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War (What is it Good For?)

Key Points
  • Anyone still calling the trade situation between the United States and China a “skirmish” (or a “kerfuffle”) must have been on vacation with no Twitter access last week.

  • Leading indicators are still flashing limited recession risk, but the recent downward revisions to profits and payrolls were notable.

  • The stability in the dividing line between the manufacturing and consumer segments of the economy is coming under increasing stress.

The Wiktionary literal/original definition of the phrase “shoot from the hip” is to “discharge a firearm while it is held near the hip, without taking time to aim via the gunsights.” The figurative/modern definition is to “speak quickly based on first impressions, without carefully studying the background information or wider context.” Last week we witnessed what could be defined as tweeting-from-the-hip.

As I queried on Twitter last Friday, I’m wondering whether there remains anyone still calling the trade situation between the United States and China a “skirmish” and not a “war.” The latest salvo(s)—on top of what was already in place or in the queue—was China’s retaliatory tariffs on U.S. imports and the re-imposition of tariffs on U.S. autos/auto parts. This was followed by President Trump’s announcement Friday that the United States will raise the existing 25% tariffs on $250 billion of imports from China to 30%; and raise the 10% tariffs on the remaining $300 billion of goods we import from China to 15%.

I hereby order…

Then of course there was the tweet by Trump “hereby ordering” U.S. companies to move operations from China, with the threatened utilization of the International Emergency Economic Powers Act (IEEPA); which if declared, would give the president broad authority to block the activities of individual companies or entire economic sectors.

It was a recipe for a swift decline last Friday; with the retaliatory upping of tariffs by President Trump coming after the market’s close. Early this morning, S&P futures were plunging anew, only to be lifted by a comment from Trump at the G-7 meeting that China “called our trade people and said let’s get back to the table.” And after declaring both China’s President Xi Jinping and Federal Reserve Chair Jerome Powell “enemies” in a tweet Friday, today Trump lauded Xi as a “great leader” and said “anything’s possible” when asked if he planned to delay tariff increases on China.

And so it goes.

Leading indicators flashing limited recession warning

I wrote a comprehensive and somewhat-evergreen report two weeks ago looking at the history of recessions in the modern U.S. era (Recession Watch (or Distant Early Warning?)). Given the latest increase in economic uncertainty courtesy of the ramping of the trade war—but also last week’s release of the Leading Economic Index (LEI), it’s worth a closer look again. Let’s start with a quick look at economic uncertainty, as quantified in Bloomberg’s U.S. Economic Policy Uncertainty Index. It is a highly volatile index, but should elicit no surprise that it recently spiked again.

Spike in Economic Policy Uncertainty

Economic Policy Uncertainty Index

Source: Charles Schwab, Bloomberg, 'Measuring Economic Policy Uncertainty' by Scott Baker, Nicholas Bloom and Steven J. Davis at, as of 8/26/2019.

As mentioned, the LEI was released last week by The Conference Board, and it surprised on the upside for a change. The index rose 0.5% month/month after two prior months of declines; with weakness in the manufacturing components as well as the yield curve offset by strength in unemployment claims and building permits. It was in keeping with what we’ve been discussing, which is the still-firm dividing line between the weak (albeit smaller) manufacturing portion of the U.S. economy and the stronger (and larger) consumer portion.

CEOs’ outlook = weak

Of growing concern though is the potential blurring of this dividing line if business malaise morphs into consumer malaise. There are signs this could be in the early stages. Prior to Friday’s chaos, Chief Executive magazine released their “CEO Confidence Level in Business Conditions One Year From Now,” which fell 6% in August and is now considered a “weak” outlook. In addition, the University of Michigan measure of Consumer Sentiment—which post-dated The Conference Board’s release of Consumer Confidence—dropped to the lowest level of this year; with losses spanning all components.

For now, even though consumer sentiment has been dented, consumer spending has held up. That said there is a reason why manufacturing indicators dominate the LEI relative to services or consumer indicators: they tend to lead overall shifts in the economy. The chart below shows the year/year change in the LEI; and what is currently the third major shift down in growth. Thanks to last month’s strength, it is not yet approaching the average reading heading into recessions historically; but it bears watching.

LEI in 3rd Slowdown This Cycle


Source: Charles Schwab, Bloomberg, The Conference Board, as of 7/31/2019.

Better or worse…

I’m a bit of a broken record when it comes to analyzing economic data and connecting those dots to the stock market and/or economic inflection points: “Better or worse tends to matter more than good or bad.” In that vein, take a look at the table readers have seen many times before; which I put together every month. Although the levels of the leading and coincident indicators remain mostly green (strong) and yellow (fair); there has been a pickup in the number of red (worsening) trend readings; albeit having improved from the prior month in the case of the LEI. 

LEI Table

Source: Charles Schwab, Bloomberg, The Conference Board, as of 7/31/2019.

In addition, there are now two out of four components of the Coincident Economic Index (CEI) that are worsening. As a reminder, those four components are (not coincidentally) the key metrics analyzed by the National Bureau of Economic Research (NBER)—the official arbiters of recessions—to declare and date recessions. 

History of CEIs around recessions

My research colleague, Kevin Gordon, recently did a deep dive look at the history of NBER declarations and the trajectory of the CEI’s components heading into recessions historically. Using NBER’s own indexing methodology, the series of charts below show several important historic trends. First, when the NBER concludes a recession is underway they then go about the task of dating its start month—which is generally around the peak in economic activity. 

The date noted for each cycle is the date that the NBER made the announcement of the start date of each recession (noted by the gray bars). The fact that the NBER looks back to near the peak of activity to date recessions’ starts is why you’ve been hearing (including from us) that if we are heading into a recession from today’s level of economic growth, it’s possible the NBER could ultimately date it as having already begun. That is not my base case (nor the LEI’s message); but worth pondering nonetheless.

2007-2009 Recession                                                  2001 Recession

Recession 2007 2001

Source: Charles Schwab, Bloomberg, (NBER) National Bureau of Economic Research. Personal income less transfer payments, manufacturing and trade sales, payrolls, and industrial production indexed to 100, where 100 equals the peak in each indicator’s level from 12/31/2006-12/31/2009 and 3/31/2000-5/31/2002.  

1990-1991 Recession                                                    1981-1982 Recession

Recession 1990 1981

Source: Charles Schwab, Bloomberg, (NBER) National Bureau of Economic Research. Personal income less transfer payments, manufacturing and trade sales, payrolls, and industrial production indexed to 100, where 100 equals the peak in each indicator’s level from 7/31/1989-9/30/1991 and 7/31/1980-5/31/1983.

1980 Recession                                                               1973-1975 Recession

Recession 1980 1974

Source: Charles Schwab, Bloomberg, (NBER) National Bureau of Economic Research. Personal income less transfer payments, manufacturing and trade sales, payrolls, and industrial production indexed to 100, where 100 equals the peak in each indicator’s level from 1/31/1979-1/31/1981 and 11/30/1972-9/30/1975.

1969-1970 Recession                                                  1960-1961 Recession

Recession 1970 1960

Source: Charles Schwab, Bloomberg, (NBER) National Bureau of Economic Research. Personal income less transfer payments, manufacturing and trade sales, payrolls, and industrial production indexed to 100, where 100 equals the peak in each indicator’s level from 12/31/1968-5/31/1971 and 4/30/1959-8/31/1961.

Profits and job growth strong? Not anymore.

There were major revisions made over the past few weeks to two measures of the economy that have flown a bit under the radar given the attention devoted to tweets-by-the-hip. The first—which I highlighted in my recession report two weeks ago—was the multi-year downward revision to the National Income and Products Account (NIPA) measure of U.S. corporate profits (covering all public and private companies). The ~$200 billion downward revision by the Bureau of Economic Analysis (BEA) was concentrated in the past three years, and resulted in a now-flat trend in corporate profits over the past five years vs. the pre-revision upward trend, as you can see below.

Corporate Profits Flat for Five Years

Corporate Profits and Revision

Source: Charles Schwab, Bloomberg, Bureau of Economic Analysis, as of 6/30/2019. *With inventory valuation and capital consumption adjustments.

The trade war was launched only a few months after corporate tax cuts passed Congress. In our view, the hoped-for surge in capital spending that was expected following the tax cut has been offset by the negative impact of the trade war. It was therefore interesting that another tweet last week referred to the additional tariffs being threatened by the United States as “taxes” (which is frankly what they represent).

More recently, there was a significant preliminary downward revision to non-farm payroll growth from the Bureau of Labor Statistics (BLS). That estimate was a downward revision of 501k to the increase in payrolls for the year that ended in March 2019; with the next annual revision coming in February 2020. As you can see in the chart below, it was a meaningful revision (2.5 million payrolls down to 2.0 million payrolls; a 20% haircut). We assumed an even distribution of the revision across the 12 months to construct the post-revision line. With the revision, payrolls rose by 168k per month instead of the originally-reported 201k.

Significant Downward Revision to Payroll Growth

Payroll  and Revisions

Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics (BLS), as of 7/31/2019.  *Based on BLS’ 2019 preliminary benchmark revisions for 12-month period ending March 2019.

Markit’s manufacturing PMI moves into contraction territory

Back to the weakness in manufacturing, it was seen within the LEI in ISM new orders as well as the average workweek. The ISM’s release dates back to August 1. Needless to say, a lot has happened since then; so it’s worth looking at the PMIs from Markit, which were released last week, and therefore capture more (although not all) of the latest trade-related uncertainty.

As you can see in the chart below, not only has Markit’s headline manufacturing PMI fallen below the key 50 reading (the demarcation between expansion and contraction), even the services PMI is getting uncomfortably close.

Manufacturing & Services PMIs Weakening

 Markit PMIs

Source: Charles Schwab, Bloomberg, as of 7/31/2019. PMI = Purchasing Managers Index.

We’ve obviously seen the indirect hit to business (and to a lesser degree consumer) confidence from the trade war. But this dented confidence has had a direct impact on capital spending intentions, which have plunged. There will likely be an increasing direct hit; especially if the currently-threatened higher tariffs are implemented given they are significantly-more consumer oriented. The visuals below show the direct impact on U.S. gross domestic product (GDP) of the already-implemented and prospective tranches of U.S.-declared tariffs on Chinese imports (which are paid by U.S. companies importing goods from China). What it doesn’t (yet) show is the impact on U.S. growth of China’s retaliatory tariffs on goods they import from us.

Estimated Impact of U.S.-Imposed Tariffs on U.S. GDP

GDP Impact to Tariffs

Source: Charles Schwab, Cornerstone Macro, as of 8/26/2019.

Fed to the rescue?

There are some offsets to the weakening of the growth outlook, including monetary policy. However, although the Fed is likely to continue to lower rates according to the fed funds futures, it’s unlikely the elixir for what ails the economy. In his speech at the Fed’s Jackson Hole confab last Friday, Chair Powell cited, “uncertainty about the recent developments,” and the latest Federal Open Market Committee (FOMC) meeting minutes noted that trade tensions, the global economy and “softness in business investment and manufacturing so far this year [were] seen as pointing to the possibility of a more substantial slowing in economic growth than the staff projected.”

In summing up Powell’s speech last week, he said that the White House and Congress—not the Fed—have primary responsibility for the economy’s trend and that the Fed can only react to keep growth moving within its legislated mandate. The most relevant quote from Powell was this perhaps: “While monetary policy is a powerful tool, it cannot provide a settled rule book for international trade.”

The bottom line is investors, business leaders and consumers have been given a lot to chew on with regard to trade and its impact on the economy. Although the consumer side of the economy has remained resilient, the fact that businesses and capital investment are squarely in the crosshairs of a worsening trade war, means we need to keep a close eye on the stability in the line that divides the manufacturing and consumer sides of the U.S. economy.

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