Notes on the week aheadContributor Dr. David Kelly
Nice Levels – Shame about the Pace
My formative early teenage years were spent in Dublin, in the gritty era of punk rock. Punk rock produced many great bands such as the Clash, the Ramones and the Boom Town Rats. One of the lessor bands of the movement were the Monks, who had only one hit, entitled, with great sensitivity: Nice legs, shame about the face.
I would, I am sure have forgotten entirely about the song, were it not for one afternoon when I was out jogging near our home. Cool people, of course, didn’t jog and I was the very definition of awkward as I lolloped along in my bright orange tracksuit. But I wasn’t too conscious of this until I passed a gaggle of teenage girls, one of whom yelled out, in a fake North Dublin accent: “Nice legs – shame about the face”. Her friends appreciated the moment – I did not.
I was thinking about this on Friday when the May jobs report came out. Because all you could really say about it and the U.S. economy today is: “Nice levels – shame about the pace”. Moreover, in reaction to this slower growth, lower inflation and trouble in the global economy, the Fed is clearly taking a more dovish stance, making at least two rate cuts likely by the end of 2019.
The reality that the U.S. economy is in a good place by historical standards is clear across a number of dimensions.
- The unemployment rate in May remained at an almost 50-year low of 3.6%.
- Other indicators of a tight labor market, such as unemployment claims, consumer perceptions of the job market and the U-6 unemployment rate all remain very positive.
- The economic expansion will enter a record 11th year next month, and,
- Operating EPS for the S&P500 rose 22% last year to its highest level ever
However, momentum in the economy is clearly waning. Payroll job growth slumped to 75,000 in May and, with downward revisions to the prior two months, job gains have averaged just 127,000 per month over the past four months compared to 223,000 per month in 2018.
Wage growth was also slow in May, despite the tightness in labor markets with average hourly earnings rising just 3.1% year-over-year, down from 3.4% in February. Data due out this week on Job Openings on Monday and Unemployment Claims on Thursday will likely confirm that the labor market remains tight. However, they cannot obscure the reality that the pace of both job and wage gains has slipped.
The idea that the economy is at a good level but moving at a slowing pace is also evident in the components that feed into GDP. At this stage, it appears that real GDP for the second quarter might show less than 1% annualized growth. Data due out this week on Retail Sales for May should help tighten this still very rough estimate.
In addition, recent data have suggested that inflation will continue to run beneath the Fed’s target of year-over-year growth of 2% for the personal consumption deflator. Not only are wages not accelerating but slower global growth has contributed to a quick slump in oil prices. We expect the May CPI report, due out on Wednesday, to confirm steady inflation at 2.1% year-over-year at the headline level and 1.9% excluding food and energy. However, this should translate to just 1.5% growth year-over-year in both the headline and core consumption deflators for May. More importantly, there is little sign that either of these deflators will return to the Fed’s 2.0% year-over-year target at any stage in 2019.
At a global level, last weekend brought a welcome suspension of the tariffs on Mexico that the President threatened 10 days ago. However, both actual tariffs and, more importantly, the uncertainty caused by on-again/off-again tariff threats, is exacting a toll on global commerce. Clear evidence of this was on display in last week’s U.S. international trade report which showed U.S. exports down year-over-year for the first time since 2016 and imports up just 0.2% relative to a year ago.
Even broader evidence of a global economic slowdown comes from Markit PMI data. In May, the global manufacturing index fell to 49.8, its lowest reading since October 2012, while the global services index fell from 52.7 to 51.6, posting its weakest number in almost three years. In both cases, the U.S. numbers fell alongside the global readings.
The epicenter of the slowdown appears to be in those economies that specialize in exporting manufactured goods, including Germany, Japan, China, Korea and Taiwan. This does suggest that on-going uncertainties about future tariffs are contributing to the weakness. However, in the modern global economy, no country or sector is an island, and what started as an export- manufacturing problem has begun to impact the global economy in general. It should also be noted that other indicators of economic activity in many countries are not quite as negative as the PMI data so it will be important to check data due out this week, particularly on economic activity in China.
All of this is important in the context of Fed policy for the rest of the year. As economic growth has slowed and trade tensions have risen, markets have increasingly priced in Fed easing, with the Fed Funds futures market, as of Friday, pricing in one Fed rate cut at the July FOMC meeting and a second by November with the possibility of a third before the end of the year.
Statements by Fed officials have fueled this speculation with both Chairman Jay Powell and Vice-Chairman Richard Clarida saying last week that if trade issues led to a weaker economic outlook, they would take this into account in setting policy. Markets reasonably interpreted this as a very dovish signal and, unless the Fed quite deliberately tries to alter this perception over the next two months, market pressure will grow for a rate cut in July.
There are twin dangers to this strategy. First, it might embolden the Administration to prolong a trade war that is already clearly damaging the global economy. Second, all parties, including the Administration, the Fed and investors, seem to assume that rate cuts are an effective antidote to economic weakness. However, the last decade of seemingly ineffective monetary stimulus in the U.S., Japan and Europe suggest that, at least starting from this level of interest rates and at this point in the evolution of developed economies, this assumption is wrong. Consequently, a witch’s brew of an escalating trade war and declining interest rates could, in a worst case scenario, push the economy into recession and short-term rates down to their zero lower bound.
This is a worst case scenario. The Administration may try to tie down trade deals quickly to prevent further economic harm, the economy may prove to be a little more resilient and the Federal Reserve may push back at those who currently demand that they embark on the slippery slope of monetary ease. However, for investors, the risk of policy mistakes, combined with the venerable ages of our economic expansion and twin bull markets in stocks and bonds, all suggest a more cautious approach entering the second half of 2019.