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Weekly Economic Vital Signs - Out Of Ammo

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by: Lawrence Fuller
Lawrence Fuller
Registered investment advisor, portfolio strategy
Summary

This is a weekly series focused on analyzing the previous week’s economic data releases.

The objective is to concentrate on leading indicators of economic activity to determine whether the economy is strengthening or weakening, and the rate of inflation is increasing or decreasing.

This week we examine factory orders, the ISM and PMI Services Indices, the JOLTS report for September, and productivity.

Factory Orders

Factory orders, which include durable goods (reported last week) and nondurables, declined 0.6% in September. Durable goods orders were revised down from a decline of 1.1% to 1.2%, while nondurable goods order rose just 0.1%. We know that Boeing (NYSE:BA) aircraft orders have been weighing on the decline in durable goods orders, but nondurables remain soft as well, and the decline in capital spending was revised down from a decline of 0.5% to 0.6%. The Fed’s rate cuts have had little impact on the real economy to date.

PMI and ISM Non-Manufacturing

The manufacturing sector has been in recession in recent months, but thankfully, it only accounts for a small sliver of overall US economic activity. The service sector accounts for closer to two-thirds of all activity, so the PMI and ISM surveys of service sector activity are particularly important to follow.

Markit’s Non-Manufacturing (PMI) Index showed one of the weakest readings last month since this expansion began in 2009. It fell further in October to 50.6 from the previous month’s reading of 51.0, which suggests near stagnation for the service sector. In what runs contrary to last month’s employment estimate by the BLS, which the stock market celebrated, the PMI saw the “sharpest decrease in workforce numbers since 2009.” Sounds to me like we may see some downward revisions in coming months from the BLS. The new order sub-index fell below 50.0 for the first time in a decade, implying an outright decline in orders.

Unsurprisingly, investors ignored Markit’s report last week in favor of the more optimistic outlook from ISM.

ISM Non-Manufacturing Index rose to 54.7 in October from 52.6 in September, led by strength in business activity, employment and new orders. The negative is that backlogs fell into contraction at 48.5, which is down from 54.0. That doesn’t bode well for employment moving forward. I have found the ISM to lag the PMI in recent years, which tells me that ISM readings are likely to worsen moving forward as they play catch up with the much weaker Markit PMI index. According to the ISM, October’s survey results are consistent with GDP growth of 2.1%. I think a more realistic estimate is closer to 1%.

JOLTS Report

Job openings declined to an 18-month low of 7.02 million in September, which is 4.28% of the labor force and down from the record high of 4.68% in November 2018. While this is still a very large number, it has been declining over the past year. I suspect employers are starting to pull job listings. Still, the number is 1.26 million more than the number of unemployed workers, but the gap is starting to narrow. The reason for this gap is that the unemployed don’t have the skills necessary to fill the job openings available. I’ve been expecting job growth to slow for some time, and this report reaffirms that we are headed in that direction.

Productivity and Costs

We realize an increase in productivity when the output per worker increases at a faster pace than the hours worked, but that wasn’t the case last quarter. Output increased at an annual rate of 2.1%, while hours worked rose 2.4%. Productivity unexpectedly fell for the first time in four years, as output per hour fell 0.3% compared to an estimate for a 1.0% increase. We know that demand for goods and services rose at a slower rate in Q3, which is one reason for the decline in output. At the same time, labor costs rose 3.6%. If this deceleration in output continues, it will further weigh on productivity, profit margins and corporate profitability at a time when profits have declined for three quarters in a row. This will ultimately lead to job losses.

Conclusion

The stock market is knocking out one new all-time high after another, but is the stock market a true reflection of today’s market fundamentals and tomorrow's economic outlook? I would have said absolutely yes before the days of central bank intervention, but now we must acknowledge and recognize that the Fed is using all of its tools to depress borrowing costs and levitate risk asset prices in hopes of prolonging the expansion with the trickle-down wealth effect that was initially launched by Ben Bernanke.

I think investors are making a grave mistake when interpreting stock market strength as economic health. The stock market is being used as a tool to stimulate demand, but given how strong its performance has been, we are seeing very modest economic growth. Furthermore, we are borrowing $1 trillion a year to sustain this very modest growth rate. We are accumulating so much debt that the Fed has now been forced to monetize $60 billion per month in new Treasury issuance. The renewed growth in the Fed’s balance sheet is also invigorating animal spirits to lift stock prices, which is creating an even wider divide between valuations and fundamentals.

My view is that the economy is now dependent on financial market performance, central bank intervention and trillion-dollar deficits to sustain what is now a 2% growth rate. We are running out of ammo. The Fed has very little room to cut interest rates further.

At some point we will be forced to address on fiscal irresponsibility with an effort to narrow our budget deficits, which will slow the rate of economic growth. We are borrowing from tomorrow to make today look a whole lot better. Lastly, the stock market will eventually correct, if not suffer a bear-market decline, and that may be the most likely catalyst to result in a recession.

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: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.