RECESSION WATCH

Services Data Point to Sharper Slowdown Fourth-quarter GDP growth likely to be marked down after services survey underwhelms

Revenues across the U.S. service sector rose a seasonally adjusted 1.2% in the fourth quarter from the third, the Census Bureau said Thursday. That marked the weakest pace of growth in five quarters. (…)

As the government catches up on incomplete economic data because of the shutdown, the fourth quarter GDP looks weaker, dragging Q1’19 lower along the way. The latest data tend to confirm the abrupt decline in Business Sales at the end of 2018 as I showed in Monday’s DANGER ZONE post:

Importantly,  revisions in services data are significant, confirming Markit’s findings in its March 12 U.S. Business Outlook that I quoted in Monday’s post:

Interestingly, and worryingly, Markit found that much of the increased pessimism is at service providers where “the net balance of service sector firms expecting a rise in business activity has dipped from +40% last October to +29% in February.” (…)

All in all, the net balance of companies predicting greater profitability (+26%) is the weakest for two years, with “reduced confidence around future profits largely emanating from weaker sentiment at service sector firms.”

FYI, the Service sector accounts for 77% of the U.S. economy, 86% of total employment and 80% of new jobs created in the past year.

BTW, a reader asked me for a chart of business sales ex-energy. I finally found one, courtesy of Ed Yardeni, which shows that there is currently no big differences in trends unlike in 2015:

FLASH PMIs

U.S. business sees soft end to first quarter amid factory slowdown

At 54.3 in March, down from 55.5 in February, the seasonally adjusted IHS Markit Flash U.S. Composite PMI Output Index pointed to the weakest upturn in private sector business activity since September 2018. Softer business activity growth reflected more subdued demand conditions in March, with new work rising at the weakest pace since April 2017. A number of firms cited cautious spending patterns among clients and less upbeat business sentiment.

Private sector companies responded to slower new business growth by reining in staff hiring during March. Latest data pointed to the weakest increase in payroll numbers since June 2017.

Input price inflation moderated to a two-year low during the latest survey period. Softer cost pressures led to the least marked rise in prices charged by private sector firms since October 2017.

Meanwhile, survey respondents indicated another dip in optimism regarding the year ahead business outlook. March data signalled that the degree of positive sentiment was the weakest since June 2016.

The seasonally adjusted IHS Markit Flash U.S. Services PMI™ Business Activity Index posted 54.8 in March, down from February’s seven-month high of 56.0. Nonetheless, the latest reading was still well above the neutral 50.0 value and signalled a solid overall upturn in business activity across the service economy.

Mirroring the trend for business activity, March data indicated a softer rise in new work received by service providers. The latest survey also pointed to the smallest increase in employment numbers since May 2017.

On a more positive note, input cost inflation was only modest in March, with the latest survey pointing to the slowest rise in operating expenses for exactly two years.

The seasonally adjusted IHS Markit Flash U.S. Manufacturing Purchasing Managers’ Index™ (PMI™) registered 52.5, down from 53.0 in February and the lowest reading since June 2017. Softer rises in output, new orders and employment all weighed on the headline PMI in March. The latest expansion of production volumes was only modest and the least marked since June 2016.

A number of manufacturers commented on a cyclical slowdown in client demand. Reflecting this, new orders increased at the weakest rate for just under two years in March.
Growth of input buying was the slowest since May 2017, with survey respondents citing the need to adjust purchasing volumes to softer demand conditions. This helped alleviate pressure on supply chains, with lead-times from vendors lengthening to the least marked degree for almost one-and-a-half years.

Input price inflation continued to moderate in March, with the latest rise in average cost burdens the slowest since August 2017. Moreover, factory gate prices increased at a relatively subdued pace that was the weakest recorded for over one year.

Chris Williamson, Chief Business Economist at IHS Markit:

(…) The PMI survey data nevertheless remain encouragingly resilient, indicative of the economy growing at an annualised rate in excess of 2% in the first quarter, suggesting some potential upside to many current growth forecasts. A gap has opened up between the manufacturing and service sectors, however, with goods-producers and exporters struggling amid a deteriorating external environment and concerns regarding the impact of trade wars. The survey is consistent with the official measure of manufacturing production falling at an increased rate in March and hence acting as a drag on the economy in the first quarter.

At the moment, the service sector appears to be holding up relatively well. But the worry is that manufacturing woes are spreading to service providers, via reduced demand for services such as transport and storage as well as deteriorating business optimism about the outlook – which fell to the lowest for nearly three years in March – and a cooling of the labour market. The survey showed hiring across both manufacturing and services hit the weakest for just under two years in March. (…)

• THE DAILY EDGE: 19 MARCH 2019 discussed the Economic Outlook from Freight’s Perspective.
• The chart below shows the spread between the forward-looking and lagging components of the Philly Fed index, suggesting that we may see weaker manufacturing activity going forward. (The Daily Shot)

Source: @MikaelSarwe

Flash eurozone PMI falls in March as manufacturing downturn deepens

The eurozone economy lost momentum again in March, expanding only modestly as manufacturers reported their steepest downturn for six years. The service sector showed greater resilience but remained in its worst growth spell since late-2016. Stagnant order books and gloomier future expectations meanwhile led to reduced hiring.

The IHS Markit Eurozone Composite PMI® fell from 51.9 in February to 51.3 in March, according to the preliminary ‘flash’ estimate. The March reading was the third-lowest since November 2014, running only marginally above the recent lows seen in December and January.

New order growth stagnated for a second successive month following a slight decline in January, with backlogs of work dropping for the third time in four months. The reduction in backlogs was the largest since November 2014 and was indicative of excess capacity developing in the economy. Employment growth consequently slowed, down to the joint-weakest since September 2016, as increasing numbers of companies reviewed their payroll requirements in the light of reduced workloads.

Key to the deterioration in business growth was a further marked decline in export orders (which include intra-euro area trade). New exports of goods and services fell for a sixth straight month, deteriorating at the steepest rate since comparable data for total exports were first available in September 2014.

The worsening trend was primarily a reflection of an acceleration in the rate of decline in manufacturing. The headline manufacturing PMI fell to its lowest since April 2013 as downturns in factory output and new orders gained momentum. While the drop in factory output was the steepest for just under six years, the deterioration in new orders was more marked and the sharpest since December 2012. The latter was fueled by the largest fall in new export orders since August 2012.

Factory output has now fallen for two successive months and new orders for six straight months. With new orders contracting at a steeper rate than output, backlogs of work fell to the greatest extent since December 2012. Factory employment more or less stagnated as a result, showing the weakest rise for over four years, and input buying fell to a degree not witnessed for six years.

Service sector growth remained more resilient, dipping only marginally on February and running above the lows seen at the turn of the year. However, the rate of expansion remained well below that seen this time last year and subdued compared to the average recorded during 2018.

Although inflows of new business ticked higher in the service sector, exports fell to the greatest extent seen since data were first available in late-2014. Backlogs of work meanwhile fell for the second time in three months, contributing to an easing in service sector jobs growth to the second-lowest for just over two years.

Looking ahead, companies’ expectations of output in the coming year slipped lower, running above the lows seen at the turn of the year but remaining among the weakest recorded since late-2014. Manufacturing optimism remained especially low, easing to the gloomiest since December 2012. Reduced optimism principally reflected the expected impact of lowered forecasts for economic growth, with widespread concerns specifically focusing on heightened political uncertainty, trade wars and Brexit. The auto sector also remained a key area of expected weakness.

Mixed signals were seen in relation to prices. Having slipped to the lowest for one-and-a-half years in February, average selling price inflation picked up slightly in March, though input cost inflation eased for a fifth successive month. Input prices rose at the slowest rate since October 2016, with an especially marked rate of cooling seen in the goods-producing sector as supplier pricing power waned. However, service sector costs also rose at a reduced rate.

In Germany, business activity grew at its slowest rate since June 2013 with new orders declining for a third successive month. Although service sector growth remained robust, manufacturing output fell at the sharpest rate since August 2012. Factory orders deteriorated to the greatest extent since the height of the global financial crisis in April 2009. Hiring in Germany meanwhile slipped to a 34-month low as backlogs of work fell for a fifth successive month and business optimism about the year ahead waned.

In France, business activity fell for the third time in four months. While February saw a rebound from yellow vest protest disruptions, March saw activity deteriorate again as new order inflows contracted for a fourth straight month. Employment growth slowed to near-stagnation, its lowest since December 2016.

Elsewhere, the rate of output growth accelerated to its highest since last September as service sector growth hit an eight-month high. Manufacturing output stagnated, however, failing to grow for the first time since June 2013 in response to a third successive monthly drop in goods producers’ new orders.

The survey indicates that GDP likely rose by a modest 0.2% in the opening quarter, with a decline in manufacturing output in the region of 0.5% being offset by an expansion of service sector output of approximately 0.3%.

A rebound in February from one-off factors such as the yellow vest protests in France appears to have already lost momentum. Most worrying is the plight of the manufacturing sector, which is now in its deepest downturn since 2013 as trade flows contracted at the sharpest rate since the debt crisis ridden days of 2012. The service sector is showing more resilience, notably in Germany, but remains in one of its worst growth patches since 2016.

Forward-looking indicators such as business optimism and backlogs of work suggest that growth could be even weaker in the second quarter. Worryingly, with order book backlogs shrinking at the steepest rate since late-2014, more and more companies are pulling back on hiring, and likely reviewing their investment spending.

Any such further loss of growth momentum in the second quarter compared to the 0.2% GDP rise signalled for the first three months of the year would raise doubts on the economy’s ability to grow by more than 1% in 2019.

• German 10-Year Yields Drop Below Zero for First Time Since 2016

Japan manufacturing output falls at fastest pace in almost three years amid sluggish demand

• Flash Japan Manufacturing PMI® signals further downturn, with figure unchanged at 48.9
• Further production cutbacks amid weaker new order inflows
• Business confidence remains below long-run average

Further struggles for Japanese manufacturers were apparent at the end of Q1, with latest flash PMI data showing a sustained downturn. Slack demand from domestic and international markets prompted the sharpest cutback in output volumes for almost three years. With input purchasing falling, firms appear to be anticipating further troubles in the short-term. Indeed, concern of weaker growth in China and prolonged global trade frictions kept business confidence well below its historical average in March.

The Conference Board Leading Economic Index® (LEI) for the U.S. Increased Economy to Continue Expanding in Near-Term

The Conference Board Leading Economic Index® for the U.S. increased 0.2 percent in February to 111.5 (2016 = 100), following no change in January, and a 0.1 percent decline in December. The US LEI increased in February for the first time in five months,” said Ataman Ozyildirim, Director of Economic Research at The Conference Board. February’s improvement was driven by accommodative financial conditions and a rebound in stock prices, which more than offset weaknesses in the labor market components. Despite the latest results, the US LEI’s growth rate has slowed over the past six months, suggesting that while the economy will continue to expand in the near-term, its pace of growth could decelerate by year end.

There is a growing problem with this good leading indicator: it has been flat for 6 months following 6 months of sustained gains.

The 12-month growth looks impressive and well anchored…

…but the 6-month trend is slowing fast…

…and will drop even faster if no quick upturn materializes. Note also that February’s uptick is mainly due to financial data as opposed to ‘’real world” trends.

Canadian Growth: Headed for the Big Sleep or Just Dozing?

Canada, like much of the global economy, is showing sales weakness across sectors with its most topical three-month and six-month sales growth rates by sector showing declines. Manufacturing shipments, retail sales – both overall and excluding autos – as well as wholesale sales, all are falling on balance over three months and six months and the pace of the drop is intensifying.

However, January brings some respite to these trends. Manufacturing shipments rose by 1% in January and wholesale sales rose by 0.6%. The jury is still out on retail sales that have not yet been reported.

Year-over-year trends are modest. Canadian inflation metrics generally are up by about 1.5% over 12 months. So the manufacturing gain of 4.4% leaves some real growth on the table while retailing and wholesaling seem to offer only very thin margins for real growth.

Year-on-year sector growth rates generally peaked in mid-2017 and since have been eroding. However, all three sectors show a modest bump up in the most recent 12-month growth rates compared to their penultimate ones.

A snapshot of other Canadian sectors shows that there still is some resiliency. Employment gains are still solid and have even picked up some speed recently. Mining and oil output, important Canadian sectors are on an upswing. And the unemployment rate remains at a low level. But housing starts have been weak; they are declining at a horrifically fast pace over three months. Manufacturing output barely ekes out a gain over 12 months and is now on an accelerating path of contraction. Exports are also showing an accelerating contraction with severe weakness logged over the last three months. Imports, a series that is more connected with domestic demand than with international events, show more resiliency than exports. Still, imports fall at a 2.6% annual rate over six months and rise at just a 0.5% pace over three months. Year-over-year imports are rising in step with inflation.

Canada’s situation is more or less similar with that of the other G7 countries. It does not have an inflation problem. And it is having a hard time keeping growth in gear and yet economic performance has been good even if not strong. The unemployment rate is low. The problem is the turn of events in the current situation. Currently, there are mixed signals and mixed results by sector, but there is a liberal dose of weakness thrown in. Concerns about global trade overhang Canada as they do every other trading nation. The Baltic dry goods index has been showing weakness in global shipping volumes for a number of months now. Canada trades intensely with the U.S. where growth signals also have been dodgy and where the Fed has halted a program of rate hikes and just wiped the potential for rate hikes in 2019 off the slate. The U.S. yield curve is flatting voraciously again. That is never a signal that is friendly to U.S. growth. And it is ominous for Canada as well since the U.S. economy is an important trade partner and because U.S. growth has a lot to say about which way commodity prices turn and they also are important to Canada’s economy.

US agriculture secretary warns on China’s trade tactics Sonny Perdue says Beijing’s ‘attitudes’ are hardening in talks to resolve spat

China’s Debt Problem

This is excerpted from Matthews Asia’s Andy Rothman latest note:

China’s debt problem is serious, but the risk of a hard landing or banking crisis is, in my view, low. The reason is that the potential bad debts are corporate, not household, debts and were made at the direction of the state—by state-controlled banks to state-owned enterprises. This provides the state with the ability to manage the timing and pace of recognition of nonperforming loans. It is also important to note that the majority of potential bad debts are held by state-owned firms, while the leverage of the privately owned companies that employ the majority of the workforce and account for the majority of economic growth isn’t high. Additional positive factors are that China’s banking system is very liquid, and that the process of dealing with bad debts has begun. (…)

China’s overall debt-to-GDP ratio rose rapidly after the GFC and is very high, but in context appears less frightening: it is lower than the debt-to-GDP ratio of five of the G-7 advanced economies.

Understanding the composition of China’s debt is important to evaluating the seriousness of the problem. A key factor is that the Chinese household debt-to-GDP ratio is relatively low, about 50%, compared to 77% in the U.S., 86% in the U.K. and 58% in the eurozone as of June 2018.

Moreover, the largest share of Chinese household debt is home mortgages, and these are far safer than the mortgages that created significant problems in the past decade for households in the U.S. and U.K. For example, about 90% of new homes in China are bought by owner-occupiers (not speculators) who are required to pay a minimum of 20% cash to receive a mortgage, and most put down 30% cash or more—far above the U.S. median cash down payment of 2% of the purchase price in 2006.

The products that broke Lehman Brothers—and caused havoc throughout the U.S. financial system—do not exist in China. There are no subprime mortgages and very few mortgage-backed securities. There is no secondary securitization so no collateralized debt or loan obligations (CDOs and CLOs). Most mortgages are held to maturity by the issuing bank, raising the incentive for careful due diligence on borrowers. (…)

It is also worth noting that in addition to a relatively low household debt-to-GDP ratio of 50%, Chinese families have a very high savings rate, with household bank deposits equal to about 80% of GDP. In the U.S., the household debt-to-GDP ratio is 77%, while household (and nonprofit organization) savings deposits are equal to 47% of GDP. (…)

China’s real problem is corporate debt. The ratio of nonfinancial corporate debt-to-GDP jumped to 116% from 93% in the three years after the stimulus began, and then continued to increase. Now at about 153%, China’s corporate debt-to-GDP ratio is one of the highest in the world. Dealing with this will be a serious challenge.

But it is important to understand that about two-thirds of corporate debt is owed by state-owned enterprises (SOEs) to state-controlled banks. (…)

It is also significant that this debt burden is concentrated among a relatively small number of state-owned firms, making the cleanup a bit easier. (…)

Privately owned small- and medium-sized enterprises (SMEs) are the engine of China’s economic growth, accounting for more than 85% of employment and almost all new job creation, as well as most investment. These firms account for a minority of the corporate debt burden and, for several years, their debt levels were declining.

The liabilities-to-assets ratio for privately owned industrial firms fell every year from 2006 (59%) through 2016 (51%). But this ratio rose to 53% in 2017 and then to 56% in 2018, resulting in a rise of the overall industrial corporate debt/assets ratio. (…)

The most important difference between China’s debt problem and past debt problems in Western countries is that in China, there is little private-sector participation in debt creation.

As noted earlier, the origin of China’s debt problem came in response to the GFC, when the state directed state-controlled banks to lend money to state-owned enterprises, to carry out the public infrastructure stimulus program. There are no privately owned banks involved, so there is no mark-to-market pressure. As a result, and in contrast to the recent experience in the West, the Chinese government has the luxury of being able to control the timing of when bad loans are recognized and dealt with.

And there has been some progress in dealing with bad loans. Over the past 18 months, there has been a material acceleration in the formation of nonperforming loans (NPLs) at China’s banks, as well as a comparable acceleration in write-offs of bad loans.

It is also worth noting that China has one of the world’s highest savings rates. This probably influenced the rapid growth in bank lending, and it also means that the banking system is unlikely to experience a liquidity squeeze.

China’s foreign debt exposure is low, about 14% of GDP in 2017. This is a sharp contrast to Thailand’s 62% ratio in 1996, ahead of the Asian Financial Crisis. By funding its infrastructure buildout domestically, rather than through foreign lenders, China has avoided one of the key problems that contributed to past emerging market debt crises. (…)

Cleaning up China’s debt problem will be expensive, but this process is likely to result in gradually slower economic growth rates, greater volatility, and a higher fiscal deficit-to-GDP ratio, not the dramatic hard landing or banking crisis scenarios that make for a sexier media story.