks, larger-caps have “outperformed” (or, more specifically, have done less badly). This tells us that traders and investors think growth will be weaker in the coming 6-12 months.
There’s good reason for that assessment of the US economy. While the data is not “screaming” recession, there is ample softness across a variety of statistics to support a bearish case. Let's start with a few leading indicators. The big one — the yield curve — is above. 1-unit building permits are softer:
1-Unit Building Permits
This leading metric has been declining for the last year.
Average Weekly Hours of Production Workers
The average weekly hours of production workers is declining. This is the first employment metric to drop as it allows employers to keep workers while simply using them to a lower degree.
And several coincidental numbers are soft, starting with industrial production.
Total Industrial Production
Total industrial production has been weaker since the beginning of the year. The drop in 2014-2016 was caused by oil’s price collapse, which was contained within the energy sector.
And then we have the latest employment report, which continued the trend of softer jobs growth. Here are two charts that illustrate the underlying weakness:
Data from St. Louis FRED system; author’s calculation
The 3-month moving average of payroll gains (in blue) is declining. While it’s been at its current level several times before, the sharper drop over a shorter period of time that preceded the most recent decline is new. However, it’s the 6-month drop (in gold) that should get your attention. Here’s a chart of the last 18-months isolated to better show the trend:
Data from the St. Louis FRED system; author’s calculations
The 6-month average of monthly job gains has been declining since July 2018. The pace of decline has accelerated over the last 5-6 months.
All of this explains why the Fed not only cut rates at its latest meeting but issued the following guidance (emphasis added):
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent. This action supports the Committee's view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain. As the Committee contemplates the future path of the target range for the federal funds rate, it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.
The italicized section is key: while the economic outlook is always cloudy, the Fed has less visibility than usual. The reason is the very uncertain international economic environment.
Here, I’d like to add a very important word of caution: yes, we do need to be concerned about the economy. BUT THAT DOES NOT MEAN THAT THE SKY IS FALLING OR THAT DOGS AND CATS WILL START LIVING TOGETHER IN THE NEAR FUTURE. This article should not be used as justification for an argument that “WE’RE DOOMED!!!!!” Remember to take account of the “relativity effect” which means that our most recent experience clouds our perception of the IMMEDIATE future. I think the mosts likely slowdown scenario is a period of prolonged weak growth fluctuating around 0% with one quarter up .7% and the next down .3%. This period will be exacerbated by a federal government that is unable or unwilling to act combined with a Federal Reserve that has far less policy room to maneuver than in previous recessions. This would also be in line with US economic fundamentals, which are an economy with slowing population growth and weak productivity.
All that being said, yes, it’s time to starting talking about an economic slowdown.
