Implications:  The ISM Services index surprised sharply to the downside in June, falling to the lowest level in more than four years and – outside of the COVID lockdown months – the lowest since July 2009.  With June’s abrupt decline, activity in the U.S. service sector has now contracted in two out of the last three months, adding to the growing pile of evidence that the U.S. economy is running out of steam.  Looking at the details of the report, eight out of the eighteen major service industries reported growth for the month while an equal amount reported contraction and two reported no change.  The drop in the overall index was a result of much lower business activity in June as well as slower new orders.  Notably, both of the indexes for new orders and business activity fell into contraction territory, the first time they have been below 50 since December 2022 and May 2020, respectively.  Meanwhile, service hiring remains muted, as the employment index fell deeper into contraction territory to 46.1, the sixth time in the last seven months below 50.  Finally, the worst piece of the report came from the highest reading of any category – the prices index – which declined to a still-elevated 56.3 in June.  Although the index is lower than the back-breaking pace from 2021-22 – make no mistake – prices are still rising in the service sector and inflation remains a major problem.  Notably, the majority of survey comments from June’s report were focused on continued inflation pressures rather than slowing activity or orders.  The service sector has been a main driver for stubbornly high inflation this year and – unfortunately for the Fed – it doesn’t seem to be abating.  Meanwhile, the service sector – which has been a lifeline for the US economy the last couple years – is starting to crack.  How the Federal Reserve responds in the coming months could determine whether we repeat the stagflationary 1970s.

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Implications:  The trade deficit in goods and services grew to $75.1 billion in May as exports fell by more than imports.  However, we prefer to focus on the total volume of trade, imports plus exports, as it shows the extent of business and consumer interaction across the US border. This measure fell in May, declining by $3.0 billion, although total trade volume is up 5.4% from a year ago, with exports up 4.3% and imports up 6.2%.  Notably, there is a major shift going on in the pattern of US trade.  Through the first five months of the year, imports from China were down 2.5% versus the same period in 2023 and down 26.3% versus the same period in 2022.  China used to be the top exporter to the US.  Now the top spot is held by Mexico; China has fallen to number three with Canada now in second place.  Meanwhile, global supply chain pressures have eased substantially over the past few years.  This was confirmed by the New York Fed’s Global Supply Chain Pressure Index in May, with the index -0.48 standard deviations below the index’s historical average. For some perspective, two years ago in the month of May the index sat 2.71 standard deviations above the index’s historical average.  Expect some temporary volatility though as Yemen’s Houthi rebels continue to deter container ships from transiting the Red Sea and Bab-el-Mandeb Strait, adding volatility to shipping costs.  Also in today’s report, the dollar value of US petroleum exports exceeded imports once again.  This marks the 24th consecutive month of the US being a net exporter of petroleum products. In other news today, initial unemployment claims rose 4,000 last week to 238,000.  Continuing claims increased 26,000 to 1.858 million.  Also on the employment front, ADP’s measure of private payrolls increased 150,000 in June versus a consensus expected 165,000. Plugging this into our models finalizes our forecast for the official nonfarm payroll report for June (to be announced Friday morning) at 194,000. Expect payroll growth to slow down further in the months ahead.  In other recent news, cars and light trucks were sold at a 15.3 million annual rate in June, down 4.0% from May and 4.8% lower than a year ago.  Expect a bounce back in sales in July as dealerships get past problems related to cyberattacks.

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Implications:  The ISM Manufacturing index closed out the first half of 2024 worse off than it began, as the index missed consensus expectations once again in June and fell deeper into contraction territory to 48.5.  Activity in the US manufacturing sector has now contracted for nineteen out of the last twenty months.   Looking at the details of the report, only eight of the eighteen major manufacturing industries reported growth in June, while nine reported contraction, and one reported no change.   Production softened in June and fell into contraction territory for the first time in four months.  While that index has bounced around 50 since the Federal Reserve began their current tightening cycle in the first quarter of 2022, the new orders index (the other forward-looking piece of the report) has remained below 50 for twenty out of the last twenty-two months.  With weakening demand, companies have turned to reducing their order backlog. That index, which declined to 41.7 in June, has been in contraction for twenty-one consecutive months.  Survey comments from manufacturing companies warned of dwindling backlogs and have started furloughing workers in response.  This can be seen from movement in the employment index, which fell back into contraction territory in June, the eighth month below 50 in the last nine.  Looking at the big picture, goods-related activity was artificially boosted during the COVID lockdowns, but then the economy reopened, and consumers started shifting their spending preferences back to services and away from goods. The ISM index peaked in the last month federal stimulus checks were sent out (March 2021) and has been weaker ever since.  Expect to see continued manufacturing weakness in the second half of 2024 as the bill for reckless and artificial spending by our government from the COVID years comes due.  In other news this morning, construction spending declined 0.1% in May, as drops in homebuilding, office projects, and power facilities more than offset an increase for manufacturing facilities.

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In 1852, Karl Marx said "Men make their own history, but they do not make it as they please; they do not make it under circumstances chosen by themselves, but under circumstances directly encountered and transmitted from the past."

He, obviously knew about the Magna Carta (1215) and the English Parliament’s Bill of Rights (1689), which created a separation of powers between the King and elected representatives. What he didn’t pay much attention to was how the United States had improved upon these documents or he would have seen a country of entrepreneurs that had freedom and property rights along with a constitution so well thought out that it has only been amended twenty-seven times in 235 years. No one puts it better than Ronald Reagan; the excerpt below comes directly from his Commencement Address at the University of Notre Dame back on May 17, 1981.

"This Nation was born when a band of men, the Founding Fathers, a group so unique we've never seen their like since, rose to such selfless heights. Lawyers, tradesmen, merchants, farmers – fifty-six men achieved security and standing in life but valued freedom more. They pledged their lives, their fortunes, and their sacred honor. Sixteen of them gave their lives. Most gave their fortunes. All preserved their sacred honor.”

“They gave us more than a nation. They brought to all mankind for the first time the concept that man was born free, that each of us has inalienable rights, ours by the grace of God, and that government was created by us for our convenience, having only the powers that we choose to give it. This is the heritage that you're about to claim as you come out to join the society made up of those who have preceded you by a few years, or some of us by a great many.”

“This experiment in man's relation to man is a few years into its third century. Saying that may make it sound quite old. But let's look at it from another viewpoint or perspective. A few years ago, someone figured out that if you could condense the entire history of life on Earth into a motion picture that would run for 24 hours a day, 365 days – maybe on leap years we could have an intermission – this idea that is the United States wouldn't appear on the screen until 3.5 seconds before midnight on December 31st. And in those 3.5 seconds not only would a new concept of society come into being, a golden hope for all mankind, but more than half the activity, economic activity in world history, would take place on this continent. Free to express their genius, individual Americans, men and women, in 3.5 seconds, would perform such miracles of invention, construction, and production as the world had never seen.”

America has proven that men and women not only can make their own history, but they can make it as they please, with circumstances chosen by themselves. Happy 4th of July to you all.  Let’s take time this week to step back and realize just how fortunate we are to live in a time and place where the fire of invention still burns hot, course corrections (however messy they may be) still take place, and the future remains as bright as ever.  May we continue to honor the legacy of those who came before us by striving to uphold the principles that have made this country a beacon of hope and freedom for the world.

(We first published a version of this same Monday Morning Outlook in celebration of July 4th, 2023.) 

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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Implications:  The Fed will welcome today’s personal income and spending report showing healthy consumer activity and a breather on inflation, but we wouldn’t get too caught up on a single month’s report. PCE prices – the Federal Reserve’s preferred measure of inflation – were unchanged in May, bringing the twelve-month comparison to 2.6%.  But don’t go popping Champagne quite yet, remember that PCE prices rose by 0.3% or more in each of the prior four months, and prices are running above a 3% annualized pace this year through May.  “Core” prices, which exclude the ever-volatile food and energy categories, rose 0.1% in May and are also up 2.6% versus a year ago.  The Fed has prioritized a subset of inflation dubbed the “Supercore,” which is services only (no goods), excluding food, energy, and housing.  That measure rose 0.1% in May, is up 3.4% versus a year ago, and has remained stubbornly around 3.5% on a year-ago basis for the past seven months.  No matter which measure they choose, or how they try to spin it, inflation remains above the Fed’s target.  Transitioning to a focus on how consumers fared in May shows some positive momentum.  Personal income rose 0.5% in May and is up 4.6% in the past year.  Private-sector wages and salaries led the way, up 0.7% on the month and up 4.5% in the past year.  Unfortunately government activity continues to run hot as well, with government transfer payments rising 0.3% in May while government pay rose 0.5% and is up 8.5% in the past year, matching the largest twelve-month increase in more than three decades. We don’t think the growth in government pay – or massive government deficit spending – is sustainable or good for the US economy.  Consumer spending rose a more modest 0.2% in May, with both good and services showing gains.  When adjusting for inflation, consumption rose 0.3%.  We are closely watching the service sector as the driver of consumer activity both now and in the near future, and we expect activity to temper as higher interest rates and continued inflation pressures take their toll.  In other recent news on the manufacturing front, the Kansas City Fed Manufacturing Index, a measure of factory activity in that region, fell to -8 in June from -2 in May, following similar negative readings earlier this week from the Dallas and Richmond Feds. On the housing front, pending home sales, which are contracts on existing homes, fell 2.1% in May following a 7.7% decline in April.  Plugging these figures into our model suggests existing home sales, which are counted at closing, will drop in July, probably to the lowest level so far this year.

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In today’s Three on Thursday, we take a look at the surge taking place in net interest payments on treasury debt securities. Each year, when the U.S. incurs a deficit, it contributes to the growth of our national debt. The current outstanding federal debt has surpassed a staggering $33.6 trillion. However, what truly counts is the government’s ability to meet all the interest payments on this accumulating debt.

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Implications:   The final reading for real GDP growth in the first quarter ended up coming in as expected, revised slightly higher to a 1.4% annual rate from a prior estimate of 1.3%.  The upward revision to the overall number was mainly due to net exports (imports were revised lower), business investment (equipment and software along with structures) and government purchases. These more than offset a downward revision to consumption, mainly in services. Today we also received our second look at economy-wide corporate profits for Q1, which were revised lower, now down 1.4% from Q4 verses the 0.6% decline reported last month, but still up 6.4% from a year ago.  The government includes Federal Reserve profits in this data, and the Fed is making losses.  So, we follow profits excluding those earned (or lost) by the Fed, which are up 6.3% from a year ago.  However, profits excluding the Fed declined 1.2% in Q1, the largest drop for any quarter since Q3 2021 with domestic non-financial companies’ profits falling the most.  Plugging in non-Fed profits into our Capitalized Profits Model suggests stocks remain overvalued.  In addition to corporate profits, we also got a second look at the Q1 total for Real Gross Domestic Income, an alternative to GDP that is just as accurate.  Real GDI was revised lower to a 1.3% annual rate in Q1 and is up 1.8% versus a year ago.  Regarding monetary policy, inflation remains stubbornly high.  GDP inflation was revised slightly higher to a still elevated 3.1% annual rate in Q1 versus a prior estimate of 3.0%.  GDP prices are up 2.4% from a year ago.  Meanwhile, nominal GDP (real GDP growth plus inflation) rose at a 4.5% annual rate in Q1 and is up 5.4% from a year ago.

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Implications:  Durable goods orders inched positive in May, narrowly beating a consensus expected decline.  However, the details in today’s report – along with downward revisions to prior data – show a slowing economy.  Although orders for durables were up slightly in May they are down 1.5% from a year ago.  May orders were led higher by defense aircraft and motor vehicles and parts, up 22.6% and 0.7%, respectively, in May. That said, transportation orders are very volatile month-to-month, and orders declined 0.1% excluding the transportation sector.  Looking deeper at the details of the report shows mixed performance across the major non-transportation categories, with orders for machinery (-0.5%), primary metals (-0.4%), and electrical equipment (-0.4%) declining, while fabricated metal products (+0.3%) and computers and electronic products (+0.1%) increased.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – declined 0.5% in May. If the pace of these shipments remains unchanged in June, core shipments would decline at a 1.9% annualized rate in Q2 versus the Q1 average.  The growth in shipments has moderated significantly since surging in 2020 as PPP loans and stimulus payments flooded the system, and shipments fell into contraction in the fourth quarter of 2023 before the rebound last quarter.  We expect this trend of turbulent readings to continue as the economy feels the lagged effects of the Federal Reserve’s tightening of monetary policy.  In other recent news, initial claims for jobless benefits fell 6,000 last week (possibly held lower by the Juneteenth holiday) to 233,000, while continuing claims rose by 18,000 to 1.839 million.  The figures are consistent with continued job gains in June, but at a slowing pace.  

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Implications:  New home sales came in weaker than expected in May, posting the largest monthly decline since 2022 following back-to-back gains.  It looks like activity is stuck in low gear, with sales having normalized roughly at the same pace they were in 2019 before COVID.  Stubbornly high inflation continues to be the biggest headwind to a broader recovery, delaying widely expected rate cuts from the Federal Reserve and keeping 30-year fixed mortgage rates above 7%. Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle amounts to a 24% increase in monthly payments on a new 30-year mortgage for the median new home.  The good news for potential buyers is that the median sales price of new homes has fallen 9.3% from the peak in 2022. It does look like a small part of this decline reflects a lower price per square foot as developers cut prices.  The Census Bureau reports that from 2022 to 2023 (the most recent data available) the median price per square foot for single family homes sold fell 1.1%. While that decline is modest, it represents a stark reversal from the 45% gain from 2019 to 2022.  That said, most of the drop in median prices is likely due to the mix of homes on the market including more lower priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 200% versus the bottom in 2022. Total inventories have continued to climb higher as well, hitting a new post-pandemic high in May. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  Though not a recipe for a significant rebound, more inventories giving potential buyers a wider array of options will continue to put a floor under new home sales.  One problem with assessing housing activity is that the Federal Reserve held interest rates artificially low for more than a decade, and buyers started to believe those low rates were normal.  With rates now reflecting true economic fundamentals, the sticker shock on mortgage rates for potential buyers is very real.  However, we have had strong housing markets with rates at current levels in the past, and as long as the job market remains strong and buyers understand that the past was a mirage, it’s possible they will eventually adjust.  In other recent housing news, the Case-Shiller index increased 0.3% in April and is up 6.3% from a year ago. Meanwhile, the FHFA index ticked up 0.2% in April and is up 6.4% from a year ago.   In the manufacturing sector, the Richmond Fed index, a measure of factory activity in the mid-Atlantic, fell to -10 in June from 0 in May.  Also earlier this week, the Federal Reserve released monthly figures on the money supply showing M2 up 0.4% in May and up 0.6% in the past year.  After surging in the first two years of COVID, M2 declined from early 2022 through early 2023 and has since been close to flat.  This recent history should eventually put downward pressure on the growth rate of nominal GDP.

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Back in the early days of COVID, there was one key indicator that signaled or predicted the high inflation ahead: the M2 measure of the money supply. Unlike in the aftermath of the Financial Panic and Great Recession of 2008-09, M2 surged at an unprecedented pace in 2020-21.

So, while others looked back and said “QE doesn’t cause inflation” we didn’t.  While many said that inflation was “transitory,” we warned about inflation going higher and being more persistent.  And here we are more than four years past the onset of COVID and inflation is still lingering above the pre-COVID trend.  The Consumer Price index is up 3.3% from a year ago while core consumer prices are up 3.4%.

What we take from all of this is that many economists, investors and policymakers ignored M2 to their detriment.  As a result, they have been surprised by the surge and persistence of inflation.  You think they might have learned.

But now a new conventional wisdom has taken hold, which says the US is out of the woods on a potential recession.  This, in their view, supports a trailing price-to-earnings ratio of 24 on the S&P 500, a level that in the past has been associated with low future returns on equities.

We hope a recession doesn’t happen, but think their dismissive attitudes towards warning signs like M2 (which has declined in the past 18 months) increases the chances they get caught flat-footed by a downturn.  We know it’s not visible yet, but every once-in-a-while there’s an economic report that should make people re-think their pre-conceived notions.

That applies to home building in May.  Out of the blue, housing starts dropped 5.5%, completions fell 8.4%, and permits for future construction declined 3.8%.

Housing starts and permits are now sitting at the lowest levels since the early days of COVID, even as the flow of immigration remains elevated.  Whether you support or oppose high levels of immigration, where are all the newcomers going to live if we aren’t building more housing?  And isn’t one of the arguments in support of high immigration that industries like home construction need cheap labor to build more homes?

In the meantime, retail sales surprised to the downside in May, eking out only a 0.1% gain for the month, but including revisions to prior months were actually 0.3% lower.  Retail activity is roughly unchanged since the end of last year, which means after adjusting for inflation, consumers are buying fewer goods.  Car sales rose slightly in May, but are down from last December and even down from June 2023.

In addition there’s an early sign that the labor market may have some trouble ahead: initial claims for unemployment insurance averaged 211,000 per week in the fourth quarter of 2023, as well as the first quarter of 2024.  But initial claims have averaged about 240,000 in the past two weeks.  Hopefully this is just some seasonal variation and claims will go back down soon, but it is worth watching closely in the weeks ahead.  (One caveat is Thursday’s initial claims report will include Juneteenth, a relatively new holiday which may confuse seasonal adjustments.)  

None of this means a recession has already started.  Industrial production surged 0.9% in May, which is not a recessionary number at all.  The Atlanta Fed GDP Model is back up to tracking 3.0% annualized growth in Q2, while we are tracking 2.0%.  And private payrolls continue to average over 200,000 jobs added per month, even if gains appear to have been led by part-time positions.

It's also important to recognize that fiscal policy has never been this “loose” (the deficit so high) when the unemployment rate has been so low.  But with the interest burden on the federal debt as a share of GDP suddenly shooting up to the highest since the 1980-90s, the days of using the budget to try to artificially boost growth should soon come to an end.

There’s no guarantee of a recession in the year ahead, but the risk shouldn’t be casually dismissed.  Not paying attention to M2 has cost investors more than once already.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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