U.S. Risk Of Recession And Manufacturing PMI - Economy's Slowing But No Recession Yet

by: Tim Worstall

The U.S. Economy is definitely slowing in its growth but no real sign of recession yet.

Manufacturing output continues to grow even if more slowly.

Recession risk is rising but is still small.

There Will Be A U.S. Recession At Some Point

There have been varied claims that we've beaten the business cycle - one British Prime Minister comes to mind - but no one really thinks that we have. Thus we are going to have another recession at some point. This, the US's longest peacetime expansion - 10 years and counting now - is going to end and the economy will shrink for at least some period of time.

The question is when is this going to happen? The answer being not yet as far as we can see. The importance to us as investors is that the investments that do well in the macroeconomic downturn are different from those that prosper in the current upturn. We'd thus like to divine when the switch occurs so as to take advantage.

U.S. Manufacturing PMI

Manufacturing is only a small part of a modern economy and so, as in most rich nations, is it for the US. Some 10 to 12% of GDP for example. Part of this is because of industrial outsourcing - much of what would have been done in the manufacturing combines of old is now contracted out and is now classified as services. The same things being done, just in a different and reclassified corporate shell. When the food in the Ford canteens is done by a contractor that's a service, when it's done directly by Ford it's part of manufacturing.

But it's also true that services have grown faster than manufacturing over the past half century, making the latter a smaller part of the economy.

Manufacturing is also more variable over the business cycle than services. It grows faster in the booms, shrinks more in the recessions. We can thus use it as that canary in the coal mine, as a warning indicator for the rest of the economy.

At present manufacturing is still growing:

Economic activity in the manufacturing sector expanded in July, and the overall economy grew for the 123rd consecutive month, say the nation’s supply executives in the latest Manufacturing ISM® Report On Business®.

... “The July PMI® registered 51.2 percent, a decrease of 0.5 percentage point from the June reading of 51.7 percent.

Given the way such an index is constructed, a reading of 50% is no change, higher is growth, and lower is contraction.

If we prefer in chart form:

US PMI (US PMI from Moody's Analytics)

As we can see while output is still expanding, that expansion is slowing down considerably.

Manufacturing isn't going to be the cause of the next US recession but it could be a warning sign of it:

Manufacturing is struggling, but we are not overly concerned for now, even though the ISM index has fallen for four consecutive months and manufacturing output has dropped in each of the past two quarters. The weakness in manufacturing reflects an inventory adjustment, slower global growth, uncertainties surrounding U.S. trade policy, and past appreciation in the U.S. dollar. Some of these weights will lift sooner than others, so manufacturing is not likely to stage a strong comeback in the second half of the year.Still, manufacturing's troubles have fanned concerns that they signal broader problems in the economy and are being seen as an indication that a recession is approaching. Manufacturing has garnered attention among Democratic presidential candidates, but we caution against reading too much into its ups and downs. Manufacturing is not the U.S. economy; it accounts for only 10% of GDP and 9% of employment.

As Moody's says, the sector isn't large enough to turn the economy itself. But it can still be that guide to what will happen more generally. My own suspicion - opinion - here is that trade uncertainty is doing a lot more damage than people like to think it is.

The Larger Recession Risk

We can look and see if we have the signs of a recession coming as above. We can also think about this the other way around. What has caused recessions in the past? So, are we seeing any signs of those things happening now? Not as far as we can see, no:

The odds that the U.S. will be in recession in the next six months increased from 16% in May to 19% in June. The odds of a recession are fairly low, as none of the classic causes of U.S. recessions—overheating risks, shock to the economy’s balance sheet, or financial imbalances—look worrisome. A decline in consumer sentiment and a drop in housing permits increased the probability of recession. Equity prices and initial claims for unemployment insurance benefits helped limit the increase in the odds of a recession. The historical average of our probability of recession is 22%.

All of this is a calculated opinion from Moody's Analytics of course and opinions are opinions however well-informed.

US recession probability (US recession probability from Moody's Analytics)

Note that while the probability has risen, we're still at about the long-term average over booms and busts.

As I've been saying, the biggest threat is of course Trump and trade. Moody's again:

U.S. trade policy could go down a darker path and push the economy into a recession next year. The odds of this are still low, and the more likely scenario is for limited escalation from this point forward.President Trump has threatened an all-out trade war, putting a 25% tariff on all Chinese imports to the U.S., which comes to some $520 billion for the past year—about one-fifth of all imports into the country. In this dark scenario, Trump also goes all in on the 25% tariffs on vehicle imports and parts. It’s impossible to forecast Trump, but if he follows through, the rest of the world wouldn’t take this lying down and would retaliate in kind to the U.S. actions.This would include a combination of tariffs on U.S. goods and nontariff responses. For example, China could make it more difficult for U.S. businesses to obtain regulatory approval for various business activities or delay the time it takes for U.S. goods to clear customs. It could even allow the yuan to depreciate further, as it did last year when the trade war first broke out.

We can only hope that the current threat to add 10% tariffs to the rest of China imports is a negotiating tactic - even a political move, as with the Mexican threats a few weeks back.

My View

There's nothing in the American domestic economy to make us think that a recession is imminent. Manufacturing is still growing, and all the numbers we see about the rest of the economy are still positive. Moody's calculation of the recession risk is up slightly but still modest.

I agree. Can't see any reason for a recession nor any sign of one. The Fed's minor change in interest rates - that one I miscalled but got the effect of right anyway - isn't going to change matters much.

The one big exception to all this is Trump and his trade policy. If he decides to go big on sanctions against China then all such bets are off.

The Investor View

We want to know when and if the next recession is coming. Our risk to observe for this is that trade war. There's just nothing else we can really see that indicates any heightened risk of a recession soon. This is why the markets shuddered on Trump's announcements of those extra 10% tariffs.

Those are the risks we've got to observe: Trump and trade. The difficulty is that if we do get an economic slowdown as a result of such tariffs there's not much domestic policy can do about it - other than rescind the tariffs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.