Weakening PMI Services Index

After reviewing the non-manufacturing ISM report, you must be wondering about the stability of this recovery. Is it possible that the services index is signaling a slowdown in the 2nd half of the year? Reviewing the July Markit services report will help us find out if the ISM was a fluke or a signal of a greater trend. The Markit PMI was 56.0 which missed estimates for 56.3 and was below the prior report of 56.5. This report showed economic growth is weakening (going from great to good growth).

Growth in incoming orders fell in the second half of July, ending the month at the slowest growth rate since early in the year. Business optimism for the next 12 months fell to a 6 month low because of worries about tariffs affecting demand. Backlogs fell for the first time in over one year.

Some investors are willing to ignore any weakness in economic data related to tariffs because much of it is fear about a future trade war, not a summary of the effects that are happening now. It’s easy to sleep on the worries about tariffs with the stock market near a record high. Personally, I get worried when risks increase along with stock prices. When you combine the services report in the 2nd half of the month with manufacturing, the Markit PMI composite for July is 55.7 which is down from 56.2 in June. That is a 3 month low.

The weakening seen in the Markit and ISM reports is the worst possible situation in rate of change terms. To be clear, there were good aspects to this report. I have higher standards for the economy when the stock market is roaring and showing signs of froth. Reviewing the good in this report, the decline in order growth could be a blessing because the economy may have reached capacity constraints. Business activity is near its strongest level in 3 years. Employment is limited by the lack of skilled workers which should drive up their wages. Because output capacity was less constrained, input price inflation eased; however, selling prices are still almost at a 4 year high. This means the consumer is being hit with higher prices which could hurt demand.

Real Wages Are Hurt By Oil

As I mentioned, the consumer is being hit with rising expenses which is a problem for many as they aren’t seeing enough wage growth to make up for those costs. The chart below does a great job of outlining the recent turn for the worse real wages have taken. Real wage growth was negative in June. The July CPI report comes out on Friday. It will give an update on real wage growth since the most common measurement of real wages uses headline CPI as a deflator. The expectation for year over year headline CPI growth is 2.9% which is the same as last month. That’s high since oil had a weak month. The grey line shows rising oil prices have lifted inflation and suppressed real wages.

(Click on image to enlarge)

Trade Deficit Increases In June

Trade reports tell us about the effect of the tariffs on global trade growth, how trade will affect GDP growth, and how Trump might react in future negotiations. These reports show the effects of policies and can catalyze policies. For example, tariffs can slow trade growth and an increase in the deficit can spur Trump to implement more tariffs to try to lower the deficit. I also think strong economic growth and a rising stock market empowers Trump to issue more tariffs which could eventually catch up to the economy. In this case, good news is bad news just like how rising growth means more rate hikes which hurt future growth. 2019 is starting to look like it could be a bad year because there will be tough comparisons, declining tailwinds from the fiscal stimulus, contractionary monetary policy, and potentially higher tariffs.

Let’s look at the June trade report and then review Trump’s statements on trade. The trade deficit missed estimates after beating estimates in the past couple of months. The June deficit was $46.3 billion which was worse than the consensus of $45.6 billion. The May deficit was revised from $43.1 billion to $43.2 billion. The main reason the trade balance was stronger earlier in the year and weaker in June was because exports fell in June for the first time since February. Exports fell 0.7% to $213.8 billion as the growth in service exports was drowned out by the decline in goods exports. There were declines in capital goods, vehicles, and consumer goods exports.

Personally, I like to see imports and exports increasing because it signals economic growth is strong. I think import growth is a good signal for the economy. However, when import growth is combined with export declines, the deficit rises. Imports were up 0.6% to $260.2 billion. Consumer goods imports were up $2 billion to $53.6 billion and oil imports were up $1.2 billion to $14.1 billion.

Specifically, the deficit with China was $33.5 billion in June. It’s up 8.6% year to date. This could signal that Trump will increase tariffs with China. The deficit with Europe is up 11% and the deficit with Mexico is up 5.5.%. The deficit with Canada declined 23.4%.

President Trump doubled down on tariffs when he tweeted the following statement. He wrote, “Tariffs are working big time. Every country on earth wants to take wealth out of the U.S., always to our detriment. I say, as they come, Tax them. If they don’t want to be taxed, let them make or build the product in the U.S.”

Conclusion

I am starting to get more bearish on equities which means I have transformed from bullish to neutral. The higher stocks go with the backdrop of increasing tariffs and weaker economic growth, the more bearish I will become. I think the market overreacted to tariffs early in the year and is now underreacting to them. The likelihood that tariffs will hurt the economy is higher than a few months ago, yet stocks are much higher.