U.S. Economy - Contraction Is Here

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by: Leo Nelissen
Summary

I started discussing the chances of a slowing growth trend in the last quarter of 2018.

Unfortunately, for the economy, this has resulted in economic contraction according to the latest ISM data.

The best way to play the next few months is by sticking to cash and bonds to invest capital once the economy starts to turn around.

In December of 2018, I wrote my first article discussing the chances to get an economic slowing growth trend. Throughout the first 8 months of this year, I have updated this case and continued to report of slower economic expectations. My most recent article was called 'Economy - Contraction Is Close'. Well, what can I say, here we are. The just-released leading growth indicators are indicating that slowing growth has turned into contraction meaning that the US economy is about to get even more headwinds. In this article, I will give you the details and tell you why I will stick to cash and bonds.

Source: Author

What's Happening?

The easy answer to this question is: growth is rapidly declining putting pressure on 'hard' economic data and earnings.

Below, I will show you a few key graphs I use to predict the direction of the economy. It won't be a pretty picture.

Let's start with the number one indicator for economic expectations. The ISM manufacturing index tells us what we can expect in terms of 'hard' economic growth over the next 3-6 months. I also added the regional manufacturing average as both are highly correlated and regional data give us a lot of further insights as I will show you in this article.

Anyhow, the just-released August data shows that the ISM manufacturing index has declined from 51.2 to 49.1. This is 0.9 points below the neutral 50.0 level, meaning that the economy is now expected to contract going forward. In other words, slowing growth has turned into contraction. Personally, I did expect a further decline in the mid-term but had expected to see another reading above 50.0 as regional manufacturing surveys slightly improved in August as you can see below.

Another indicator that not only confirms this ugly slowing growth trend but falls even further is new orders. New orders went from 50.8 to 47.2. Not only is this 2.8 points below 50.0 but also below 2015 bottom levels. This is the lowest level of new orders since the end of the GFC.

Adding to that, the graph below shows you two indicators. The bottom part of the screenshot is the normalized ISM new orders index (normalized for 0 where values below 0 are bad). The upper part of the graph shows the new orders minus inventories graph. This indicator falls below 0 when inventories outperform new orders, meaning that companies have too high inventory levels considering that new orders are rapidly falling.

Source: Twitter (@James_LVDTA)

The interesting (one could say scary) thing, is that we are also seeing a rapid decline of the regional manufacturing employment index. Employment is headed for its 2015 lows after rapidly climbing to multi-year highs in 2018. Back then, this put a lot of pressure on labor-intensive industries like transportation and retail. I am sure Q3 earnings releases will reveal if labor shortage is still an issue given that demand is about to slow significantly.

Moving over to a less volatile but maybe even better indicator, we see that regional future capital expenditures have also hit a new low in August. I am afraid that a further downtrend of this indicator could further strengthen the downtrend of the general economy. Note that this indicator did extremely well after bottoming in 2016 which caused a lot of money to flow to cyclical machinery and other capex-related stocks like Caterpillar (CAT). Between 2016 and the end of 2018, these companies were in a very good place. Unfortunately, at this point, the exact opposite seems to be true.

With regard to 'hard' economic data, I want to show you the graph below. The number of hard economic data indicators is countless. A few important indicators are industrial production, new manufacturing orders, retail sales, employment growth. The first two can be seen in the graph below. At this point, it is almost impossible to avoid contraction.

This brings me to...

The Bottom Line

The US economy is contracting. I am glad my indicators have done a good job predicting a slowing growth trend back in 2018. Unfortunately, it means that the economy is suffering. I expect hard economic data to come in very weak in the months ahead. I also expect the pressure on the stock market to rise as I discussed in a previous article. One part of the conclusion can be seen below.

At this point, the market is pricing in much higher growth in the fourth quarter and remainder of the third quarter. If this does not happen, we are in for another significant stock market decline in case the Fed and global central banks don't start some magic rally like they did back in 2012 when they had way, way more ammunition to fight slow growth.

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I am largely sticking to cash and bonds. My largest position is cash which is waiting to be deployed in cyclical mid-term trades and long-term investments as soon as the economy starts to turn around. Until that happens I am not willing to buy any significant long positions.

On a side note, I want to thank everyone for engaging in very interesting discussions regarding the state of the US economy and stock market. It's always a blessing to hear your opinions regarding my indicators and approach.

Thank you very much for reading my article. Feel free to click on the "Like" button, and don't forget to share your opinion in the comment section down below!

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.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.