Week in Review
It was one of those weeks where underwhelming economic news morphed into decent news for the markets simply because it meant more love from global central banks. This trumped (that’s almost unforgivable, I know) impeachment talk, and don’t even start on the Saudi attacks – that seems like a lifetime ago!
On the economic front we found out manufacturing really stinks (I guess we sort of knew that already) and that the services sector is starting to wilt. For example, German manufacturing is contracting at its fastest pace since the depths of the Global Financial Crisis a decade ago. Their manufacturing PMI registered 41.4 in September, a steep fall from last month (anything below 50 indicates that sector is shrinking).
Same story in the U.S. This week’s ISM manufacturing number fell to 47.8 in September from 49.1 in August. This was the weakest print since June 2009.
We appear to have tariffed our way into a manufacturing recession around the world. Who would have thought?
If You Are Stuck in a Hole, What Do You Do?
You’d think you’d stop digging.
Oh no! On Wednesday the Trump administration imposed almost $7.5bn worth of tariffs on Europe. The primary target was Airbus, but for some reason Scotch whisky and European wine were hit with a 25% tax. This is really getting out of hand!
This didn’t come out of nowhere, however. The World Trade Organization ruled in favor of the U.S. regarding illegal aid to Airbus. Well, that’s true. Airbus has fed at the trough of European largess ever since its creation. But they aren’t the only ones. The European’s have a case before the WTO regarding the U.S. subsidizing Boeing. Well, they have a point as well. The WTO is expected to rule in Europe’s favor early next year and permit the European’s to levy tariffs on U.S. goods. Watch out Harley Davidson and Kentucky Whisky!!
As with most trade disputes, the knock-on effects are akin to shooting yourself in the foot. For example, Delta’s shares fell 5% on Wednesday and another 3% on Thursday because they already have Airbus airplanes on order they can’t cancel. Furthermore, Boeing doesn’t have the capacity to ramp up production to replace existing orders. So, Delta and other airlines will pay more for their planes, their profitability will take a hit, and the higher costs will be almost certainly be partially passed through to consumers.
And while we are talking about how easy it is to win trade wars, Just ask U.S. Steel how the steel tariffs worked out for them. A 25% tax on imported steel was announced on March 1st, 2018. The share price for U.S. steel has fallen close to 76% since then.
Will Services Follow Manufacturing?
Anyhow, back to the economy. A key question is whether the manufacturing recession spills over into services. After all, in the U.S. manufacturing makes up just 11% of the economy. Even in Germany where manufacturing makes up double that amount, the service sector has been growing all year.
However, the latest reports on service sector growth in Europe are not encouraging. The U.K. service sector is contracting while Germany’s is slowing rapidly.
It’s a similar story in the US. The ISM non-manufacturing index declined by more than expected in September (blue line in the chart below).
The red line above shows the employment index. If we take the employment indexes for both the services and manufacturing sectors and combine them, you get the chart below.
This would indicate that job growth is likely to slow reasonably quickly in the months to come.
Job Market Show Hints of Slowing
This was partially confirmed by Friday’s payrolls number. The headline jobs number at 135K for September ex-Census (136K total including temp Census hires) was below consensus expectations of 145 thousand, however the previous two months were revised up 45 thousand, combined. The unemployment rate declined to 3.5%; the lowest rate since 1969.
But wage growth softened.
Waiting on the Fed
So why did the markets rally on Thursday and Friday?
It all comes back to the Fed. It is hard to see how they don’t cut rates when they meet October 29th and 30th. As you can see below, the odds of a quarter-point cut are running at 78%.
The final meeting of 2019 is on December 10th and 11th. There’s a decent chance we see another cut then. and as you can see below, there are pretty high odds we see another cut in December.
As Tim Duy notes:
“Bottom Line: October begins on a weak note, strengthening the case for a rate cut at the end of the month. Still much data ahead, but it needs to on net show improvement to keep the Fed from cutting again. Those ISM false alarms in the 1990s were likely false because, like now, the Fed cut rates proactively. It remains to be seen if the Fed can pull off that trick a third time. The fact that housing responded quickly to lower interest rates suggests that they can.”
Mean Reversion in 2020?
This gets to the nub of the issue – will the Fed cut enough to get ahead of the economic slowdown and prevent a recession? Tim thinks so because he thinks lower rates will boost growth in interest rate sensitive sectors of the market – housing, car sales, etc.
Another way of showing this is by looking at past instances of manufacturing recessions in the U.S. The chart below shows the ISM number for manufacturing going back to 1982.
You can see that the index has fallen from roughly 60 to below 50 over the last few months (from #6 high and #6 low). So how has the market performed during falls of similar magnitudes historically?
Actually, not that bad. In four out of the five historical examples the market was higher 12 months out. The lone exception (as it is for many things) is 2008. In 2008 no amount of rate cuts was going to prevent the housing bust. In the other instances a policy shift happened rapidly enough to avert a deep recession. This doesn’t mean this cycle will play out the same way, but it is interesting nonetheless for any investor with a time horizon beyond the short-term.
Have a good weekend.
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