Why This Slowdown Carries Elevated Risks

As the fourth quarter gets off to a rocky start, the consensus narrative is fully aware of the ongoing slowdown in global manufacturing that began over 20 months ago and is warming to the idea that the manufacturing malaise has spread to the services sector. 

In addition to the deceleration in economic activity, a slowdown in employment has emerged as a hot topic, more than a year after the peak in leading cyclical employment data. 

The economy goes through cycles. Most economic analysis focuses on the business cycle but the growth rate cycle, or the fluctuations in growth that occur within a business cycle, are the most impactful to asset prices and can overlap with the business cycle. 

Within this context of business cycles and growth rate cycles, most analysis is focused on growth but there are separate cycles in inflation and employment that are related but not always synchronized with cycles in growth. 

In 2015, the global economy experienced a meaningful deceleration in growth, centered around manufacturing, which led to a US growth rate cycle downturn and increased levels of recession fears. Cycles turn and the 2016 global slowdown inflected higher by the middle of the year, in large part due to massive stimulus in China earlier in 2015. 

Today, while there are certainly conversations about a recession, based on forward projections of S&P 500 earnings growth and optimistic economic forecasts, the consensus is firmly positioned for a similar outcome; the manufacturing slowdown will ultimately reverse without generating recessionary conditions. This thesis typically involves some resolution to the ongoing trade war with China. 

Looking at the economy strictly through cycles in growth, inflation, and employment, we can see why this slowdown is different than earlier downturns and why recession risk is particularly elevated. 

In both 2015 and today, outlined by the price of industrial commodities, the inflation cycle was decelerating so this is a constant risk across the last slowdown and this current slowdown. Although most outlets are not yet talking about the wave of disinflationary pressure, global bond markets have accurately reflected this reality. 

US Industrial Commodity Prices:A pasted imageSource: Bloomberg, EPB Macro Research

Today's inflation cycle downturn has reduced 10-year breakeven rates (inflation expectations) from 2.2% to 1.4%

Commonly, the industrial cycle is dismissed, particularly in the United States, due to the shrinking share of total GDP or size relative to services. 

We continue to focus on the industrial cycle because despite the diminishing share of total GDP, the cycles in manufacturing, one of the most cyclical industries, are still highly impactful to cycles in total growth and employment. 

The chart below shows US Real GDP growth on the top panel and the US ISM Manufacturing PMI on the bottom. This economic expansion, the cyclicality of the manufacturing sector still correlates to the rate of change in total growth. 

Today, despite the share of GDP, it is difficult to have a meaningful slowdown in the manufacturing sector without an adverse impact on total growth. 

US Real GDP Vs. US ISM PMI:A pasted imageSource: Bloomberg, EPB Macro Research

The main difference between the 2015-2016 slowdown in growth and today's downturn is the present conditions in employment. The last downturn started as the employment cycle was reaching a rate of growth near 2.5% in private payrolls. 

The employment cycle recovered with a lag to the growth rate cycle but only managed to reach a growth rate of roughly 2.1% before starting a new cyclical downturn in January of 2019. 

Total Private Employment Growth Year over Year:A pasted imageSource: Bloomberg, EPB Macro Research

As leading indicators of employment move lower, employment growth today is weaker than the worst point of the last slowdown. When the growth rate cycle was hitting its weakest point, in early 2016, private payroll growth was over 2.0% compared to today's reading of 1.57%. 

The employment cycle is starting on a weaker footing, capping the total growth rate of the economy and thus, making the economy more susceptible to recessionary conditions. 

Ultimately, total growth is a function of how many people are working and how productive those people are. You cannot have a decelerating rate of employment growth yet accelerating rates of total growth without an offsetting rise in productivity. 

Employment growth is starting from a weaker level at a time when the leading indicators of employment are touching the lowest growth rate in 10-years. 

Our in-house leading employment index, comprised of the most cyclical areas of employment, fell to the lowest growth rate since 2009, suggesting that total private payrolls growth will continue to decelerate beyond the already near nine-year low. 

US EPB Leading Employment Index Growth Rate (%):A pasted imageSource: Bloomberg, EPB Macro Research

The leading index of employment peaked in April of 2018, several months before the January 2019 peak in total employment growth. 

US EPB Leading Employment Index Growth Rate (%):A pasted imageSource: Bloomberg, EPB Macro Research

Given that the leading indicators of employment are moving lower, we are likely to see a continued decline in total employment growth but more specifically, manufacturing employment growth. 

While total employment growth is near a nine-year low, manufacturing employment growth is not, which is a concern. 

The leading indicators point to a continued slowdown in manufacturing employment growth which is likely to exert downward pressure on total employment growth, beyond its already multi-year low and likely to the weakest growth rate of this entire expansion. 

Total Manufacturing Employment Growth Year over Year:A pasted imageSource: Bloomberg, EPB Macro Research

Many refer to the 2015 slowdown as a "manufacturing recession" due to the contractionary rate of growth in the sector but a true recession comes with declines in employment, something that was scarce last time. 

We did not see sustained employment losses despite the deceleration in growth. 

Last month, the economy lost an estimated 2,000 manufacturing jobs. The 12-month cumulative sum of manufacturing employment is 117,000, down 56% from a year earlier. The six-month cumulative sum has fallen to 19,000, down 82% from a year earlier. 

With the leading index of employment decelerating to the weakest level of this economic cycle and the prospects for an upturn in employment growth not yet in sight, the economy is vulnerable to declining manufacturing employment. 

US Manufacturing 12-Month Cumulative Payrolls Change:A pasted imageSource: Bloomberg, EPB Macro Research

Typically, the argument surrounding the small size of the manufacturing sector re-emerges but changes in manufacturing conditions still impact the total economy as outlined in the GDP and ISM chart above (first chart). 

If we look at real per capita wage growth for the total economy and for the manufacturing sector, the decelerations in manufacturing wage growth are tied to decelerations in broader income growth, the ultimate fuel for sustained consumption growth. 

A continued decline in manufacturing employment growth threatens to knock manufacturing income growth into negative territory. Contractionary rates of manufacturing income growth would more than likely pull cumulative wage growth below its current 3.22% reading. 

US Manufacturing Wage Growth Vs. Total Wage Growth:A pasted imageSource: Bloomberg, EPB Macro Research

At a time when total consumption growth is decelerating, debunking another misguided media narrative about the "strong consumer," decelerating employment growth and thus aggregate income growth risks pushing total consumption growth to a five-year low. 

During the 2015 economic slowdown, the deceleration in consumption started from a 4.5% reading. Today, initial conditions for consumption are also weaker. 

US Total Real Consumption Growth:A pasted imageSource: Bloomberg, EPB Macro Research

In 2015, inflation was cycling lower, growth was cycling lower and employment started to decelerate, but the growth cycle turned before employment weakened sufficiently to be recessionary. 

Today, a clear downturn in inflation, growth, and employment are all present but employment growth is starting from a much weaker base (as is consumption), and the leading indicators of employment have moved meaningfully lower. 

The possibility of a trough in the rate of global industrial growth increases near the end of this quarter. 

Given that initial conditions in employment and consumption are materially weaker than the start of the 2015 slowdown, recession risk is already starting from a higher level.

US 4-Factor Coincident Index Year over Year (%):A pasted imageSource: Bloomberg, EPB Macro Research

The most relevant question when assessing the risk of a recession is around employment growth. Will the industrial cycle turn before manufacturing job losses push total employment growth and ultimately consumption growth beyond their already respective multi-year low?

While it remains premature to declare a recession is an imminent risk, the combination of weak (and decelerating) conditions in the four main coincident indicators of the business cycle, coupled with continued declines in the growth rate of the leading employment index, strongly make the case for minimizing risk exposure.