Implications:  Payrolls continued to expand in February, but other signals from the labor market show all is not well.  Nonfarm payrolls grew 151,000 in February, narrowly missing the consensus expected 160,000. A large part of the gain came from health care and social assistance jobs, up 63,000.   Meanwhile, jobs at restaurants & bars dropped 28,000.  We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (that includes COVID lockdowns and re-openings for leisure & hospitality).  In what is probably the best news for February, this “core” measure of jobs rose 83,000, beating the 33,000 monthly average in the past year.  However, in what is probably the worst news for February, civilian employment, an alternative measure of jobs that includes small-business start-ups dropped 588,000.  As a result, and in spite of a 385,000 drop in the labor force (people who are either working or looking for work), the unemployment rate ticked up to 4.1% versus 4.0% in January.  Meanwhile, the U-6 measure of unemployment spiked upward to 8.0% from 7.5%.  That measure counts as unemployed not only those normally counted but also those working part-time who say they want full-time jobs as well as “marginally attached” workers, who are unemployed workers who still say they want a job and have looked for one in the past year.  Other details in today’s report suggested moderate economic growth, but reasons for the Federal Reserve to be cautious about cutting short-term interest rates.  Total hours worked increased 0.1% in February and are up 0.6% in the past year.  Add that gain in hours worked to the trend growth rate in productivity (output per hour) of 1.8% per year in the past decade and you get close to 2.5% economic growth.  Meanwhile, average hourly earnings rose 0.3% in February and are up 4.0% in the past year.  The Fed would probably like to see that annual gain closer to 3.5% before it’s comfortable with the path toward 2.0% inflation.  Notably, federal government payrolls (excluding the Post Office) declined 7,000 in February, the largest drop for any month since 2022.  Given the Trump Administration’s goal of reducing the federal workforce, we expect more of this in the months ahead, potentially much more.  That may cause some short-term pain for the US economy, but we expect long-term gains from reducing the size and scope of the federal government, including more jobs gains in the private sector.

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With the market volatile, we thought it would be a good time to take a look at alternative valuation models. Every major valuation metric of the S&P 500 Index is flashing warning signs. In this week’s “Three on Thursday,” we look at three key different valuation models – plus, as a bonus, our own in-house model – each offering a unique perspective on just how stretched equity prices may be.

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Implications: Imports soared to a record high in January as businesses were front running tariffs that might be put in place by the Trump Administration. The increase in imports was led by industrial supplies, mainly due to a massive increase in finished metal shapes, which can be used in the manufacturing of cars, appliances, and other equipment. This category also includes gold bars which are considered finished metal shapes. Several countries were key to the import surge all with their largest monthly increase ever recorded. Imports from Switzerland soared by $9.6 billion (mainly gold), while imports from Ireland increased by $6.2 billion, and those from Australia by $2.2 billion. The surge in imports will have a huge influence on the calculation of real GDP for the first quarter because when it comes to GDP accounting, imports are a negative. As a result of the surge, it now looks like international trade will be a roughly 3 percentage point drag on the growth rate in Q1 and overall real GDP should drop at about a 1.5% annual rate, with a rebound bounce in growth in Q2 as firms soon end the process of front running tariffs. Looking at the overall trend, total trade is up 14.7% from a year ago, with exports up 4.1% and imports up 23.1%.  There also continues to be a major shift going on in the pattern of US trade and with new tariffs that look lasting on China we expect this to continue.  China used to be the top exporter to the US.  Now the top spot is held by Mexico; China has fallen to number two with Canada nipping at her heels.  Also in today’s report, the dollar value of US petroleum exports exceeded imports once again.  This marks the 32nd consecutive month of the US being a net exporter of petroleum products. In other news this morning, initial jobless claims declined 21,000 last week to 221000, while continuing claims rose 42,000 to 1.897 million.  These figures are consistent with continued job growth in February, but at a slower pace than seen in recent years.

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Implications:  The February ISM Services report signaled continued expansion in the sector that drives two-thirds of the US economy.  The overall index beat consensus expectations and rose to 53.5 in February from a previous level of 52.8.  We do believe sentiment can move this survey so it may reflect new optimism of political change.  Fourteen out of eighteen major service industries reported growth in the month while three reported contraction.  The overall increase was led by faster growth in employment, with the index moving to the highest level since late 2021 at 53.9.  However, growth was split, with an equal number of industries (seven) reporting an increase versus a decrease in employment in February.  Notably, two of the industries to report a decrease in employment were Public Administration and Health Care & Social Assistance, both of which were lifted by government spending but likely now affected by the impact of DOGE.  As for other details, new orders picked up while business activity remained steady.   Both of these forward-looking indexes sit in expansion territory (52.2 and 54.4, respectively), but survey comments suggest things could change quickly, as they were full of concerns over tariffs and how they will affect activity if implemented.   Finally, the highest reading of any category was once again the prices index, which increased to 62.6 in February, with sixteen out of eighteen major industries paying higher prices.  Inflation was a major problem before any new tariffs and will continue to be one if the Federal Reserve does not have the resolve to let tight money suffocate the embers of inflation that remain.  As for the economy, the service sector continues to be a lifeline for growth, standing in contrast to the recent wave of weak economic data.  In other news this morning, ADP’s measure of private payrolls increased 77,000 in February versus a consensus expected 140,000. We’re estimating Friday’s official report will show a nonfarm payroll gain of 165,000 with the unemployment rate remaining steady at 4.0%.  On the autos front, cars and light trucks were sold at a 16.0 million annual rate in February, up 3.2% from January and up 2.1% from a year ago.

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Implications:  Activity in the US manufacturing sector expanded marginally for the second month in a row, but the details of the report were ugly.  Nearly all major measures of activity declined in February and sit in or are hovering near contraction territory.  The new orders index led the drop, falling to 48.6 from 55.1.  Production cooled to a reading of 50.7, while the employment index fell to 47.6; the tenth month in the last twelve below 50.  Although manufacturing was already tepid before, it appears a key reason for the drop in the index this month had to do with policy coming out of Washington.  Survey comments were full of tariff concerns, with reports of price increases from suppliers and delayed customer orders over uncertainty with how the tariffs will be implemented.  Notably, one respondent in the Computers & Electronic Products industry said that limits on U.S. government spending in key organizations like the FDA, EPA, and NIH are delaying some of their orders. We expect volatility in the data to continue in the months ahead as businesses figure out how the new policy environment changes the outlook for investment and growth.  Perhaps the worst part of the report was that inflation remains a major problem in the manufacturing sector.  Prices paid by companies rose again in February and the pace accelerated, with the index rising to 62.4. That is the highest index level since the surging inflation of 2022, a clear sign that the embers of inflation remain even as manufacturing stagnates.  We hope the Federal Reserve has the resolve to stomp the embers out, despite the short-term economic pain that may result from federal policy changes – pain that will ultimately pave the way for long-term growth. In other news this morning, construction spending declined 0.2% in January, as a large decline in homebuilding fully offset smaller increases elsewhere.

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Is the US already in recession?  Probably not.  But in the first quarter, real GDP is very likely to have a minus sign in front of it.  Yes, a negative reading for real growth!

Even before Friday there were some troubling signs.  Retail sales fell 0.9% in January while housing starts dropped 9.8%.  The personal saving rate hit a new post-COVID low in the fourth quarter, existing home sales declined 4.9% for the month and, with pending home sales (contracts on existing homes) down, February will likely be weak as well.  Meanwhile, manufacturing production slipped in January as did shipments of capital goods excluding aircraft and national defense.

In addition, in what could be an early sign of layoffs in the private sector from DOGE-related government spending cuts in Washington, initial claims for unemployment insurance jumped to 242,000, up noticeably from the 213,000 in the same week the year before.

But the real reason for a drop in real GDP was reported last Friday.  The advance report on international trade in January reported a massive surge in imports for the month, led by industrial supplies.  This is important because the primary way the government counts GDP is to add up all the things we’re buying – whether by consumers, businesses, or the government – and then to subtract out imports.  Gross Domestic “Product” is a measure of how much the US is producing, so imports don’t count.  For example, if we buy 100 mousetraps total but we imported 20 of them, then we only made 80 mousetraps in the USA.

Plugging the surge in imports into our models suggests negative growth for Q1, which was confirmed by the Atlanta Fed’s GDP Now, which is tracking -2.8% growth in Q1.

But just because we expect a negative reading in Q1 doesn’t mean a recession is here.  The data are volatile for many reasons.  For example, unusually cold winter weather plus California fires probably held down retail sales and homebuilding.

And it seems clear that the surge in imports in January reflects many importers front-running proposed tariffs by the Trump Administration – they’re bringing the goods in early to avoid higher tariffs later – which means the import surge should reverse sometime in the next few months.  If so, the drop in Real GDP in the first quarter could be followed by a temporary surge in Real GDP growth in the second quarter.    

But that still leaves the effects of what is likely to be a consistent effort by the Trump Administration to bring down government spending.  We think those efforts are a positive for future long-term economic growth, but in the short-term could deliver some pain as some consumers and businesses who have grown addicted to living off government redistribution need to adapt to a more free-market environment.

With headwinds, tailwinds, and side winds hitting all at once, the data are not very clear.  While we do expect the US to face an eventual recession, a negative Real GDP growth report for Q1 is not yet defining evidence.  It is a reason to be concerned, but we will look elsewhere for confirmation.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Hold off on income and spending for a moment.  A report that usually gets little notice – an “advance” report on international trade – showed a huge spike in imports of industrial supplies in January and, therefore, the trade deficit.  Even assuming a reversal of the trade deficit in February and March (back down to the December level), international trade could be a very large drag on Real GDP growth in Q1, potentially resulting in negative growth for the quarter.  Meanwhile, in spite of a spike in income, consumer spending was soft in January while inflation was still running hot.  Personal income surged 0.9% in January and is up 4.6% in the past year.  However the gain in January was largely due to cost-of-living adjustments to social security benefits, which pushed government transfers higher.  Government benefit payments to individuals are up 7.6% in the past year; excluding COVID, that’s near the largest 12-month increase in more than a decade.  Meanwhile, pay in the public sector rose 0.5% in January and is up 6.1% in the past year, versus private-sector wages and salaries, which are up 0.4% on the month and are up 4.2% in the past year.  We don’t think the growth in government pay – or massive government deficit spending – is either sustainable or good for the US economy, which is why we’re hoping recent policy changes in DC represent a shift in thinking on the growth of government.  Long term, it’s the growth in private-sector earnings that’ll better sustain the economy.  In spite of higher income in January, personal consumption declined 0.2% (unchanged from December when including upward revisions to prior months).  Spending on services rose 0.3% in January and is up a strong 6.4% from a year ago, but goods spending fell 1.2% in January, fully offsetting gains elsewhere.  The drop in goods spending was likely at least partly due to unusually cold winter weather plus fires in southern California, and should reverse for February.  On the inflation front, PCE prices increased 0.3% in January, are up 2.5% in the past year, close to the 2.6% increase in the year ending January 2024, which means the Fed made virtually no progress in the inflation flight over the past year.  “Core” prices (which exclude food and energy) also rose 0.3% in January and are up 2.6% versus a year ago.  The Fed has signaled plans to pause on rate cuts for the foreseeable future, but risks remain that activity in Washington could translate to a pullback in government spending in 2025 and beyond, which may cause short-term economic pain before longer term gain.  In other recent news, pending home sales, which are contracts on existing homes, fell 4.6% in January following a 4.1% decline in December, suggesting another drop in existing home sales (counted at closing) in February.

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Donald Trump is back in the Oval Office, and tariffs have once again taken center stage in U.S. economic policy. As these policies take shape, the question remains: Will tariffs be the economic powerhouse Trump envisions, or will they introduce new uncertainties into an already fragile global market? In this “Three on Thursday,” we explore the historical role of tariffs as a revenue source and assess whether they could ever replace the U.S. income tax. 

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Implications:  Real GDP was unrevised at a 2.3% annual growth rate for the fourth quarter, with slight upward revisions to inventories, net exports, and government purchases that were offset by downward revisions to business investment in intellectual property and consumer spending. To analyze the growth trends more accurately, we follow "core" GDP, which includes consumer spending, business fixed investment, and home building, while excluding government purchases, inventories, and international trade, which are too volatile for long-term growth. “Core” GDP was revised lower to a still-respectable 3.0% annual rate from a prior estimate of 3.2% in Q4.  Despite solid core growth, there were some economic blemishes in the report.  Business fixed investment – equipment, commercial construction, and intellectual property – declined at a 3.2% annual rate in Q4 in spite of the boom in AI spending, the first drop since 2021.  These investments are crucial to lifting productivity growth in the years ahead.  Meanwhile, much of the gain in Real GDP was accounted for by consumer spending, which grew at a 4.2% annual rate and is up 3.1% in the past year.  The reason that’s a problem is because some of this growth in consumer spending is unsustainable; the personal saving rate declined to 3.8% in the fourth quarter, well below the 6.7% rate that prevailed pre-COVID. A move by consumers to reassert a higher saving rate again could mean an abrupt slowdown in the growth of consumer spending as well as the production of those goods and services for consumers.  We also can’t help but notice the continued abnormally large contribution from federal government spending, which was revised upward to a 4.0% annual rate in Q4 versus a prior estimate of 3.2% and is up 4.2% in the past year.  Now, with DOGE-related spending cuts in Washington, that rapid growth in government is ending and the economy may pay a temporary price.  Regarding monetary policy, today’s inflation news confirms the Fed’s battle is not over. The GDP price index was revised upward to 2.4% annual growth rate in the fourth quarter from a prior estimate of 2.2%. These prices are up 2.5% in the past year, barely an improvement from the 2.6% reading in the year ending in Q4 2023. In turn, do not expect any rate cuts from policymakers for at least the next couple of meetings.

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Implications:  New orders for durable goods jumped 3.1% in January following declines in the prior two months.  That said, the details of today’s report were not quite as strong as the headline suggests.  Transportation drove orders higher in January but can swing wildly from month to month as aircraft orders tend to come in chunks rather than steadily over time.  That was the case once again in January, as commercial aircraft orders surged 93.9%.  Excluding the transportation sector, orders for durable goods were unchanged in January (and down 0.3% when including revisions to prior months).  Rising orders for computer and electronic products (+1.7), machinery (+0.2%), and electrical equipment (+0.1%) were fully offset by a 1.2% decline in fabricated metal products.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – declined 0.3% in January.  If unchanged in February and March, these orders would be down at a 0.1% annualized rate in Q1 versus the Q4 average, which would represent a third quarterly decline in four quarters.  Durable goods – both including and excluding transportation – have struggled to keep pace with inflation over recent years.  And now that the Trump Administration is back in Washington with a mandate to cut taxes, regulations, and the size of government, we expect volatility in the data to continue in the months ahead as businesses figure out how the new policy environment changes the outlook for investment and growth.  In turn, the Federal Reserve will navigate what these changes mean for the path of inflation.  There is plenty of potential for both progress and payback in 2025, as the US works to wean itself off outsized deficit spending and on to a more sustainable growth path.  There may be pain before the gain.  In other news this morning, initial jobless claims rose 22,000 last week to 242,000, while continuing claims declined 5,000 to 1.862 million.  These figures are consistent with continued job growth in February, but at a slower pace than seen in recent years.

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