A blowout jobs report, but reasons for concern in the activity survey
- The labour market ended 2018 on a solid footing, but recent survey data are consistent with a slowing in economic growth back towards potential.
- Tighter financial conditions present a risk that the slowdown could happen more rapidly than anticipated.
- Despite this downside risk, less Fed tightening than previously thought should serve to stabilise growth a bit above potential this year. I continue to expect growth this year of 2.3%.
- The soonest the Fed will tighten, in my view, is the May FOMC meeting. In fact, the next move could be delayed until Q3 given the lack of meaningful inflation pressure and the need for greater clarity on the impact of tighter financial conditions and the global growth backdrop.
One of the interesting developments of the past two years had been the persistent strength in US survey data, outright but also relative to the hard data. A range of activity surveys, such as the manufacturing and service-sector ISM reports, and the regional Federal Reserve manufacturing surveys, had reached or eclipsed levels seen in prior expansions. Business and household sentiment indicators had also risen to lofty levels.
The strength in the survey measures, combined with a step-up in growth in 2018, supported the Trump administration’s view that its policies were indeed lifting trend growth. But this narrative now appears to be coming to an end. Recent data releases indicate that the loss of momentum that began in the fall has become more meaningful as the calendar turns to 2019. A slowing in growth in 2019 has been my base case for well over a year now, but the fairly sharp tightening in financial conditions (albeit from a highly accommodative state) now suggests a growing downside risk to the outlook.
Most importantly, the manufacturing PMI survey from the Institute for Supply Management dropped sharply in December. The decline is not all that surprising given similar declines in the regional Federal Reserve December manufacturing surveys. Still, it is a sharper one-month decline than any seen during the 2014-2015 corporate profit recession. Of some concern, two-thirds of the decline in the overall index stemmed from weakness in new orders and production.
Exhibit 1: ISM surveys
Source: ISM, BNPP AM, December 2018
In addition to providing some advanced information on the manufacturing PMI, regional surveys from the New York, Dallas, Kansas City, Richmond and Philadelphia Federal Reserve Banks are valuable for their expectations measures. As seen below, six-month forward capital expenditure (capex) expectations remain at fairly high levels, but the median six-month forward expectation for new orders has come down considerably, and is now even a bit below its historical average.
Exhibit 2: Manufacturing firms’ expectations for capex and new orders – median reading of regional Fed surveys
Source: Federal Reserve Banks of New York, Dallas, Kansas City, Richmond and Philadelphia
I view these readings in a “glass half empty” light. Note that the last time these two indicators diverged (in 2006-07), it was the capex plans that converged lower to new orders. In addition, the new orders expectations are consistent with other indicators of a gloomier activity outlook. The most recent Duke University/Fuqua CEO survey indicated that CEOs see elevated recession risks over the next year or so. In addition, capex plans may remain intact if firms believe that enhancing productivity through investment will make them more competitive in a slower growth environment.
In other survey data, the NFIB small business optimism survey has declined for four straight months through the latest release (November), and is now approaching the bottom of the post-election range. Consumer confidence data have also begun to show some cracks, largely in the components that reflect forward expectations. In particular, the expectations component of the Conference Board indicator fell sharply in December, but it is worth noting that such sharp movements in this indicator are not uncommon and are quite prone to reversals.
On the hard data side, not surprisingly, there continue to be signs of deceleration in interest rate-sensitive portions of the economy, even as indicators of overall consumer spending remain decent. Most recently, pending home sales – which tend to lead existing home sales by a few months – fell again in November, and are now down close to 8% on a year over year basis.
Housing activity will remain weak – I expect residential investment to subtract from economic growth this year. Home prices will likely continue to decelerate, crimping incentives for new construction. And while the recent decline in interest rates will improve affordability through lower mortgage rates, it is quite possible that banks will begin to tighten mortgage lending standards in a decelerating growth environment.
Exhibit 3: 30-year mortgage rate estimate
Source: Fannie Mae, through December 2018. Estimate based on 60-day commitment rate, plus 50bp servicer spread
I still expect growth to remain above trend this year, at around 2.25%, thought the tightening of financial conditions represents a downside risk to this projection, as does the weak global backdrop. But I remain constructive on growth as we are now seeing a dovish pivot in Fed communications, which makes clear that they are not inclined to raise rates any time soon. Chair Powell not only stressed that the Fed can be patient given muted inflationary pressures, but also highlighted risks related to financial conditions and global growth. Tellingly, he highlighted the importance of a risk management approach, and held out Yellen’s pivot away from raising rates in 2016, when similar risks emerged, as an excellent example of risk management. He also suggested some flexibility in balance sheet policy if growth should indeed slow. These and similar comments by a number of other FOMC participants have reduced market perceptions that the Committee risked a policy error through over-tightening.
There are other reasons beyond monetary policy for remaining constructive on the outlook. The manufacturing survey data have indeed been weaker, but the US economy is driven by the services sector, where there is much less evidence of any slowing in activity. Recall that in late 2015/early 2016, when the manufacturing sector appeared to be in recession, the services sector continued to power the US economy. A similar dynamic is likely to play out this year.
Finally, another reason I am keeping my 2.25% growth projection is that, as Chi Lo and I explore elsewhere, we have turned more optimistic on the US-China trade war. The odds of extended negotiations with no further escalation in tariffs have increased. Lower uncertainty over trade policy reduces a headwind for the US economy.