Just one day after the Fed cut rates for the first time since December 2008 and ended quantitative tightening, President Trump tweeted his most damaging threat in the US/China trade war to date. He announced that the White House would implement 10% tariffs on the remaining ~$300bln in Chinese imports starting September 1st . In that moment, investor focus shifted abruptly away from Chairman Powell’s clumsy press conference and the debate over whether or not future rate cuts would be the start of a “long easing cycle” or just a “mid-cycle adjustment”. Instead, investor attention turned squarely towards the major flight to quality bid occurring in developed market bonds and the de-risking in global equities. The 10yr Treasury yield rallied over 30bps in one week alone (a +2 standard deviation move) as investors sized up the perceived negative impact of further trade escalation on the global economy.
Lost in the mad scramble, a number of important US economic data points were released that suggest the solid labor market and strong consumer that the Fed has consistently hung its hat on throughout the expansion may be at risk. While many continue to point out that the absolute level of growth remains reasonable around 2% and consumer confidence remains near cycle highs, the rate of change in these economic variables deserves equal consideration, especially when attempting to identify inflection points in the US economy.
Let’s look at three data series which were all recently released, reflect activity in the month of July and were collected before the most recent tariff announcement took place:
1) Non-farm payrolls growth over the past 6 months averaged 141k which is down from over 200k as recently as January. Observing only the level of growth would cause little alarm. Job growth of 141k remains above the breakeven amount of jobs needed to accommodate for new entrants and put downward pressure on the unemployment rate. That breakeven rate is estimated to be around 75k – 100k. What is of more concern is the rate of the deceleration in job growth. While we did have a similar size slowdown in job growth from 2015 – 2017, it occurred over a nearly 3 year time period rather than 6 month horizon. Looking at the 6 month changes historically, the move year to date is a noticeable deceleration in the context of the recovery.
2) The ISM Non-Manufacturing survey in July declined from 55.1 to 53.7 – the lowest level since August 2016. Observing the level of the survey in a vacuum would lead to the conclusion that service activity remains in solid expansion with a decent buffer of nearly 4 points above the 50 demarcation level (below 50 signifies contraction). So far this year, the deceleration in this survey has also been notable but still consistent with other mid-cycle slowdowns.
3) The Nominal Labor Income Proxy is a less followed indicator that tracks average weekly hours worked, employment and hourly wages to create a more complete measure of total aggregate take home pay. The growth in the nominal income proxy is currently running at a pace of 4% YoY. Once again, the level of income growth appears respectable and enough to support consumption. This point is bolstered by recently revised savings data which suggests the consumer has more dry powder in the form of savings than originally estimated. On the other hand, the nominal income proxy has decelerated rapidly from a pace of 6.2% YoY in January. The 6 month decline in the pace of growth stands out as significant. Moreover, the magnitude of the slowdown appears closer to levels consistent with recessions rather than mid-cycle weakness.
Similar to the market, the Fed seems all too focused on trade headlines to determine their next move despite the fact that doing so makes them uncomfortably beholden to the White House. Fed speakers since the July meeting have said they want to wait and watch for the dust to settle in order to see the impact of the new trade developments on the data . Nevertheless, the case may be building for the Fed to continue to ease policy even putting aside the most recent trade escalation.
Now the Fed is stuck in a bind. In an effort to not seem overly reactive to recent headlines from the President and the subsequent equity market volatility, they have turned their focus away from the fundamentals. While the Fed is distracted with trade, they may be missing a window of opportunity to arrest the vicious cycle between risk markets and the Fed’s reaction function as well as support the US service economy. If they are too slow in identifying the trend, the damage will be felt in tighter financial conditions, further declines in inflation expectations and an even flatter yield curve. More importantly, a delayed reaction by the Fed which results in the market pricing in a policy error will ultimately exacerbate any cooling in the US labor market that may be already occurring.