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October 3, 2019 Video 5 min read
The U.S. economic fire is still burning, but recent Purchasing Managers' Index (PMI) data on the manufacturing and service sectors represented two buckets of cold water tossed on the flames.
Unexpectedly weak data on the manufacturing sector released on Tuesday was among the most recent, and perhaps most significant, pieces of data to shine a light on the negative impact of the ongoing trade conflict between the United States and China. The ISM Manufacturing Index dipped to 47.8 in September, falling short of expectations. (A reading below 50 indicates contraction in the sector.)

The report provided further evidence that activity in the nation’s factories is slowing — a fact that is showing up clearly in declining new orders, slower production, and shrinking production payrolls. If there’s any question about the degree of impact that trade disruption specifically is playing a key role in the downturn, the plunge in new export orders in September leaves little doubt, as that component fell to 41. The result? Manufacturing activity slipped to its weakest level since June 2009.

Equity markets have reacted directly to the ISM Manufacturing report in subsequent days, as investors recalibrated their expectations against the backdrop of rising recession risk. On Tuesday, the Atlanta Fed’s GDPNow estimate of economic growth for Q3 dipped from 2.1 to 1.8%, largely due to that downside surprise. Economists’ consensus estimates were also trimmed. Even so, the projection is for third-quarter growth remains generally in line with estimates of long-term potential growth of about 1.7%.

It may be surprising that expected growth is still this close to 2% if manufacturing is contracting. In the 1970s, that certainly wouldn’t have been the case; but the transformation of the U.S. economy into a service-based economy in recent decades now insulates it to a degree from a manufacturing downturn. To be clear, it’s not that weakness in manufacturing doesn’t matter as it certainly does. The manufacturing sector is a key source of quality jobs and an important cyclical contributor to (and indicator for) the economy. Still, at about 11% of GDP, manufacturing represents a relatively small slice of a much larger pie. By comparison, private service-producing industries ($14.8 trillion) are over six times the size of the private manufacturing sector ($2.4 trillion).

So, what of the service sector? The spillover effects from manufacturing are increasingly being felt there as well. The ISM nonmanufacturing index released this morning also slipped in September, dipping to 52.6 from 56.4 in August (a three-year low). The service sector is still expanding, but at a slower pace. The recent ebbing tracks very closely with the slowdown that occurred between July 2015 and August 2016.

Investors have long watched the manufacturing sector as an indicator of the health of the economy and a leading gauge of turning points in the cycle. Still, the results must be interpreted through a careful lens. It’s true that the ISM Index for September fell to its lowest point in over a decade. We would note that manufacturing has contracted for brief periods twice during the current expansion (in 2012 and 2015/2016). Additionally, although it’s weakening, the index remains at a level typically associated with a growing economy. Continued deterioration in the index to the low 40s would be a more worrisome sign and something to watch for.

More broadly, the economy’s growth is increasingly dependent upon the health of the consumer sector. Contributions to growth from business investment and exports were negative in the second quarter, and likely remained headwinds through the summer, but confirmation of that awaits release of the first estimate of GDP for Q3 later this month. The good news? The consumer sector still looks to be in good shape, supported by a solid job market, gradually improving wage growth, and manageable debt service costs. Although various measures of the consumer mood have slipped in recent months, they remain relatively upbeat from a long-term perspective in their view of the economy and assessment of their personal financial situation. Retail sales have been solid in recent months, with strong auto sales a particularly positive sign. When consumers are worried about their jobs or the outlook for the economy, sales of big-ticket items generally fall.

So why have the markets sold off in recent days? The markets lead the economy, not vice versa. Equities tend to fall in advance of actual downturns, as investors sniff out any indication of weakness. That doesn’t mean that the market always gets it right – quite the contrary. As Economist Paul Samuelson cynically observed many years ago, “The stock market has predicted nine of the last five recessions.” Like many good jokes, there is more than a little truth to that. Investors are constantly discounting the range of potential outcomes based on a myriad of factors that could impact the markets. Understandably, disappointing economic data tends to weigh on investor sentiment and equity prices, all else being equal. That’s effectively what we’ve seen in recent days.

One additional wildcard that we will be watching closely is the reaction from monetary policymakers at the Fed. In recent days, the market has priced in a much higher probability of a third rate cut when the FOMC meets on October 29 and 30. A week ago, the market was effectively tossing a coin, pricing in a 50% chance of a cut this month. As of this morning, that probability has risen to 90%. Coming out of its last meeting in mid-September, all indications were that policymakers were split on the need to trim further. Undoubtedly, they will be closely monitoring financial conditions and forthcoming economic data carefully, but recent developments appear to be much more likely to provide the central bank with an additional nudge to ease further than to stand pat. Although the effect wouldn’t be immediate, further easing would provide additional support to the expansion.

Of course, it’s impossible to determine today whether the recent slowdown will be exacerbated in the coming months. Economic data remains mixed, despite these key reports surprising to the downside. We’ll continue to closely monitor a broad swathe of incoming data to evaluate the contours of the future path for the economy. Today, most data points to a continuation of the current expansion. Even in the past few weeks, our conversations with various economists and market strategists suggest that although recession risks have risen, most still expect the economy to be on a safe footing into 2020 or beyond. Whether or not that will be the case remains to be seen, but forecasts remain broadly constructive.

For now though, investors should be prepared for the potential for volatility to remain elevated as the market digests developments in Washington and at the Fed, potential progress on trade negotiations, a forthcoming flurry of corporate earnings reports for the quarter just ended, and the continuing drumbeat of economic data. We will continue to monitor these developments closely and consider the resulting impact on both the potential risks and the opportunities that may be created. As always, if you have any questions, please contact your PMFA relationship manager.
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