The sun shines brightest across the North American continent as we enter summer’s dog days. Cold sweet lemonade is the refreshment of choice at ballparks and swimming holes alike. Many people drink it after cutting the grass, or whenever else a respite from the heat and some thirst quenching satisfaction is needed.
The economy, after 10 years of growth, appears to be heading for a respite too. Second quarter earnings, currently being reported by S&P 500 companies, have been a mixed bag thus far. But in sectors that actually make stuff, like materials and industrials, earnings are suffering double digit declines.
From a practical standpoint, earnings are declining in these sectors because manufacturing is contracting. For example, this week it was reported that the Chicago Purchase Mangers’ Index (PMI) collapsed in July to 44.4. That’s the second weakest Chicago PMI reading since the Great Financial Crisis.
As context, a Chicago PMI reading below 50 indicates a contraction of the manufacturing sector in the Chicago region. So far this year, the Chicago PMI has been down five out of seven months. On top of that, weaker demand and production pushed the employment indicator into contraction for the first time since October 2017.
Unfortunately, the weakness in manufacturing extends beyond the Chicago region. Yesterday [Thursday] it was reported that the U.S. Manufacturing PMI dropped in July to its lowest level since September 2009. Employment also fell for the first time since June 2013. What’s going on?
Economic Lemons
One place to look for edification is the auto industry. Namely, car dealers are reporting fewer buyers. In turn, they’re ordering fewer vehicles from manufacturers.
The dealers don’t have room for the cars they have. Automakers, parts manufacturers and dealers directly employ more than two million people. As demand for cars declines, the jobs associated with the auto industry also decline.
Having too many cars with too few buyers is something an economist would call a supply glut. Of course, the easiest way to clear excess supply is to reduce prices. This may work up to a point. But if prices must be reduced beyond the cost of labor and materials inputs, there’s a problem.
How to make lemonade from these economic lemons is generally impossible. Still, that doesn’t mean companies don’t try by taking on greater and greater levels of debt. And the big banks, which are backstopped by the Fed, continue extending credit to keep the sham going.
U.S. nonfinancial corporate debt of large companies is about $10 trillion, or roughly 48 percent of gross domestic product (GDP). That’s up about 52 percent from its last peak in the third quarter of 2008, when corporate debt was about $6.6 trillion, roughly 44 percent of 2008 GDP. Hence, corporate debt is at record levels and is rising much faster than economic output.
At this point in the business cycle, corporations have loaded themselves up with so much debt that they’re extremely fragile. Should the economy slow, ever so slightly, it will be game over for countless overleveraged companies. Defaults will pile up like old furniture and tires along the dry LA River bed.
Do You Hear a Bell Ringing?
But while Main Street’s been cooling off, Wall Street’s been running hot. Promises of cheap credit from the Fed have propelled stocks to record highs. Year to date, stocks, as measured by the S&P 500, are up over 17 percent.
On Wednesday, however, some uncertainty was added to the market. At the conclusion of the July Federal Open Market Committee (FOMC) meeting, Fed Chair Powell cut the federal funds rate 25 basis points. But instead of telegraphing additional rate cuts would follow, like Wall Street expected, Powell said it was merely a mid-cycle adjustment. In other words, he’s winging it.
Will the Fed cut rates further this year? Will they hold? These were the questions Wall Street was asking on Wednesday afternoon as the S&P 500 closed down 36 points.
Yesterday, after sleeping on the Fed’s ambivalence, traders showed up to work with focus and intent. They bought the dip with confidence. And everything was great until about mid-day. The S&P 500 was up 33 points…and then something unexpected happened.
President Trump, via Twitter, dropped a turd in a crowded swimming pool:
“…the U.S. will start, on September 1st, putting a small additional Tariff of 10% on the remaining 300 Billion Dollars of goods and products coming from China into our Country. This does not include the 250 Billion Dollars already Tariffed at 25%.”
Following Trump’s tweet, Wall Street freaked out. The S&P 500 dropped 68 points, ending the day at 2,953.
“No one rings a bell at the top of the market,” says the old Wall Street adage.
Make of this week’s manifestations what you will. We hear a bell ringing. Do you?
Sincerely,
MN Gordon
for Economic Prism
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