If the U.S. Consumer Slips, It Could All Come Crashing Down

If the U.S. consumer slips, it could all come crashing down... Consumers are losing confidence today... A flurry of disappointing economic data... In Europe, things keep getting worse... The Fed will do whatever it takes to keep the 'one-legged stool' upright...

The U.S. economy is starting to look like a 'one-legged stool'...

If you've ever tilted back on a stool so it was balancing on one leg, then you know what I (C. Scott Garliss) am talking about... It takes a lot of maneuvering, concentration, and muscle control to stay upright.

But no matter how hard you work to maintain your balance, your muscles will get tired at some point. When that happens, you'll slip... and the stool will crash to the floor.

Today, the U.S. consumer is the one leg of the stool that's working...

At any given time, consumer spending accounts for roughly 70% of our economic activity. In the first quarter of this year, consumer spending accounted for more than $14 trillion of the $21 trillion in U.S. gross domestic product ("GDP").

As I'll explain in today's Digest, the U.S. consumer could be getting tired of keeping up his balancing act. And if he falls, the entire economy could come crashing down. But as you'll see, the Federal Reserve will do whatever it takes to keep that from happening.

Despite the ongoing trade dispute with China, U.S. economic strength has held up so far...

Since the end of 2015, U.S. GDP growth has steadily climbed. In the first quarter of 2016, it stood at 1.1%. It has averaged 1.9% year-over-year growth since then... reaching a peak of 4.2% in the second quarter of 2018. In the second quarter of this year, the growth rate was 2%. So while the data have fluctuated, we've seen consistent gains in that span.

Meanwhile, the economic strength around the rest of the world is slowing...

In the first quarter of 2016, China's rate of growth was 6.7%. It peaked in the first half of 2017 at 6.9%... By the second quarter of this year, growth had slowed to 6.2%. And now, the Chinese government hopes to simply hit the low end of its target range for the year (6% to 6.5%).

Europe hasn't fared much better... In the first quarter of 2016, growth in that region stood at 1.7%. It peaked in the fourth quarter of 2017 at 2.7%. It has since dropped to 1.2% during the second quarter of this year.

In both cases, the growth rate has steadily declined since peaking in 2017. If this recent trouble around the rest of the globe carries over to the U.S., it could create a ripple effect...

When the economy doesn't grow as quickly, many companies start cutting their spending to prepare for tough times. The lack of spending eventually leads to slowing business. And the drop in business causes companies to lay off employees in an effort to save money.

When stories like that begin to pop up in the news, U.S. consumers begin to worry... They suddenly feel more vulnerable and become unsure of what the future holds. As consumers' fears rise, they spend less money and tuck more away in their savings accounts... just in case.

Think about it...

If you're worried that you'll get laid off, you likely won't make an expensive, life-changing purchase like a car or a house. And you'll cut back on the little "extras" in life, too... Suddenly, you'll realize how unnecessary it is to drink a pumpkin spice latte every day.

The thing is, some of these types of stories have already started popping up in the news...

A number of data points over the past few weeks have shown that U.S. economic growth could be slowing down. It started with the Conference Board's latest Consumer Confidence Survey on September 24...

The Conference Board is a private research group that releases a monthly report on the attitudes and spending intentions of U.S. consumers. It helps us see how consumers are feeling. When they're optimistic, they spend... And when they're pessimistic, they save.

In September, the numbers were much weaker than expected...

The index dropped for the second straight month, falling from 134.2 in August to 125.1 in September. Even worse, as you can see in the chart below, the month-over-month decline was the largest since last November to December – when the markets were in freefall...

But that was just the beginning...

On October 1, the Institute for Supply Management ("ISM") released its latest Purchasing Managers' Index ("PMI") data. It's a broad survey of U.S. manufacturing activity... A reading of more than 50 indicates expansion, while less than 50 signifies contraction.

This information is important for Wall Street... The data are viewed as a "leading indicator" because they generally predict the economy's future growth or contraction. When factories produce more, it's because demand for their goods is rising. And when they produce less, it's because demand is declining. Overall U.S. economic activity tends to follow this.

The PMI number for September was much weaker than expected... It came in at 47.8, down from 49.1 in August. It was the second straight month showing contraction, and it was the lowest reading on this indicator since June 2009 – the last month of the Great Recession.

That tells us the U.S. manufacturing slowdown is getting worse. New orders, new export orders, production, and employment numbers were all weak... implying near-term growth will remain low.

Considering the U.S. is the world's largest economy, the ISM's manufacturing data are especially critical... This information will influence money managers' investment decisions for the next six to eight months.

Around the same time, global data provider IHS Markit released its own PMI numbers for September. And on the surface, they appeared to be better than expected... IHS Markit's U.S. Manufacturing PMI rose from a 10-year low of 50.3 in August to 51.1 in September. The five-month high seemed to signal that U.S. manufacturing was recovering.

But these numbers are misleading...

The month wrapped up the worst quarterly performance since the financial crisis a decade ago. And respondents to the IHS Markit survey said they're still cautious about future business. The survey showed that foreign business activity dropped, while domestic activity increased due to falling prices. And the cost of manufacturing goods rose due to tariffs.

Next came disappointing employment numbers from data processor ADP...

The October 2 data release indicated that U.S businesses in the private sector added 135,000 jobs in September, lower than the expected 140,000. Even more important, at that time, ADP significantly reduced its estimate for August... The company now believes 157,000 jobs were created in the month, down from the original estimate of 195,000.

The revised data still represent growth, but the recent trend isn't good.

As regular Digest readers know, labor gains are vital to an expanding economy... When more people are employed, it implies increased competition for workers. That leads to better pay. And of course, when people make more money, they spend more.

It's a chain reaction that keeps the economy chugging along at a healthy clip.

But when the economy begins showing cracks, the number of new jobs starts to fall. As the demand for new workers drops, fewer people find employment. In turn, the pay for workers begins to slip. As individuals make less, they spend less. The economy starts to weaken.

Over the past six years, ADP's data have indicated an average monthly gain of 198,700 new jobs. This year, the average monthly gain is only 173,200 jobs – a drop of about 13%. And as you can see in the following chart, the trend is moving in the wrong direction...

With the number of new monthly jobs on the decline over the past year, that's a lot less money being made and spent by U.S. workers. That's not a sign of a growing economy.

And the troubling signs didn't stop there...

On October 3, the latest release of ISM's Non-Manufacturing Index ("NMI") signaled that the global weakness is starting to affect the domestic economy.

Most experts typically view the NMI as ancillary. Its subsectors include retail, utilities, agriculture and forestry, transportation and warehousing, mining, and public administration – services that all see increased demand when U.S. manufacturing is growing. They're much more domestically focused than the ISM's PMI subsectors. Many of these businesses support the manufacturing industry, so they wouldn't see the same type of demand without it.

The NMI registered 52.6 in September, down from 56.4 in August. (Again, anything more than 50 indicates expansion.) While the latest data showed that the non-manufacturing sector grew for the 116th straight month, more cracks appeared below the surface... You see, the NMI fell to its lowest level in three years. It was 51.8 in August 2016.

In normal times, this wouldn't be a big deal. But with so much uncertainty in the markets right now, analysts are scrutinizing all available data. And as I said earlier, even though global manufacturing has been deteriorating, we hadn't seen any trouble in the domestic markets yet. Countries and companies had been able to cope with the slowdown so far.

But that's starting to change... In the U.S., the weakness in manufacturing – which can be viewed as future economic growth projections – is spilling over into the rest of the economy.

The U.S. Labor Department's latest job numbers also disappointed when they were released last Tuesday...

The data showed a gain of 136,000 nonfarm jobs in September, while economists had projected 145,000. And it's also significantly lower than the 12-month average of 179,000. As you can see in the following chart, the number has trended down over the past year...

This is also important... Nonfarm payroll employment is one of the most accurate snapshots of the health of the U.S. labor market. The workforce it represents affects roughly 80% of the inputs for our country's GDP. When nonfarm payrolls go up, it's generally assumed that U.S. GDP will, too. And when the number falls, the opposite is true.

Meanwhile, the situation in Europe keeps getting worse...

IHS Markit's final Eurozone Manufacturing PMI – another indicator that Wall Street follows closely to check the pulse of the global economy – went from bad to worse in September.

According to IHS Markit, operating conditions in the region were the worst in seven years. The index fell to 45.7 in September, down from 47.0 in August. More important, the data indicated the eighth consecutive month of economic contraction in the eurozone...

Germany – which makes up 30% of the eurozone's GDP – continues to be the main drag on the regional economy. Last month, the country's PMI dropped to 41.7... its lowest reading since the financial crisis.

With the continued manufacturing weakness in the eurozone, the region's GDP will suffer – notably in Germany. And since the third-quarter economic numbers have already been dismal, the country's economy will likely soon dip into a recession. A recession in Germany will force its government to introduce fiscal policies to support the slumping economy.

In other words, the German government will have to introduce stimulus measures – like tax cuts for individuals and businesses – to encourage more spending. This will improve confidence by putting more money back into consumers' pockets. The German government hopes the move will increase demand... which will spur economic growth.

But there's an upside to all of this weakness...

As we discussed earlier, the consumer is the main support for the U.S. economy right now.

Federal Reserve Chairman Jerome Powell and a number of other key policymakers have recognized this point in their recent speeches. They're paying close attention to consumer confidence. They understand that if it falls apart, the U.S. economy will quickly get worse.

The central bank is already trying to combat weakness related to trade uncertainty...

It knows American businesses have pulled back on spending because of the ongoing dispute between the U.S. and China. Like consumers who hoard cash when they're worried, these businesses are doing the same today... And if tariffs rise, their costs will increase. Until these businesses know how the trade war will play out, they don't want to waste capital.

But that could hurt the U.S. consumer...

Remember, companies that hoard cash aren't spending as much. Those budget cuts ultimately lead to slowing business, which makes consumers start to worry. Once that happens, consumer confidence slips... and the entire economy eventually follows.

Today, the Fed must do whatever it takes to sustain consumer confidence. If it makes the cost of capital cheaper, companies and individuals will borrow more to keep things chugging along. And when they're flush with cash, sentiment improves and spending rises.

Lowering interest rates is the easiest way for the Fed to do that. Cutting the federal funds rate or buying bonds (or both at the same time) makes it cheaper to borrow money. (Bond purchases are the same as rate cuts because when bond prices go up, rates come down.)

As a result, we should expect more "easy money" policies from the Fed in the coming months. Right now, the U.S. benchmark interest rate sits at 2%. But most investors believe another rate cut is coming later this month... According to global markets company CME Group's "FedWatch Tool," the probability of a quarter-point cut at that time is roughly 73%.

If history is any guide, the central bank will do what it takes to support the consumer... the economy... and ultimately, the stock market.

And last week, the Fed did just that...

On Friday, it announced plans to increase its asset purchases.

The Fed will start buying $60 billion in U.S. Treasury bills per month into the second quarter of next year. In effect, the Fed just cut interest rates between meetings. It's making these moves to boost the amount of funds available for lending between banks.

By focusing on Treasury bills, the Fed is planning to buy more short-duration bonds and fewer long-duration bonds... which will cause short-term rates to fall and long-term rates to rise.

By buying more short-duration bonds, the Fed is pushing up prices and knocking down yields. And by not purchasing more long-duration bonds, it's essentially knocking those prices down and driving the yields higher.

In the end, this move should be great news for my colleague Steve Sjuggerud's "Melt Up" thesis...

Lowering short-term rates and raising longer-term ones will inevitably result in a widening of the "yield curve" – the difference between the rate on long-term bonds (10-year Treasury notes) and short-term bonds (two-year Treasury notes) – that Wall Street typically uses as an "all's well" signal for the economy.

And based on history, that means we should expect to see more big gains in stocks before it's all said and done – both in the U.S. and worldwide.

For now, we encourage you to stay long. But buckle your seatbelts... If the signals we discussed today keep trending in the wrong direction, the U.S. consumer's balancing act could come crashing down.

New 52-week highs (as of 10/11/19): Celgene (CELG), Dollar General (DG), and Home Depot (HD).

In the mailbag: Another reader weighs in on last week's Stansberry Conference... And a few others share their thoughts on our colleague Dan Ferris' latest Friday Digest missive. As always, send your comments and questions to feedback@stansberryresearch.com.

"My deepest appreciation of your [recent] conference recap! I've subscribed to Stansberry thinking of education, a real education, in place of going to a grad school. Indeed, Porter and his team has kept up with what he has said as his company's mission.

"As I've observed what has happened since about the 2008 crash to today, although I remember the turns of certain events took place in the financial market, I did not have enough knowledge, [this] posing was full of wisdom I think financial pros possess. I certainly recognize [the] benefit of being a Stansberry subscriber. Thank you indeed." – Paid-up subscriber T.Z.

"An absolutely incredible Digest [on Friday]!! Thank you." – Paid-up subscriber Craig R.

"Hey, Dan, maybe AIG can start a niche business during the next crash – selling car insurance only to people buying red Porsches. The premiums are a beaut." – Paid-up subscriber G.S.

"Dan, your comments about the 'conga line' (as I call it) waiting to summit Mt Everest brought back memories from my expedition 30 years ago (note the '22600' in my email address – the altitude where I 'wimped out' and turned back).

"Fortunately, back then there was no mass rush to get people to the top. It was generally just one, or perhaps two at most, expeditions which sent their best two to five climbers to summit the mountain. Our expedition got three to the top, one is still up there somewhere, and two came back alive. Basically, the top of the mountain was empty when the summiteers made their final approach to success.

"This reminds me of the market. The chances of success are better if you start out before there is a crowd, know the terrain, read the weather correctly, have very little competition, and have a ton of luck on the way to the top. Once everyone makes that infamous rush to the summit at the same time, that is when the competition is so great that a much larger percentage meet their fate – death or financial ruin.

"If I were 30 years younger than I am today, there is no way that I would join today's conga line to the summit of Mt Everest. Similarly, I try to avoid joining the crowd when there is a mass rush of people who pour into a stock that looks good at the time. Too many of these late arrivals will lose their financial lives." – Paid-up subscriber Bob R.

Regards,

Scott Garliss
Baltimore, Maryland
October 14, 2019