LONDON (Reuters) - The U.S. economy faces the greatest risk of outright recession for a decade as the slowdown spreads from manufacturing to the much larger and more stable service sector.
Most indicators show manufacturing has already started to shrink with purchasing managers’ surveys and new orders pointing to a decline in activity levels in recent months.
The Institute for Supply Management’s composite purchasing managers’ index for manufacturing fell last month to its lowest level since the last recession in 2009.
The manufacturing downturn is now more widespread than either of the mid-cycle slowdowns in 2012 and 2015/16, according to the ISM survey (tmsnrt.rs/32Zt9An).
The survey’s new orders component was far into contraction territory in both August and September which suggests activity is likely to decline further in the short term.
So far, the slowdown has been concentrated in manufacturing, driven by a sharp retrenchment in business investment plans and spending on other durable goods.
New orders for non-defense capital equipment excluding aircraft, a proxy for investment spending, fell marginally in the three months from June to August compared with the same period a year earlier.
New orders have slowed from growth of more than 8% at the same point in 2018 and are now falling for the first time since 2015/16.
Service sector output and employment tend to be much less cyclical and volatile than in manufacturing (“Business cycles: theory, history, indicators and forecasting”, Zarnowitz, 1992).
The increasing dominance of services in the economy is one of the main reasons fluctuations in the business cycle have become much less extreme since 1945.
Expansions have generally become longer while recessions have become less frequent and shorter (with the notable exception of the post-financial crisis recession of 2008/09).
The service sector has added more inertia to the economic system, dampening short-term movements like a fly-wheel or the ballast on a ship.
Nevertheless, changes in services output and employment tend to follow the manufacturing sector, albeit with a delay and at a smaller magnitude.
The ISM’s non-manufacturing survey, which covers service providers as well as construction and real estate firms, fell sharply in September to its lowest level since August 2016 and before that July 2012.
Unlike manufacturers, non-manufacturing firms continued to report growth last month, but it was not very widespread, and it has been trending consistently lower since the start of the year.
Services growth is decelerating as expected given the slowdown in manufacturing, in line with the historical relationship between the two indicators over the last 20 years.
The other source of ballast/inertia in the modern economy stems from consumer spending, which is holding up well at the moment but also shows signs of decelerating.
Real personal income excluding current transfer payments such as social security, unemployment insurance and veterans’ benefits is one of the indicators used by the National Bureau of Economic Research (NBER) to identify turning points in the business cycle.
Falls in real personal income minus current transfers is one reason NBER’s business cycle dating committee, the widely accepted arbiter of recessions, identified recessions starting in March 2001 and December 2007 – but not in 2012 or 2015, when real personal income continued increasing despite weakness elsewhere in the economy.
In aggregate, real personal income minus current transfers was still up by 2.8% in the three months from June to August compared with the same period a year earlier, buoyed by employment and wage gains.
But real personal income growth has slowed sharply from around 4% in the first half of 2018 as job growth has slowed and the impact of tax cuts has faded.
Mirroring that slowdown, real personal consumer expenditures were up just 2.5% in the three months June to August compared with a year earlier, down from growth of 3.5% at the same point in 2018.
The overall picture is one in which the most cyclically volatile parts of the economy are already contracting, and arguably in recession, while the more stable parts of the economy show continued but slowing growth.
The probability of the whole economy entering recession is now higher than at any time since 2008/09, which is reflected in the deep and sustained inversion in the U.S. Treasury yield curve.
The service sector and consumer spending can help provide continuing momentum and avert a formal recession – but only if the manufacturing situation does not worsen and starts to improve reasonably soon.
- U.S. consumer show growing signs of debt distress (Reuters, Sept. 12)
- Trump must choose between economy and trade war (Reuters, Aug. 23)
- Global economy is probably in recession (Reuters, Aug. 7)
- Twin-speed U.S. economy poses dilemma for the Fed (Reuters, July 26)
Editing by David Evans