A worrying signal from the U.S. ISM Manufacturing Survey follows an inversion of the yield curve, and it no longer makes sense to keep explaining such signs away.
By guest author Aaron Back from Wall Street Journal
Signs of a possible recession keep stacking up. At some point it no longer makes sense to keep explaining them away.
The latest grim omen came Tuesday, September 3, 2019, as the Institute for Supply Management’s manufacturing index fell to 49.1 in August from 51.2 in July, signaling a likely contraction in manufacturing activity.
Market bulls will be quick to point out that an ISM reading in contractionary territory does not necessarily signal an impending recession. The index did fall below 50 before each of the past three recessions, but it also did so in 1998, 2003 and early 2016. All three reflected genuine stress in the global economy that nonetheless failed to trigger a U.S. recession.
An inverted yield curve, on the other hand, has a much stronger track record as a predictor of recession. The yield on 10-year Treasurys has dipped below that of two-year Treasurys before each of the past three recessions and at no other time over the past 30 years, aside from a couple very brief episodes. The argument for this being a false signal now is that central banks in Europe and Japan have distorted the curve with negative rates and aggressive bond buying, indirectly suppressing long-term U.S. rates.
This is not dissimilar to an argument heard prior to the last recession in 2007, though. Back then, optimists argued that a glut of savings in China and other countries with large current account surpluses was driving down long-term rates. Needless to say, anyone buying this story got burned badly.
Both the so-called global savings glut of last decade and the negative interest rates of recent years weren’t just random phenomena but signals of real economic problems. In the 2000s, it was an unsustainable savings and trade imbalance between the U.S. and China. In this decade it is anemic global growth stubbornly resistant to traditional stimulus.
Market bulls are resting their hopes on a strong U.S. consumer, yet key consumer variables such as unemployment and wages are lagging indicators—well known for trailing developments in the broader economy. If U.S. business activity buckles under the weight of trade tensions and a global downturn, consumers will follow.
With both the yield curve and manufacturing surveys flashing red at the same time, it would be foolish to dismiss them both. No wonder investors are spooked.