The magnitude of the decline in this morning’s US ISM reading was surprising, though the decline itself wasn’t.
And although there was hardly a silver lining in the report itself other than the employment index — see Joe’s two posts this morning and the reliably excellent Counterparties roundup for more — history suggests at least one reason not to panic too much over it (for the US — everyone else should consider panicking). Not yet, at least.
Barclays looks at two previous episodes where foreign demand for US goods fell (the likely culprit here) and things didn’t turn out so poorly because of offsetting declines in energy prices, as consumer spending subsequently provided some compensatory economic relief.
It certainly won’t offset all of the damage and there are no guarantees, of course, that this time will follow suit at all, but we thought the notes interesting nonetheless (emphasis ours)…
Looking back at some previous episodes may give some insight into what happens next. Two episodes that seem applicable are the European recession in the early 1990s and the Asian recession in the late 1990s. In these periods, US export growth to the affected economies turned significantly negative.
This weighed heavily on manufacturers, as shown by declines in the ISM manufacturing new export index, and the contribution of exports to real GDP growth fell into flat to negative territory, particularly in the late 1990s. In both periods, the overall ISM manufacturing index fell below 50, and manufacturing production growth slowed notably.
Weaker foreign growth leads to falling energy prices, which help consumers
However, the slowdown in manufacturing was not the end of the story. When export growth slowed, energy prices flattened or turned negative, as weaker global growth weighed on commodity prices. The US consumer is very sensitive to energy prices, and in both periods, the drop in energy inflation helped lead to solid real consumer spending growth, which in turn buffered the economy against the export slowdown. Thus, the overall effect was that US GDP growth remained solid during these periods, despite weakening exports.
While these episodes do not necessarily provide a framework for what happens next, they do provide some perspective and caution against extrapolating from weakness in export and manufacturing growth to a broad-based slowdown in the economy. Export growth to the euro area has weakened notably, and the drop in the June Philly Fed index and the move below 50 on the June Markit flash PMI new export orders index suggest that the euro area weakness is beginning to weigh more significantly on US manufacturers. This is clearly a headwind for the economy. However, energy prices have dropped sharply, as in the other episodes discussed above.
The key to whether the export weakness turns into a more severe slowdown depends in large part on how consumers respond to the increase in spending power brought about by lower energy prices; the consumer response will dominate overall growth, as consumer spending is 71% of GDP, while exports are 14%. There is typically a bit of a lag between falling energy prices and their effect on consumer spending, but by Q3 12, declining energy prices should be supporting real consumer spending; we look for 2.5% consumer spending growth in H2 12.
… we believe the weakness in Europe is weighing on the manufacturing sector, but that increasing domestic demand is likely to keep the overall economy growing. This idea was reinforced by the employment index, which declined only slightly to 56.6 in June from 56.9 in May; this suggests that manufacturers do not see the weakness in foreign orders as causing a deep enough slowdown to merit cutting employees.
Just something to keep in mind. Despite the increasing importance of exports in recent years, the US economy is predominantly a domestic one — and we doubt that the non-manufacturing sector is due for a hit of similar magnitude or anything close to it.
Manufacturing, of course, has been falling everywhere; nevertheless it’s also quite possible that some of this in the US is down to residual seasonality distortion issues despite the ISM’s attempt to smoothe the series earlier this year.
Nomura’s economists reckon the improvement helped, but the problem isn’t gone completely. Update: Nomura’s economists got in touch to say they want to look into this a bit more after the break and think today’s could be the real deal. Small comfort, surely, but still…