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Racing for the cure

| November 1, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The U.S. economy remains on a dual track.  Domestically focused sectors such as consumer spending, labor market, services and housing continue to do well.  More globally oriented sectors such as manufacturing, business investment and exports have struggled under the specter of trade policy uncertainty and on-again-off-again tariffs.  A central question for the economic outlook is which side will win out.  Will the softness globally eventually do in the consumer, or will the stalwart consumer rescue the languishing business sector?

Standoff

In some ways, the current performance of the U.S. economy feels a little like one of those movies where a super-virus breaks out, and there is a frenzied race to come up with a cure before the human race is wiped out.  The stakes are perhaps not quite as high, but a central theme of 2019 has been the contrast between globally-oriented sectors of the economy, which have been softening, and domestically-focused areas, which continue to be robust.  Think of the manufacturing sector as the contagious infected population, and the consumer sector as the still-virus-free population.  Will the contraction in the manufacturing sector infect the up-to-now healthy parts of the economy, or will the vigor of domestically-focused industries drag the factory sector out of its funk?

Recession scenario

The blueprint for the unhappy scenario is pretty clear.  Businesses, spooked by trade policy uncertainty, tariffs, and a soft global economy, have put a halt to a myriad of investment projects.  Business fixed investment declined in real terms in both Q2 and Q3.  The path for this virus to cross over to the healthy population would be if businesses, in their caution, also begin to put a hold on hiring, or, worse yet, lay employees off.  Such a development would presumably impact household income growth as well as consumer confidence, jeopardizing the remainder of the economy.

The labor market data do not yet provide much support for this scenario.  While payroll gains have slowed, this may also reflect the scarcity of available workers with the unemployment rate at a 50-year low.  Moreover, initial claims have not moved higher this year and, in fact, also remain near 50-year lows.

Chairman Powell was specifically asked about this scenario in his October 30 press conference, and he responded that “we don’t see it yet.”  He cited positive labor market data as well as anecdotal reports from “consumer-facing companies” that were predominantly positive.  In other words, so far, so good.

The happy ending scenario

Some of the movies in the outbreak genre end with society entirely wiped out, but most have a happy, or at least a hopeful, ending.  In our economic thriller, the positive outcome would entail a recovery in the manufacturing sector, restoring to health the sectors that have been depressed this year by trade policy uncertainty and weak overseas demand.

There are reasons for optimism.  In fact, an argument could be made that we have just endured the worst of it.  There are three factors that could contribute to a pickup in activity going forward.

First, the GM strike, which stretched from mid-September until late October, temporarily depressed manufacturing activity.  The September readings for industrial production, for example, were clearly impacted, and the October figures are likely to be even worse.  However, with the strike settled, GM will likely schedule a lot of overtime and try to rebuild its inventories of popular models over the next few months.  Moreover, Ford and the UAW reached a tentative deal on a contract this week, so it looks like we may avoid a repeat of the work stoppage that GM endured (though a deal still has to be worked out at Chrysler).

Second, the travails of the Boeing 737 MAX are not going to last forever, though it may seem that way.  Since the MAX was grounded early this year, Boeing has halted production of the model, and airlines have not been booking any new MAX planes.  The economic impact has been considerable.  Domestic investment in aircraft has plunged by more than half, from $53 billion annualized in the fourth quarter of last year to $25 billion in the third quarter.  Similarly, exports of civilian aircraft and parts have dipped from $138 billion to $119 billion.  The Boeing issues have lowered GDP by almost $50 billion so far this year.  Presuming that the MAX is recertified early next year and production returns to normal by mid-2020, we could see a tailwind to business investment/manufacturing/exports that adds as much as half a percentage point to the pace of GDP growth over two or three quarters.

Finally, there is the biggest driver of all of the weakness in globally-facing sectors, the U.S.-China trade war.  We have seen numerous swings in sentiment regarding the trade outlook this year, but most of the movements have been negative since talks broke off in the spring.  The August-September period appears to have been the worst so far, as President Trump announced new tariffs and the Chinese retaliated.

More recently, the two sides came together and reached a tentative Phase One agreement that is scheduled to be formally ratified in November.  This all hews to my long-held guess at how the trade negotiations would evolve relative to the election cycle.  President Trump took a belligerent tone in the summer, seeking to cement his image as someone who would challenge China, but he needs the U.S. economy to be at its best during the 2020 presidential campaign, so he was always going to need to make nice by late 2019 or perhaps early 2020.

The situation remains unpredictable, but I would be surprised if things return to the gloomy days of August and September any time before next November.  If this hypothesis is correct, then business sentiment should gradually improve (another potential positive on this front would be Congressional approval of the USMCA), and business investment would presumably rebound to some degree over the next few quarters.

Conclusion

At this point in our outbreak movie, there is reason for hope but the situation is still touch-and-go.  However, there are reasons to be optimistic that the past few months will, in retrospect, prove to be the worst of the cycle for globally-facing sectors.  The prospects for overseas demand remain mediocre at best, so even the happy ending scenario is not an overwhelming victory (after all, at the end of outbreak movies, those who succumb to the virus are still dead after a cure is finally found), but it is not hard to construct a scenario where real GDP growth returns to the solidly above-trend 2.5% pace seen for most of 2018 and the first half of 2019.

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