The U.S. Economy Downshifts to Modest Growth

Market Reaction: October 3, 2019


It has been a bumpy week for U.S. stocks with the Dow Jones slipping about 3.0% over the past few days. The sell-off started after the ISM manufacturing index (a gauge of economic activity in the manufacturing sector) showed a marked deceleration in September. The index had been signaling that the industry was contracting prior to this, but the sector now appears to be more firmly in contraction (or recession). This is important because weakness in the manufacturing sector about 11% of the U.S. economy) can be a leading indicator of weakness in the services sector (about 70% of the U.S. economy). As an example, an automaker also employs accounting services and marketing services for Super Bowl ads, etc. Meaning that a deep enough manufacturing recession can impact other economy activity as well. That is likely what we witnessed with the ISM non-manufacturing index falling from 56.4 in August to 52.6 in September.

Both ISM surveys garner a lot of attention on Wall Street because they are a timely gauge of economic growth. As figure 1 shows, the new orders component of the non-manufacturing index (or services) sector has a strong correlation to real gross domestic product (GDP). Based on the September reading, growth looks likely to slow to a range of about 1.5% to 2.0% year-on-year in coming quarters.

Figure 1: ISM Non-Manufacturing New Orders Component vs. Real U.S. GDP
ISM Non-Manufacturing New Orders Component vs. Real U.S. GDP
This chart shows ISM Nonmanufacturing New Orders Index (Left) and U.S. Real GDP (Lagged One Quarter, Y/Y%, Right). Because of the strong correlation between the new orders component of the non-manufacturing index with the real gross domestic product (GDP), growth looks likely to slow to a range of about 1.5% to 2.0% year-on-year in coming quarters.
Sources: Haver Analytics and Citi Personal Wealth Management as of September 2019.

Although disappointing, the potential moderation in growth is not out of line with what Citi’s economists were expecting. In fact, we highlighted in our 2018 Mid-Year Outlook that we expected growth to taper off in the back half of 2019 as the fiscal stimulus from the Tax Cuts and Jobs Act starts to wane. Citi’s economists are forecasting growth of about 2.0% growth in the third quarter of this year – perhaps slightly above what the ISM non-manufacturing index is suggesting.

Importantly, economic growth is likely to remain positive for some time with the consumer still in reasonably good shape. It’s also worth noting that the Federal Reserve just cut interest rates twice in order to protect the U.S. economy from this expected slowdown. While monetary policy is not the best tool to use combat weakness due to trade policy, it should help to stabilize growth over time. Usually it takes somewhere between 6 months to 12 months for the economy to reflect changes in monetary policy, suggesting that the Fed’s recent actions may take hold in the early part of next year. Additionally, investors should remember that the Fed has already signaled that it will “act to sustain the expansion.” This means that additional weakness in data will likely mean additional rate cuts. This is already being reflected in markets with the market-implied odds of another rate cut in October spiking.

Even though the economy is now on “recession watch,” that doesn’t necessarily mean that the U.S. stock market is about to enter a bear market (defined as a 20% sell-off or more). In fact, bear markets outside of a recession are actually quite rare with stocks often continuing to rise (with some bumps along the way) until about 3- to 6-months prior to the end of the business cycle. With growth likely to remain positive over at least the next few quarters we are still maintaining our neutral stance on U.S. equities. Citi’s year-end 2020 target for the S&P 500 is 3,300 (about a 12% return from today’s levels).