Stocks staged a rather wobbly recovery yesterday despite another disappointing economic report, this time the ISM non-manufacturing survey of business activity in September. Getting less attention was the report of weekly jobless claims filed which continued to remain close to record lows. Clearly, the bulk of economic reports have suggested slower economic growth. As growth decelerates, the specter of recession increases. But while the data is discouraging, it still doesn’t point to an actual recession, at least not yet. Clearly, tariffs, Brexit, and a possible impeachment process have some impact on confidence but none of the above appear, as of yet, to materially change consumer habits. As long as consumers are working, secure in their jobs, and getting paid well, a recession seems a much less likely outcome than slower growth.
One factor that will help keep us out of recession is the steps taken by the Federal Reserve to keep the monetary environment favorable to growth. It has already initiated two rate cuts this year and the tepid data this week virtually insures at least one more this month. Markets expect a fourth cut in December, undoing all the rate increases the Fed initiated in 2018, but we don’t want to put the cart before the horse. December’s rate decision will depend on economic data between now and then.
Certainly, a persistent positive has been the labor market. Today’s employment report reinforces that trend. Employment growth in September was 136,000 jobs. Including upward revisions to July and August numbers, the increase was about 157,000. That is a very healthy number despite a slight decline in manufacturing jobs signaled earlier this week by the September manufacturing surveys. The average work week was flat as were wages. Year-over-year increases in wages of 2.9% remain well above the rate of inflation. Workers are getting real gains in income. The unemployment rate fell to 3.5%, the lowest since 1969. In order to have a recession with employment growth as strong as it is would require a huge drop in productivity, something that doesn’t appear likely over the near term.
While the employment numbers were at least as good as expected, the flat work week and decelerating wage growth suggest that we can’t label anything about this economy as robust. The most likely path is that economic growth over the next year will range between 1.5% and 2.5% before considering short term fluctuations in inventories. The headwinds created by the 2018 rate increases have just about worked their way through the economy while the impact of the rate cuts is just beginning to be felt.
Let me give an example. Housing is one of the industries most impacted by rate changes. The Fed’s first rate cut was in July and bond markets responded over the summer. There was a moderate but healthy increase in mortgage refinancing activity almost immediately. But it can take as long as 60-90 days to complete a mortgage refinancing. Similarly, while orders for new homes and new building permits are starting to respond to the lower rates, the impact to GDP is only reflected when a newly built home is completed and sold. That could take as long as a year. Corporations are taking advantage of lower rates and refinancing debt obligations. But once again, the time to complete a complex refinancing can take several months. Thus, over the summer, the delayed impact of higher rates instituted in 2018 was more impactful to actual economic activity than the impact of lower rates associated with a rate cut cycle that just began in July.
Playing this out further, the cyclical bottom in U.S. growth should be the second half of this year. Overseas, there are also signs of stabilization, particularly in Asia. While Europe is basically flat, consumers around the world are still confident and spending. Most of the world’s economic weakness relates to manufacturing, trade, and capital spending. Not to beat a dead horse, but in a world that is oversupplied with almost everything but labor, the solution to overcapacity is less investment and increased demand. It is going to take years to absorb the excesses existing today. China, for one, has to stop building zombie plants and apartments. China alone can supply all the world’s steel needs and then some. 5% of world oil supply goes off market briefly and despite a brief spike in prices, the cost of a barrel of oil today is less than it was before the missile attack on Saudi facilities.
Obviously, the absorption of excess capacity, and that includes everything from manufacturing plants to retail space, takes time. It causes weak prices and squeezes profit margins. That is why in 2019, our economy is growing about 2% in real terms and 4% in nominal terms while, at the same time, corporate profits are flat to down slightly. Earnings per share are held up by stock repurchases. Rising cash flows, a result of less need for capital investment, also leads to rising dividends.
One of Wall Street’s pet expressions is that the Fed is your friend when it is accommodative. Despite the outlook for flat or slowly rising earnings over the next year, low interest rates and rising dividends should support equity prices. Today’s employment report should provide some stability to the market, at least for the short term. October is a volatile month and most corporations are forbidden to buy back stock at the moment until they report third quarter earnings. There will be more tariff news this month and Brexit is an ongoing concern. But with that said, at least at the moment, the swoon earlier this week, which eerily resembled the start of the 20% decline that began last October, appears to be just a two-day swoon. With that said, we haven’t had anything close to a 10% correction so far this year, and the S&P 500 remains locked in the 2600-3000 trading range. There is room for a 10% decline without violating the range. Managements are going to be wary discussing their fourth quarter outlooks without clarity on tariffs. Therefore, the best counsel at the moment is to be vigilant, expect higher than normal volatility, and pick entry and exit points carefully.
Today, Alicia Silverstone is 43. Liev Schreiber is 52. Susan Sarandon turns 73.
James M. Meyer, CFA 610-260-2220