FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
September 24, 2019

IN THIS ISSUE:

1. US Manufacturing Sector Officially in Contraction Mode

2. Strong Consumer Spending Continues to Drive Economy

3. Is the Treasury Yield Curve Really Inverted? It Depends

4. Fed Cut Rates a Second Time to Fight Yield Curve Inversion

Overview

As regular readers know, I have been very positive about the economy in recent years, unlike many financial writers who have been predicting a recession for the last two years or longer – the so-called “PermaBears.” While I still don’t believe a recession is headed our way anytime soon, a key economic indicator just signaled that the manufacturing sector is contracting.

This indicator has signaled contraction prior to each recession over the last 50+ years, so we have to take it seriously. That’s especially true in light of the continued inverted yield curve which has also preceded each recession going back decades. While I don’t see a recession just ahead, the pendulum appears to be slowly swinging in that direction, as we’ll discuss today.

Yet as I have written recently, US consumers are not buying the left’s narrative that the economy is headed for a recession, and they continue to increase spending and consumption. Until that changes, the US economy should continue to roll.

The Fed cut interest rates a second time last week as was widely expected. I continue to believe the Fed is doing this because of the inverted yield curve, which as we’ll se below has happened prior to each of the last seven recessions.

Meanwhile, the major US stock indexes are flirting with new record highs. If they manage to breakout to new highs, that could bring a powerful surge to the upside just ahead, since a lot of money is currently on the sidelines and could rush back in.  If stocks hit new highs, that will further undergird consumer confidence.

We’ll talk about all of that and more as we go along today.

US Manufacturing Sector Officially in Contraction Mode

The Institute for Supply Management’s (ISM) Index fell to 49.1% in August from 51.2 in July, well below the pre-report consensus of 51.0%. This was the lowest reading since January 2016. This is important because any reading below 50 indicates a contraction in the manufacturing industry.

Clearly, the manufacturing sector has been hammered by US-China trade tensions and President Trump’s tariffs. The ISM Index has fallen by nearly 10 points since the trade war ramped up last summer. Other factors have weighed on the Index as well, including oversized inventories overhang, slowing automobile sales and Boeing’s troubles with its 737Max.

While the ISM Index has slipped below 50 ahead of each recession in recent decades, we cannot read too much into this latest sub-50 reading. For one, it remains to be seen if the Index stays below 50 going forward. You can see that it dipped below 50 in 2016 when it looked like Hillary would win in a landslide, but we didn’t have a recession.

For another, when the ISM Index falls below 50 and stays there, the recession didn’t follow, on average, until 18-24 months later. And for another, Richard Moody, Chief Economist at Regions Bank, says the “recession threshold” for the ISM Index is a reading of 43 or below. It remains to be seen if we’ll reach that level.

The good news is that the ISM Service Index came in stronger than expected for August. The ISM reported that its Service Index rose to 54.6% in August, beating the consensus estimate of 54.2% and 53.7% in July. As with the manufacturing index, any reading above 50% indicates expansion in the services sector. A reading above 55% reflects “outstanding performance.”

The ISM Services index clearly reflects that the US economy has sustained its momentum despite heightened trade conflict and the global economic slowdown. Gains were broad-based and occurred in 16 out of the total 17 industries surveyed.

Notably, the services sector accounts for 70% of the US GDP while the manufacturing sector commands only around 12% of economic activity.

On another positive note, unlike the ISM manufacturing index which fell into negative territory last month, the Fed reported earlier this month that industrial production rose 0.6% in August after declining 0.1% in July. Capacity utilization, which measures how much of our factory potential is being used at any given time, also rose 0.4% in August to 77.9%.

In summary, while the ISM Index falling below 50% is a significant negative indicator, there are still some positives in the manufacturing sector. Should the ISM Index remain below 50 just ahead, that doesn’t suggest a recession until 18-24 months from now.

Strong Consumer Spending Continues to Drive Economy

In July, US consumer spending increased significantly, indicating that worries about a near-term recession were probably overblown. Consumer expenditures increased 0.6% in July, fueled by households’ purchases of a variety of goods and services. The increase exceeded the consensus estimate of 0.5% and represents a solid improvement over June’s gain of 0.3%. After accounting for inflation, consumer spending experienced a 0.4% increase in July. This was a major improvement over the 0.2% increase experienced in June.

Meanwhile, on September 5, the Department of Labor reported that US productivity (output per hour work) increased 2.3% in the 2Q of 2019, surpassing the consensus estimate of growth of 1.5%. Higher productivity will enable producers to raise workers’ pay without hiking the price of finished products. Consequently, higher wages will benefit workers, raising their standard of living.  

The above scenario clearly shows that US consumer spending has remained robust so far in the 3Q after it rebounded in the 2Q. Remember, consumer spending accounts for apprx. 70% of gross domestic product.

Is the Treasury Yield Curve Really Inverted? It Depends

The subject of an inverted yield curve remains a hot topic among market analysts and investors alike. The question is whether we are really in an inverted yield curve today, or not. Traditionally, we monitor the yield curve by looking at the 2-year Treasury note versus the 10-year Treasury note – the so-called “2/10 spread.”

While the 2/10 spread did invert momentarily in early August, with the 2-year yield rising above the 10-year, it quickly reversed itself – and the 10-year yield has remained above the 2-year yield since then. So, if we use the 2/10 spread as our bogey, then the yield curve is not inverted, but the two remain very close.

However, if we look at the 3-month Treasury bill versus the 10-year Treasury note, then the yield curve is inverted and it has been for several months. As of the end of last week, the yield on the 3-month Treasury bill was 1.89% and the yield on the 10-year T-note was 1.69%.

This is important because the Treasury yield curve has inverted prior to the last seven recessions. The recessions occurred, on average, about 16 months after the yield curve first inverted. Take a look at this chart:

The last time the yield curve inverted was in late 2007, and we all know what happened after that.  

Fed Cut Rates a Second Time to Fight Yield Curve Inversion

It remains my opinion that the Fed is deeply concerned about the inverted yield curve, and why wouldn’t they be after looking at the chart above? A yield curve inversion is about as reliable an indicator of a coming recession as they get.

The 3-month/10-year Treasury spread first inverted back in April and has remained upside-down for the most part since then. I believe this is why the Fed Open Market Committee (FOMC) abruptly decided in late July to lower the Fed Funds rate – when almost no one expected it.

After all, the economy was strong, the unemployment rate was near a 50-year low and inflation was comfortably below the Fed’s target of 2%. So, why the need for a rate cut? I think the chart above tells it all!

I believe this also explains why the FOMC lowered the Fed Funds rate by another 0.25% last week, as was widely expected this time. And it won’t surprise me if they cut it again at the end of their last policy meeting this year on December 11.

While I suspect there are members of the FOMC who don’t want to see President Trump re-elected next year, they don’t want to risk a recession and are taking steps to avoid it.

Best regards,

Gary D. Halbert

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