After a relatively quiet September, October opened with a thud when a stunningly weak manufacturing survey showed decided weakness last month. While noting that this was a survey and not actual data, and the survey was weaker than expected, in part due to inventory liquidation, when combined with moderating consumer confidence and overall economic slowness, investors got spooked. The timing of yesterday’s decline was also eerie as it came almost precisely one year to the day from the start of last year’s 20% slide in the fourth quarter.
While not all data is weakening, the preponderance of information suggests an economy losing steam. While the 2-10-year Treasury yield curve is no longer inverted, the 3-month to 10-year curve is still inverted, a telltale warning that a recession isn’t far away. Growth in Europe has stagnated, Japan remains in a funk, and China is being impacted by tariff concerns and too much debt.
The Federal Reserve is caught in the middle. Before yesterday, I would have said the Fed has good reasons to skip cutting rates in October. It could afford to wait until December. There is a lot more data to come this week with the biggie, the monthly employment numbers, coming out on Friday. But just based on the manufacturing survey alone, the odds of another cut at the end of this month have increased. With that said, investors increasingly wonder how effective interest rate policy can be as a prime driver of economic growth. In a world where tariffs are slowing trade and serving as an added tax, and where fiscal policy drivers for growth around the globe are hardly existent, monetary policy alone cannot reignite growth.
A year ago, the Fed had just initiated its third of four rate increases in 2018. Corporate profits, courtesy of a large tax cut, were rising at double digit rates. Interest rates overall were rising. The U.S. 10-year Treasury yield was pushing toward 3%. But growth was slowing after peaking in the second quarter. The outlook for 2019 a year ago was for earnings per share growth to moderate to mid-high single digits. A year later, that proved to be rather optimistic. But lower interest rates helped to keep stock valuations elevated.
Since early 2018, the S&P 500 has flirted with the 3000 level, sometimes exceeding it by a bit and sometimes coming up a bit short. To break through, earnings estimates will have to rise from current expectations, something that doesn’t seem likely as long as the trade wars continue. At the moment, the timetable for tariffs suggests further escalation in mid-October and again in December. So far, those are threats; not commitments written in stone. But the threats overhang the market. The escalating impeachment concerns threaten to further polarize Congress and put the new trade agreement with Canada and Mexico in jeopardy, although House Speaker Nancy Pelosi and Trade Representative Robert Lighthizer are trying hard to get a deal done. One shouldn’t expect any other significant legislation between now and the Presidential election.
All this somber news suggests the possibility of a repeat of last year’s weak fourth quarter. Indeed, if I look back over the past several years, when traders get negative, markets fall sharply. So much volume is concentrated today in so few hands that when all get negative at the same time, as they are prone to do at economic inflection points, the declines can feel very painful. But without real fundamental data to back up the declines, they have tended to be short-lived. Last year’s September-December swoon was entirely reversed by April. That is a far cry from bear markets we have seen in the past, most recently in 2008-2009. For that kind a decline to persist requires major changes in consumer behavior, something that is hard to fathom as long as most Americans are gainfully employed with wages rising faster than inflation. Moreover, there are some bright spots. Low interest rates have reignited some interest in housing. That market is clearly off its lows. Technology spending, mostly for software and infrastructure remains robust as companies move more to the Cloud. Internet retailing is robust and growing at double-digit rates.
One key is to try and differentiate a wobble in the economy’s growth rate from the start of a true recession. Here are some keys to watch:
1. Weekly unemployment claims – they have stayed persistently in the 200,000-225,000 range for many months. Any move above that range would be a warning. Anything above 250,000 would be dangerous.
2. Housing starts – if despite low rates, housing demand wanes, that would be a true indicator of the impotence of monetary policy. So far at least, housing appears to be perking up, a good sign.
3. A significant drop in consumer confidence – while surveys suggest some increase in apprehension, so far consumers are confident. Lower energy prices help. Could impeachment talk soil the mood? I don’t think it does directly. But if events played out in a way that the future of a Trump Presidency was in doubt, related uncertainties could give way to some pause. Interestingly, polls today show an overwhelming support for the impeachment process in Congressional districts with a Democratic Representative and overwhelming opposition in Republican-held districts. Should those opinions change in either direction in a meaningful way, the future would change accordingly. Members of Congress follow the polls.
4. The JOLTS survey of job openings – this monthly survey has shown measurable declines in recent months. Further declines would be disconcerting.
5. The stock and bond markets – Paul Samuelson, the noted economist, noted that markets have predicted nine of the last five recessions. That means almost as many false signals as positive ones. But virtually all recessions are preceded by some stock market decline. With rates declining, bond markets are signaling lower inflation expectations, although recent rallies suggest that maybe the lows in rates for this cycle are behind us. However, a meaningful deterioration in the economy would lower inflation expectations further and could invert the 2-10-year spread once again. If that were to happen, it would raise a pretty vivid warning sign. So far, over the past few weeks, the spread has actually widened a touch.
The bottom line is that growth is slowing but signs of recession are still not visible. We see some points of concern but no real sense that recession is imminent. That could change, of course, particularly if the full package of proposed Chinese tariffs are implemented by the end of 2019. However, given the economic and political climate today, I still believe it is unlikely we see the full package implemented. Right now, the President needs a few wins, not more pain.
These conclusions don’t preclude a brief sharp correction. We haven’t had one yet this year. October is often a volatile month, and stock valuations are full. But I don’t see any correction likely to be long lasting without a commensurate recession. So far, data doesn’t support a recession thesis.
Today, Kelly Ripa is 49. Sting is 68. Singer Don McLean is 74. He has been spending the last 48 years singing one song, “American Pie” as the centerpiece of his concert tours.
James M. Meyer, CFA 610-260-2220