Weekly global economic update has been saved
Cover image by: Sylvia Chang
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The latest PMIs for manufacturing suggest a global economy that continues to grow but at a decelerating pace. In almost every major economy, the manufacturing PMI fell from June to July, with the PMI indicating negative growth in the Eurozone, Mexico, Taiwan, and South Korea. Growth remained positive in the United States, the United Kingdom, Japan, ASEAN, and China. One glaring exception to the deceleration trend was India where the PMI increased substantially, indicating rapid growth of manufacturing.
The global PMI from Markit fell from 52.2 in June to 51.1 in July, the lowest level in two years and indicating a very modest pace of growth. Moreover, the subindex for global output indicated no growth at all in July. Output fell in advanced economies such as the United States, the United Kingdom, Eurozone, and Japan but increased in emerging markets. Meanwhile, new orders and export orders both declined. Both input and output prices rose sharply, but at a slower pace than in the previous month. The countries with the highest PMIs (indicating the fastest growth in activity) were India, Australia, the Netherlands, and Brazil. The countries with the fastest declines in activity were Poland, Taiwan, Myanmar, Czech Republic, and Turkey. Of the 28 countries surveyed by Markit, 13 showed declining activity.
In the United States, the manufacturing PMI fell from 52.7 in June to 52.2 in July, a 24-month low, but reflecting moderate growth. Output and new orders declined. Export orders fell at the fastest pace in two years. Companies reported that difficulties in finding suitable workers, combined with shortages of raw materials, contributed to weakness in production. Also, cost inflation, while high, fell to the lowest level since mid-2021 as the prices of many components declined. Markit said that supply chain problems have eased. This implies that faltering demand might have a favorable impact on inflation. Markit reported that “companies are taking an increasingly cautious approach to purchasing and inventories amid the gloomier outlook, and likewise appear to be cutting back on investment, with new orders falling especially sharply for business equipment and machinery in July.” Markit concluded that, with the exception of the early days of the pandemic, “US manufacturers report the toughest business conditions since 2009.”
In Europe, the Eurozone is experiencing a decline in manufacturing activity. The PMI for the region fell from 52.1 in June to 49.8 in July, a 25-month low. Output fell at the fastest pace since the start of the pandemic as did new orders. On the positive side, price pressures diminished as inventory accumulation soared and supply chain pressure eased. Business sentiment was very poor owing to concerns about the war in Ukraine and the overall state of the economy. The four largest economies in the Eurozone (Germany, France, Italy, Spain) all fell into negative growth territory (Italy being the lowest) while there was positive and strong growth in the Netherlands. Meanwhile, it was reported separately that retail sales in Germany declined at the fastest rate on record. Markit pointed to the energy sector as posing the greatest risk to the region.
In the United Kingdom, the manufacturing PMI fell from 52.8 in June to 52.1 in July, a 25-month low but a level reflecting modest growth. Output fell in July, with an especially sharp decline in output of capital goods. New orders and export orders declined. As elsewhere, supply chain stress declined leading to reduced price pressures. Interestingly, employment growth accelerated. The tightening of monetary policy by the Bank of England (BoE) is seen as the biggest downside risk.
In China, the PMI, having rebounded in June as lockdowns were eased, declined again in July. It fell from 51.7 in June to 50.4 in July, a level indicating barely any growth. The weakness reflected “subdued demand conditions” and led to an easing of price pressures. Indeed, although input prices increased, output prices declined in July, thereby putting pressure on profit margins. Also, fresh COVID-19 outbreaks led to a slight increase in supplier delivery times. Given that real GDP declined from the first to the second quarter, the July PMI numbers suggest a likelihood that GDP will grow in the third quarter.
The latest service PMIs indicate a deceleration of activity, likely reflecting the global economic slowdown. The global PMI fell from 53.9 in June to 51.1 in July, indicating a very modest rate of growth. The subindex for export orders indicated a decline. Other indicators suggested further growth but at a slower pace. Notably, the subindices for pricing showed that inflationary pressure eased, most likely due to weakened demand.
The most interesting story about PMIs comes from the United States. The PMI published by Markit showed a sharp decline in activity, with the PMI falling from 52.7 in June to 47.3 in July. Yet another organization, the Institute of Supply Management (ISM), publishes its own PMI for services and found an acceleration in activity. Specifically, the PMI from the ISM increased from 55.3 in June to 56.7 in July. How is this possible?
While the basic methodology of the two organizations is similar, there are some important differences. Both organizations poll the purchasing managers of companies. The ISM focuses on big companies while Markit polls both big as well as medium and small businesses. The ISM includes the public sector while Markit polls only the private sector. The ISM index is based on a straight average of subindices. The Markit index is a weighted average where forward-looking subindices are given greater weight. Markit claims that its index is more closely correlated with actual economic data than the ISM index. For our purposes, the Markit index is preferred as it can be compared to the indices in other countries. Still, today’s ISM report, which signaled strong growth in services, generated considerable press coverage and cannot be completely dismissed. The sharp divergence between the two PMIs reminds us that survey data can sometimes be fickle and should be taken with a grain of salt.
In any event, the Markit index for the United States was the lowest since May 2020. Markit commented that “tightening financial conditions mean the financial services sector is leading the downturn, with a further steep rise in interest rates from the FOMC.” With respect to consumer services, Markit said that “the surge in household spending on goods and activities such as travel, tourism, hospitality and recreation seen in the spring has now moved into reverse as household spending is diverted to essentials.” On the other hand, Markit said that the weakening of the economy has led to an easing of inflationary pressure.
The services PMI for the 19-member Eurozone fell from 53 in June to 51.2 in July, a six-month low that signals a significant deceleration in activity. The decline was led by Germany and Italy, with PMIs of 48.1 and 47.7, respectively, indicating declining activity. For Germany, this was a 25-month low. For Italy it was an 18-month low. The PMIs for France and Spain remained in positive territory. Market commented that, for the Eurozone, “a much hoped-for surge in consumer spending after the easing of pandemic restrictions is being thwarted as households grow increasingly concerned about the rising cost of living, meaning discretionary spending is being diverted to essentials such as food, utility bills and loan repayments.” In fact, the European Union reports that, in June, Eurozone retail sales volume (adjusted for inflation) fell 1.2% from the previous month and was down 3.7% from a year earlier. Excluding food and petrol, retail sales volume was down 2.6% from the previous month and down 4.8% from a year earlier.
As in the United States, Markit said that inflationary pressure in Europe is likely easing. However, it said that “easing of inflation could fail to materialize if energy prices spike higher as we head towards the winter.” Regarding Germany, Markit said that the earlier revival of the services sector has now hit significant headwinds “from soaring energy and food prices and a sharp drop in confidence across the economy.”
The services PMI for the United Kingdom showed deceleration in July. The PMI fell from 54.3 in June to 52.6 in July, still a moderate level of growth. Markit noted that “reduced levels of discretionary consumer spending and efforts by businesses to contain expenses due to escalating inflation have combined to squeeze demand across the service economy.” On the other hand, Markit said that input price inflation eased in July, “likely reflecting lower commodity prices and a gradual easing of global supply shortages.”
In China, services activity continued to grow at a brisk pace in July, similar to June, following a dramatic decline in activity in May related to lockdowns. The PMI increased from 54.5 in June to 55.5 in July. There was a combination of accelerated demand and reduced pressure on capacity as evidenced by a decline in backlogs. Unlike in Europe and North America, there was an increase in inflationary pressure. Markit said that “concerns over the possibility of future Covid outbreaks remained.” The revival of China’s services sector bodes well for a return to normal economic growth in the third quarter.
The rate hike did not shock investors, but the comments by the BoE were surely shocking. The BoE predicted that inflation will peak at 13% in the fourth quarter, driven largely by the impact of rising natural gas prices. Moreover, the BoE says that the rise in gas prices, fueled largely by the deteriorating relationship between Russia and Western Europe, is already leading to a sharp decline in real incomes. It expects that the average price paid by British households for fuel will rise by 75% later this year. It also expects that, over the next year, real (inflation-adjusted) income will decline by 5% even after accounting for fiscal support from the government. This would be the biggest decline since the 1960s.
Going forward, the BoE expects that the United Kingdom will fall into recession in the fourth quarter and that real GDP will decline for five quarters. This will be driven by a sharp decline in real incomes leading to declining consumer spending, despite households dipping into their savings. Interestingly, it does not expect a dramatic rise in unemployment. Rather, it expects the unemployment rate to rise to 6.25%. However, it does expect that a prolonged downturn will be successful in suppressing inflation. It anticipates that the inflation rate will drop to 2% by the third quarter of 2024.
Given the hugely pessimistic view held by the BoE about growth prospects, it is not entirely surprising that the bank appears reticent about engaging in a dramatic tightening of monetary policy. Their view seems to be that the expected surge in inflation reflects factors they cannot control and that will probably be temporary. It also expects that those factors will play the principal role in suppressing growth. Still, investors were evidently surprised by the BoE. That surprise was reflected in a decline in bond yields and the value of the pound.
The US government issues two reports on employment. One report is based on a survey of establishments, the other based on a survey of households. Let’s first look at the establishment report. In July, 528,000 new jobs were created, about twice as much as the consensus view on Wall Street. It was the biggest gain in jobs since February. In the past three months, 1.3 million new jobs were created. Employment is now at the prepandemic level but still about 5 million jobs below the prepandemic trend. In addition, job growth was strong across a wide range of industries. Strong increases in employment were reported for construction, manufacturing, retailing, transportation and distribution (including airlines), professional and business services, health care, restaurants and hotels, and local government.
The establishment survey also reports on wages. It found that average hourly earnings across all industries were up 5.2% from a year earlier, matching the lowest reported since December. With inflation running above 9%, this implies a significant loss of purchasing power for workers. Average hourly earnings were up 0.5% from the previous month, the highest monthly gain since March. This data signals that the tight labor market is not yet generating the kind of wage gains that could lead to an inflationary wage-price spiral. Recent data shows that initial claims for unemployment insurance are rising and that job vacancies are declining. This indicates that the tightness of the labor market might be easing. The separate survey of households found that the unemployment rate fell to 3.5%, the lowest since February 2020 and the second lowest since the 1960s.
How shall we interpret the surprising report released on August 5? First, one month does not make a trend. Data can be volatile and can be revised. Thus, sweeping inferences should be avoided. Still, the report is consistent with the strong job growth that took place during the first half of 2022. Moreover, we know that demand for labor has been strong as evidenced by high vacancy rates and anecdotal reports from clients. The problem in the job market has not been inadequate demand for labor. It has been inadequate supply. The August 5 report suggests that the latter problem might be abating somewhat, although employment remains well below where it would have been absent the pandemic. The problem has been lower labor force participation and much lower immigration.
The jobs report likely means that a recession has not yet begun, although jobs data tends to be a lagging rather than a leading indicator. In the past, employment had already started to decelerate sharply when recessions started. Still, the strength of the August 5 report might increase the probability of recession by compelling the Federal Reserve to tighten monetary policy faster.
The Federal Funds rate directly affects what banks charge one another for short-term funding, but importantly, it provides a benchmark for such credit products as adjustable-rate mortgages, consumer loans, and interest rates on credit cards. As such, the Fed action will likely have a rapid negative impact on credit market conditions, thereby quelling activity in the credit markets. This is meant to reduce the growth of aggregate demand in the economy so as to reduce inflationary pressure. The policy can no doubt succeed in reducing inflation. The question remains as to whether it can do so without setting off a recession.
In its announcement, the Fed noted that, although spending and production have softened, employment growth has been robust in recent months. This fact exacerbates inflation, which is already high due to the pandemic and the war in Ukraine. Thus, monetary policy is meant to suppress demand in the economy but cannot affect the pandemic or war situations.
In his press conference, Fed Chair Powell said that another 75-basis-point increase could happen in September, but that it will be data-dependent. More notably, he said that “as the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases.” Powell also said that, although he is not trying to engineer a recession, and although he thinks one can be avoided, “we think it’s necessary to have growth slow down. We actually think we need a period of growth below potential in order to create some slack, so that the supply side can catch up.” In choosing policy, Powell said the Fed would closely watch economic growth, labor market conditions, and inflation itself.
In response to the Fed action, equity prices increased sharply while bond yields fell moderately. Investors evidently saw the Fed’s action as increasing the likelihood that inflation will be suppressed. Moreover, they were likely pleased that Powell spoke about eventually easing the pace of tightening.
o Employment, the most important measure of the economy’s economic performance, has been growing at a very strong pace.
o Nondefense capital goods shipments grew in June and have been growing steadily for some time.
o A decline in inventories subtracted two percentage points from growth. This means that final demand was still positive (about 1.1% growth). Inventory swings of this magnitude do happen and may impel businesses to try to rebuild inventory levels, something that could add to growth in the third quarter.
Although the United States is not likely in a recession, the GDP report was troubling in that it shows a significant deceleration in economic activity. Although the decline in inventories explains the decline in GDP, it also points to weakness in demand, which could bode poorly for growth in production. Among the components of GDP that declined were private nonresidential fixed investment, residential investment, Federal nondefense spending, state and local spending, and inventories. The categories that saw growth included consumer spending, exports, imports, and Federal defense spending.
Within business investment, there was strong growth of investment in intellectual property (software, research and development) but declines in spending on equipment and structures. Within consumer spending, there were declines in spending on both durable and nondurable goods, but a strong increase in spending on services.
The weakness of the GDP report likely reflects the negative impact of the Federal Reserve’s policy. It’s sale of government bonds led to a sharp rise in bond yields. This in turn caused the sharp rise in mortgage interest rates, which explains the decline in residential investment. The decline in business investment likely reflects a worsening of sentiment combined with fears of higher borrowing costs. On the other hand, the exceptionally strong growth of exports of both goods and services suggests that global demand for US products remains strong—despite the rise in the value of the dollar.
Finally, consumer demand remained moderately strong despite declining real incomes. This suggests that consumers have been dipping into the massive savings they accumulated during the pandemic. The sharp rebound in spending on services suggests a return to normalcy, with a drop in demand for home-related goods more than offset by a sharp increase in spending at restaurants and other service providers.
Moreover, in June, the US government also released more recent data on consumer income and spending. Despite a real (inflation-adjusted) decline in consumer disposable income, real spending grew modestly as consumers continued to save less.
Here are some details: In June, real disposable personal income was down 0.3% from the previous month and down 3.2% from a year earlier. The decline was due to two factors. First, government transfers were down from a year earlier as stimulus funding receded. Second, and more importantly, wage income did not keep pace with inflation. Thus, consumers fell behind in real terms. However, they offset this by reducing their saving. The personal savings rate fell from 5.6% in May to 5.2% in June. The result was that real consumer spending increased 0.1% from the previous month and was up 1.6% from a year earlier. Still, the spending numbers have decelerated in recent months, evidence of a weakening of the consumer sector. But the ability of consumers to dip into their savings has stabilized spending and helped to prevent a recession—at least for now.
Over the past year, consumers have been shifting away from spending on goods and toward spending on services. This reflects the view that the pandemic is no longer a problem and that it is safe to go out and interact with other people. As such, real spending on durable goods in June was down 3.1% from a year earlier, spending on nondurables was down 2.9%, and spending on services was up a strong 4.1%. However, this trend appeared to temporarily reverse in June when real spending on durables increased a robust 0.9% from May to June, nondurables fell 0.4% from May to June, and spending on services increased a paltry 0.1%. It is not clear why this happened.
The government also reported on the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator, or PCE-deflator. The report found that consumer prices were up 6.8% from a year earlier in June and up 1% from the previous month—a big increase. When volatile food and energy prices are excluded, the core PCE-deflator was up 4.8% from a year earlier and 0.6% from the previous month. The latter figure is relatively high and suggests that underlying inflation got worse in June. Given that this is the inflation data that the Federal Reserve most closely follows, it is expected to influence their decision-making in the coming month.
Going forward, the US economy is at risk of recession, especially if the Fed (as is likely) continues to tighten monetary policy. Moreover, the rapid weakening of the European and Chinese economies bodes poorly for continued strong US export growth. If, however, commodity prices come down further, this will ease pressure on consumers and might lead to an acceleration in consumer spending. Thus, a recession might be averted. Or, at the least, a recession in the next year could be relatively mild.
In the second quarter, real GDP in the Eurozone was up 4% from a year earlier and up 0.7% from the previous quarter. The latter number means growth was at an annual rate of 2.8%. Compare that to the negative GDP growth in the United States in the second quarter. Evidently, the Eurozone economy was in excellent shape. This was likely due, in part, to strong consumer demand for tourist services. With the pandemic receding, people were eager to return to their previous love of travel. This was reflected in strong growth in France, Italy, and Spain—significant tourist destinations. On a quarterly basis, real GDP was up 0.5%, 1%, and 1.1% in these countries, respectively—very strong rates of growth. Moreover, in these three countries, real GDP was up from a year earlier by 4.2%, 4.6%, and 6.3%, respectively. On the other hand, GDP stalled in Germany, not rising at all from the previous quarter and up only 1.5% from a year earlier.
Looking forward, there are several factors that bode poorly for continued strong growth. These include a continued tightening of monetary policy by the European Central Bank (ECB); declining real incomes as inflation exceeds wage gains; and the risk of a Russian cutoff of gas during the winter months.
Here are the details: Consumer prices in the Eurozone were up 8.9% in July versus a year earlier, a record increase since the birth of the euro. Yet prices were up only 0.1% from the previous month, the lowest monthly rate since July 2021. Moreover, when volatile food and energy prices are excluded, core prices were up 4% from a year earlier, also a record high. Yet core prices actually declined 0.2% from June to July. Of course, the main difference between headline and core inflation was the behavior of energy prices, which were up 39.7% from a year earlier but were up a relatively modest 0.4% from the previous month. Oil prices have declined but natural gas prices have increased.
By country, consumer prices declined 1.1% in Italy from June to July, declined 0.5% in Spain, and increased a modest 0.3% in France. On the other hand, prices were up a more robust 0.8% in Germany. Prices also declined in Belgium and Greece. Prices increased the most in the Netherlands, up 2.1% from the previous month.
The cutback, if sustained, will reduce the likelihood that EU members will be able to accumulate sufficient stocks by the winter to avert shortages. The current goal is to hit 80% of storage capacity, but this is increasingly unlikely. Meanwhile, EU governments have jointly pledged to reduce consumption of gas by 15%, with exemptions for those member states that are less dependent on Russian gas. At the same time, the evident shortage of Russian gas deliveries to Europe has led consumers of liquid natural gas (LNG) to furiously seek new supplies, setting off competition between European states and such countries as Japan and South Korea. The latter are reported to be fearful that shortages in Europe will lead to increased European demand for LNG.
What happens next? If the cutback in supplies from Russia is sustained, and assuming European governments are unable to fully offset the cutback with alternative supplies, it is likely that, in some countries, there will be rationing of gas. This will likely mean limits on industrial use, thereby leading to a sharp decline in manufacturing output. Moreover, the sharp increase in the cost of heating homes will eat into consumer purchasing power. The result will likely be a recession.
For the ECB, this will create a conundrum. Its policy of tightening monetary policy is meant to address inflation. Yet the lion’s share of inflationary pressure is coming from the rise in energy prices over which the ECB has no control. All it can do is engineer a slowdown or recession by suppressing aggregate demand. Yet if a recession is already coming, the ECB might be reluctant to tighten severely and make it worse. Indeed, the ECB has been far more cautious about tightening than the central banks of the United States, the United Kingdom, and Canada.
The good news is that, with the help of Turkey and the United Nations, an agreement was recently reached between Russia and Ukraine to ease constraints on the export of grain that were due to a Russian blockade of Black Sea ports. This blockade contributed to a sharp rise in prices and shortages in key markets. The Ukrainian Navy reports that export operations have resumed at three Black Sea ports that had been closed since the start of the Russian invasion. This is important because Ukraine and Russia are among the biggest grain and fertilizer producers in the world. They supply some of the most populous countries in the world. The biggest purchasers of Russian and Ukrainian wheat, for example, are Egypt, Turkey, Indonesia, Bangladesh, and Nigeria.
Also, even before this deal was reached, global food prices had begun to decline. This might have reflected a strong harvest in Russia combined with expectations that restrictions would eventually be eased. Also, the weakening global economy probably contributed to the downward movement of prices. On the other hand, the decline in prices does not mean that the crisis in global food distribution is over. The war, plus climate problems, are hurting food production. A US official said, “I’m more worried about 2023 than 2022.” One problem is that, in the last few months, production of grain in Ukraine fell sharply due to the war. This, combined with restrictions on distribution, meant that farmers had limited income. That, in turn, limits their ability to invest in next year’s production. The fear is that output in 2023 will be substantially limited.
Meanwhile, climate change is rearing its ugly head in the global food market. This year has seen unusually high temperatures in numerous locations, declines in water levels, and drought. This means more crop failures and shortages of water used for food production. Here in southern California, much of our water comes from the runoff when snow melts at nearby mountains. Yet, with higher temperatures, there is less snow and more rain. Hence, there is less accumulated snow available for runoff. In Italy, drought has led to a shortage of water that could reduce grain production this year by 50%. Similar stories abound in many parts of the world.
Unless climate change reverses, which seems unlikely in the near term even if governments take major steps to reduce carbon emissions, then the world likely faces problems in food production and distribution in the coming years. Not only will this mean more hunger and malnutrition, it could also mean more political and social unrest. Moreover, this trend could undermine the progress and benefits of globalization. That is, if producing countries seek to limit exports of food to guarantee domestic supplies, there could be a reduction in trade that would reduce the efficiency of food production and distribution.
Cover image by: Sylvia Chang