Recession Odds Increase As Both ISM PMIs Fall In July

Recession Odds Increase

The latest flattening of the yield curve implies the odds of a recession are increasing. To be clear, even if this indicator shows there is a 100% chance of a recession, that doesn’t mean it will happen. This is one of many indicators I use. Ever since the start of the year, I expected Q2 and Q3 to be the weakest quarters for the economy. The combination of cyclical weakness and the trade war certainly doesn’t paint a rosy picture. If the economy avoids a recession in the next few months, I think this will just be a slowdown. Trade negotiations and the economy this fall are critical which is why we have seen so much volatility in markets recently.

Specifically, the July NY Fed recession probability index shows there is a 31.5% chance of a recession in the next year. The only false reading since 1960 was in 1967 when the percentage was in the low 40s and no recession followed. Further flattening of the 10-year 3-month spread, which was at -8 basis points in July, should get the odds above 40%. I must reiterate that this recession probability model is just the treasury curve. It’s not a complex model with variables from different markets and multiple economic data points.

The chart below shows the recession model’s forecast for the percentage of states with rising unemployment rates. 29.4% of states now have rising unemployment rates on a yearly basis. The model predicts that will rise to 68%. The delta of each state’s increase will determine how high the national rate goes. If the model is accurate, recession odds will certainly increase.

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ISM Manufacturing PMI Falls Slightly

I am just getting caught up on discussing all the economic reports that have recently come out because there has been so much news on trade, monetary policy, and earnings. The July ISM PMI fell from 51.7 to 51.2. That missed estimates for 51.9. I was expecting the PMI to fall to between 49 and 50.5, so this was better than I expected. The U.S. ISM PMI isn’t as bad as the global Markit manufacturing PMI which fell to 49.3. The ISM new orders index rose 0.8 to 50.8 which will slightly help the leading economic indicators report. That’s one of the metrics I need to see go negative before I’m bored with the recession call.

On the other hand, the production and employment indexes fell 3.3 and 2.8 points to 50.8 and 51.7. This is all before the latest tariffs on China, so look out for the PMI to fall below 50 in August. As you can see from the chart below, the PMI weakness means further bad news for real non-residential fixed investment growth in the next 6 months. Combining that with negative real residential investment growth is a deadly for GDP. That combination didn’t end up terribly in Q2 because their growth was only modestly negative. Further weakness would be a problem. The economy would need to rely on consumption growth even more to boost real final sales growth.

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Besides new orders, only inventories and customers’ inventories were up which means demand was weak. The prices index fell further below 50 as it was 45.1. Keep in mind, that when I stated inflation could increase in the beginning of 2020, that’s only if demand doesn’t fall off a cliff. Based on the current economy, easier comparisons will lead to higher inflation, but if growth weakens further, inflation will stay weak. The biggest monthly decline was in the backlog of new orders index which fell 4.3 points to 43.1. It was also the lowest reading.  

The ISM PMI was the weakest since August 2016. It really fell off a cliff since peaking in August 2018 at 60.8. Even so, it is consistent with 2.5% GDP growth which is relatively high compared to most estimates. The median estimate is 1.9% Q3 GDP growth. I’m more worried about this report than I would for other reports calling for 2.5% GDP growth because of how far the PMI has fallen in the past 11 months.

In the quotes section of this report, 4 of the 10 respondents mentioned tariffs. An electrical equipment, appliances, and components firm stated, “General business trends are continuing to show signs of weakness resulting from tariffs and cost impacts of importing and exporting.” I expect even more firms to mention tariffs in the August report.

ISM Non-Manufacturing PMI Also Falls

The Markit PMI showed divergence as the manufacturing one fell and the services one rose. However, both the ISM manufacturing and non-manufacturing PMIs fell. That’s a big difference as services is a larger portion of the economy. As you can see from the chart below, the ISM services PMI fell from 55.1 to 53.7 which missed estimates for 55.5 and the low end of the consensus range which was 54.5. This was also the lowest PMI since August 2016. This report is consistent with GDP growth of 1.8%. Finally, after many months of being wildly optimistic, the ISM report is in line with estimates.

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The production index fell 5.1 points to 53.1 and the new orders index fell 1.7 points to 54.1. At least the employment index was up 1.2 points to 56.2. This sector employs a majority of workers, so that means the labor market should improve. That didn’t end up happening in the BLS report as fewer jobs were created in July than in June. As I will discuss in a future article, the June JOLTS report also didn’t inspire confidence. Just like the manufacturing report, this prices index fell, but it was still above 50 as it was 56.5.

Of the 10 quotes in the non-manufacturing report, 3 firms made direct references to tariffs and 2 made indirect references. A management of companies & support services firm stated, “For our company, July is looking to be a record-setting month for sales. Customers have been converting quotes to sales quicker than in past months. The tariffs have increased prices for our industry, but our clients are not balking at the slight price increases that have been passed along. We feel that (the third quarter) will be strong.” As with the ISM manufacturing report, I will predict that mentions of tariffs will increase and become more negative in the next ISM non-manufacturing report because of the latest increase in trade tensions.