Over the past twenty years, in spite of incredible new technologies, US real GDP growth has averaged just 2.0% at an annual rate.  By contrast, in the twenty years prior to the most recent twenty – from the mid-1980s thru the mid-2000s – real GDP grew at a 3.2% annual rate.  Some slower growth is due to the aging and retirement of Boomers, but in our view, the real culprit is the expansion in the size of government.

Government spending surged in 2008 and during COVID.  At the same time the Federal Reserve held interest rates extremely low, M2 growth surged, immigration accelerated, and environmental regulation altered economic activity.  Economists in government and academia promised us this would boost growth and jobs, instead growth slowed.

But now policies are changing.  The Big Beautiful Bill avoided a tax hike in 2026 (and made current tax rates permanent), tariffs are heading higher, immigration has slowed significantly, and regulations are being reduced.  In the first half of this year, the economy grew at a 1.4% annual rate.  The Atlanta Fed GDP Now model currently projects a 3.0% growth rate in the third quarter.  If that forecast turns out to be accurate, the annualized growth rate for the first three quarters of this year would be 1.9%, in-line with the modest long-term 2.0% trend.

At the same time, Artificial Intelligence is taking off and even though estimates about how AI will impact productivity and growth are all over the map they all say it’s positive.

So, with all these cross currents, uncertainty is substantial and to say the economic data have been “quirky” lately would be an understatement.  Nonfarm payrolls were up only 22,000 in August and are up only 70,000 per month in the past seven months versus growth of 146,000 per month in the same seven months in 2024.  Trade patterns are extremely volatile, with real GDP down in Q1, but up in Q2 and Q3.

A sharp drop in immigration is likely a key factor behind slower job growth.  Meanwhile, government payrolls are down 97,000 in the past seven months, the biggest (non-Census related) seven-month drop in at least 35 years.  We view this a positive for long-term private sector growth, but also a drag on jobs in the short-term.

But even as job growth has slowed, much of the economy has been holding up quite well.  Through July, retail sales are up 4.1% versus the same period in 2024; sales of cars and light trucks have averaged a 16.3 million annual rate so far this year, versus a 15.5 million rate in the first eight months of 2024. Manufacturing output in the first seven months of this year is up 0.8% versus the same seven months in 2024.  That might not sound like much, but factory production is below where it was ten years ago, so any growth in this sector is good news.

Is some of this increase in manufacturing due to reshoring because of tariffs?  After all, that’s what tariffs are supposed to do.  But the stop-start nature of some of the tariffs, as well as uncertainty regarding whether the courts will eventually strike down the tariffs is likely an obstacle for many firms to build out this production in the US.  It’s tough to make large, long-term commitments with so much uncertainty.

The case now nearing the Supreme Court is a prime example, with the Kalshi prediction market tilting toward a Trump Administration loss.  This all has to do with questions about whether Congress has delegated authority over tariffs to the executive, or whether trade deficits, fentanyl and border security are “emergencies” which the executive must address.

But even if SCOTUS strikes down the tariffs by early next year, that’s not the last word.  President Trump would likely use other laws already on the books to try to impose tariffs, or could seek legislation to raise tariffs, possibly through budget reconciliation, which would require only a simple majority in the Senate.  In other words, uncertainty remains on this issue.

That leaves AI…clearly it changes things.  Is it like the railroad or cellphone which accelerated travel, communication and trade?  Or does it cannibalize activity in areas like search or coding?   Growth in certain tech jobs has already leveled off.  We are not Luddites and don’t expect mass unemployment from AI; but some will gain while others lose.  In the near term we do not see an economic boom from AI similar to what happened in the 1990s in the first internet boom.  Then, economic growth picked up quickly; so far, with AI, we are still waiting.  And whether growth picks up in the future is still dependent on whether or not Congress and the President can get spending under control.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Today’s labor market report was hotly anticipated following President Trump’s firing of the BLS head after July’s weak data and large downward revisions, and August data are likely to add to the drama. Nonfarm payrolls increased 22,000 in August, lagging the consensus expected 77,000.  Worse, payroll gains for prior months were revised down by 21,000, meaning the net gain was only 1,000.  Notably, June data now shows nonfarm payrolls dropped 13,000 following these revisions, the first decline since 2020.  While the White House is likely going to continue pointing the finger at political manipulation, new policies that strictly enforce immigration laws, as well as uncertainty around trade policy and tariffs are likely weighing-down the job numbers. We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (including COVID lockdowns and re-openings).  This measure of “core payrolls” declined 36,000 in August, the fourth straight monthly drop, and is down 143,000 versus four months ago. One piece of good news is that civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 288,000 in August. However, the labor force grew an even faster 436,000, which pushed the unemployment rate up slightly to 4.3% in August.  Taken all together, while its clear the labor market is weakening, recent numbers are consistent with a slowing but still growing economy.  Stricter immigration enforcement is likely a major part of the story, with a shift from essentially open borders having a major impact on labor supply.  The household survey shows that the foreign-born population (age 16+) has dropped 1.9 million since January while foreign-born employment is down nearly 1.0 million.  At the same time, native-born employment has grown 1.9 million.  In other words, recent softness in the labor market could reflect fewer illegal immigrants while native-born (and, potentially, legal immigrants) increase jobs and hours worked.  On the inflation front, average hourly earnings rose 0.3% in August and are up 3.7% versus a year ago.  However, these earnings are up only 3.5% annualized in the past six months, which along with recent weak headline jobs numbers gives the Federal Reserve all the ammunition it needs to re-start rate cuts later this month.  Finally, the Trump Administration is making progress reducing federal payrolls, which when we exclude the Post Office and Census workers are down 85,000 versus January, the largest seven-month drop on record going back to at least 1990.  In time, we think a smaller government should pay dividends in the form of faster economic growth.

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For today’s “Three on Thursday,” we take a closer look at the global electric vehicle (EV) market—an industry growing at breakneck speed, but in ways that may surprise you. In 2024, worldwide EV unit sales topped 17 million, and in 2025 they’re on pace to exceed 20 million, meaning nearly one in four new cars sold this year will be electric. The story, however, looks very different depending on where you are. Click the link below to find out more.

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Implications:  The U.S. trade deficit widened in July to $78.3 billion, the largest in four months. Imports surged by $20.0 billion, far outpacing the modest $0.8 billion gain in exports. Much of the jump reflects companies once again trying to front-run “reciprocal” tariff rates expected to take effect for countries still lacking trade agreements with the U.S. This comes after three straight months of import declines, which followed the unprecedented Q1 surge as firms rushed to get goods in ahead of the April 2 tariffs. That earlier spike weighed heavily on economic growth in Q1—net exports alone shaved roughly five percentage points off the growth rate, dragging real GDP down at a 0.5% annualized pace. As imports rolled off in Q2, trade flipped into a tailwind, helping to lift GDP. Superficially, July’s rebound in the trade deficit suggests trade could again turn into a temporary drag on growth in Q3. However, the largest contributor to July’s import surge was nonmonetary gold, which the BEA treats differently in GDP accounting, so the impact on growth should be much smaller than the raw import numbers imply.  Meanwhile, the structure of U.S. trade continues to shift. China has slipped to third place among U.S. trading partners, behind Mexico and Canada, with imports from China down 19.0% year-to-date through July compared to 2024. On a more positive note, the U.S. remained a net exporter of petroleum products for the 41st consecutive month, as the dollar value of petroleum exports once again exceeded imports.  In other news this morning, initial jobless claims rose by 8,000 last week to 237,000, while continuing claims fell 4,000 to 1.940 million. Also, this morning, ADP reported private payrolls fell 54,000 in August, consistent with our forecast for an increase in nonfarm payrolls of 80,000 to be reported on Friday. In other recent news, cars and light trucks were sold at a 16.1 million annual rate in August, down 2.9% from July, but up 6.2% from a year ago.

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Implications:  The US service sector once again demonstrated its resilience in August, with the index beating expectations and rising to 52.0.  That is the highest level for the ISM Services index in six months, a turnaround from its recent downward trajectory.  Looking at the details, growth was broad-based, with twelve out of eighteen major service industries reporting growth versus four reporting contraction.  The category for new orders led the overall index higher, as it rose to a ten-month high at 56.0.  Meanwhile, business activity also contributed, with the index rising to a five-month high at 55.0.  Despite the jump in orders and activity, service companies remained defensive with their hiring efforts.  Employment continues to contract in the service sector, with the category ticking up to 46.5.  That makes five out of the last six months where the employment index has been below 50, signaling contraction.  Service companies – once hamstrung with difficulty finding qualified labor – have begun reducing their headcounts, with more than four times the industries (nine) reporting a decline in employment in August versus an increase (two).  Finally, the highest reading of any category was once again the prices index, which slipped to 69.2.  That is near the highest level since late 2022, but still far from the worst we saw during the COVID supply-chain disruptions, when the index reached the low 80s.  Though inflation pressures remain – the M2 measure of the money supply is barely up versus three years ago – which means we are likely to see lower inflation and growth in the year ahead.  As for the economy, it’s important to remember that Purchasing Manager’s surveys like the ISM Services index and its counterpart on the manufacturing sector often capture sentiment mixed in with actual activity.  Uncertainty from trade policy has been weighing on sentiment, but could be alleviated as more trade agreements are finalized.  However, monetary policy has been tight enough to reduce inflation toward the Federal Reserve’s 2.0% target and is probably still modestly tight today.  And a monetary policy tight enough to reduce inflation may also be tight enough to slow the ever-resilient US service sector.

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Implications:  Manufacturing activity remained soft in August but did not contract as rapidly as in July, with the index rising to 48.7. This makes six consecutive months that the ISM Manufacturing index has been below 50, continuing a pattern that stretched all of 2023 and 2024.  While many believed the downturn was over when the index briefly rose above 50 in January and February, the subsequent six months of weak readings suggest caution is warranted.  Looking at the details of the report, seven of the eighteen major industries reported growth in August, versus ten that reported contraction.  The good news is the new orders index drove the headline increase as it broke into expansion territory for the first time since January at 51.4.  Order books were weak heading into this year, and survey comments suggest the added business uncertainty from on-again/off-again tariffs has caused many customer orders to pause until stability returns.  In response, manufacturing companies have scaled back, with both production and employment contracting in August.  Notably, though the employment index rose slightly in August, it is contracting near the fastest pace excluding the COVID shutdown months since 2009, with more than six times the industries (thirteen) reporting lower employment in the month versus higher (two).  Perhaps the worst part of the report is that inflation pressures remain even while manufacturing stagnates.  The prices index declined to 63.7, which is high by historical standards, but below the recent high of 69.7 in June, and well below the post-COVID inflation levels.  We will be watching the M2 measure of the money supply closely (which has barely moved for three years) as a signal for if these pressures will turn inflationary.  In other news this morning, construction spending declined 0.1% in July, as drops in manufacturing and commercial projects were partially offset by an increase in homebuilding.

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For the past two years, we have been warning that the stock market is overvalued.  While our capitalized profits model is simple, it is more complex than just looking at price-earnings or price-sales ratios.  We adjust for the level of the 10-year Treasury yield…the higher the yield the less stocks are worth.  So, when inflation pushed bond yields up in 2022, our fair value calculation fell even though earnings continued to rise.

But in the past three years, the S&P 500 has risen faster than earnings and sales, so much so that The Wall Street Journal online put a story on its landing page headlined “Stocks Are Now Pricier Than They Were In The Dot-Com Era.”  It led off with a stat that said the S&P 500 is now selling at 3.23 times sales (the median over the past 25-years is 1.7 times).

Price to sales is only one statistic.  When we run our model, and include a 4.25% 10-year Treasury discount rate, the market is overvalued by roughly 40%, well below the 62% overvaluation seen in 1999.

Moreover, if the market falls, the Fed will likely cut rates. Our model shows a 2.85% 10-year yield would put the market at fair value.  As a result, even though we are fearful the market is overvalued, we do not see a 40% drop in the cards.  We would say the market is roughly 20% overvalued and maintain our target of 5,200 for the end of this year.

It is clear that there is a YOLO (You Only Live Once) trade going on, and daily options (no matter how crazy they seem) are being traded like baseball cards.  Much like 1999, people have convinced themselves that markets will only go one way.  Especially the tech stocks, powered by AI, the top 10 of which make up 39.5% of the S&P 500.

Clearly, economic data are mixed.  The Trump Administration is using tariffs as one of many tools in attempts to remake the economy, and change is happening.  But tariffs are a tax, and tax increases are not positive for economic growth.  Moreover, any reshoring of investment in the US will take time and is still risky because future presidents may not hold tariffs in place.  For that matter, the courts might rule them beyond the president’s power.

At the same time, we cannot discern whether earnings attributed to AI are just cannibalization of existing businesses (like search engines) or not.  The market was right in the late 1990s.  Cellphones, fiber optic internet connections, and faster computers with better operating systems would boost productivity and profits…it was just early.  Is AI the magic technology that provides immediate and permanent returns?  So far, the jury is still out.  Real GDP in the first half of 2025 averaged just 1.4%, and job growth is slowing for a variety of reasons.

In other words, we remain cautious about the market as a whole and especially very expensive and very large market cap companies.  There are plenty of sectors and stocks within the S&P 500 that still look attractive.  That’s where we are focused.

We will get grief from those who have been bullish and correct.  But our approach is rooted in fundamentals, not momentum.  The history of markets consistently shows that valuation metrics tend to revert over time.  There are price levels that simply don’t justify expectations of historical returns.  We think today is one of those times. Back in 1999, some confidently claimed recessions were a thing of the past. They were wrong. We urge caution against excessive optimism today.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  It’s been a strong summer for consumers. Following healthy growth in June, both income and spending accelerated in July, rising 0.4% and 0.5%, respectively.  And the best news on the income front is that growth was led by private-sector wages and salaries, which rose 0.7% in July.  This is a welcome shift from the trend throughout the early parts of 2025 when government transfer payments – which are not a reliable (or desirable) long-term source of income – were the key contributor to growth.  After rising by 1.0% or more in five of the first six months this year, these transfer payments were flat in July.  One month does not make a trend, so we will watch these numbers closely in the back half of year to see if the quality of growth continues to improve.  On the spending front, personal consumption rose 0.5% in July with broad based growth.  Spending on goods jumped 0.8% led by outlays on motor vehicles and parts as well as food & beverages.  Services spending rose 0.4% with financial services & insurance and housing & utilities increasing the most.  Some of the increases may reflect tariff impacts on goods prices, but as we have noted in other pieces on inflation, higher consumer spending in some categories is largely being offset by declines in other categories, and inflation has shown little net movement in response to the tariffs.  Case in point, PCE prices, the Feds preferred inflation metric rose 0.2% July while the year ago reading stayed at 2.6%.  That 2.6% pace in the past twelve months is almost identical to the annualized rates over the past 3 and 6-month periods.  In other words, there has been no acceleration in prices since tariffs ramped up, but they haven’t eased either. With M2 growth running below the historical 6% rate, we believe inflation will diminish in the year ahead. The Fed looks almost certain to cut rates at their meeting mid-September, and we anticipate a second cut before the year is through. In other recent news on the housing front, pending home sales, which are contracts on existing homes, declined 0.4% in July following a 0.8% drop in June, suggesting existing home sales (counted at closing) will move lower in July.  On the manufacturing front, the Kansas City Fed Manufacturing Index, a measure of factory sentiment in that region, remained at +1 in August, while the Chicago Purchasing Managers Index (PMI) – where readings above 50 signal growth – declined to 41.5 in August from 47.1 in July, signaling activity in that region continues to contract.

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Back in 2008, the Federal Reserve (the “Fed”) launched a new experiment in monetary policy, shifting from a “scarce reserve” system to one built on “abundant reserves.” Beyond its contribution to inflation, this shift has created other, less-discussed problems. Last week the Fed released their latest quarterly financial report of the combined financial position of the 12 Reserve Banks through the second quarter. In this week’s edition of “Three on Thursday,” we dive into that report. Click the link below to find out more.

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Implications:  Hold off on GDP for a moment.  The most important data in this morning’s report was on economy-wide corporate profits, which rose 1.7% in the second quarter and grew 2.0% excluding the profits/losses of the Federal Reserve.  Excluding the Fed, profits are up 3.2% from a year ago, although that is the slowest growth for any four-quarter period since 2020.  Leading the gain in Q2 itself were profits from domestic non-financial industries, which rose 2.2%.  Profits from the rest of the world declined 0.7%.  Plugging in profits into our Capitalized Profits Model suggests stocks remain overvalued. Real GDP for the second quarter was revised higher to a 3.3% annualized rate, with a more favorable mix as upward revisions to personal consumption (mainly non-durable goods) and business investment more than offset small downward revisions to most other categories. For a clearer picture of underlying growth, we focus on “core” GDP—consumer spending, business fixed investment, and residential construction—excluding more volatile components like inventories, government outlays, and trade. Core GDP was revised upward to a 1.9% annual rate from the initial 1.2%. The revision higher was driven largely by stronger consumer spending, now estimated to have grown at a 1.6% rate, up from 1.4%. On the inflation front, the GDP price index was unrevised at a 2.0% annualized rate in Q2, with prices up 2.5% from a year ago, slightly lower than the 2.6% year-over-year increase in Q2 2024. In other news this morning, initial jobless claims fell by 5,000 last week to 229,000, while continuing claims declined 7,000 to 1.954 million.  These figures are consistent with continued job growth in August, but at a slower pace than last year. In other recent news on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, rose to -7 in August from a reading of -20 in July.  The report suggests the national ISM manufacturing index, to be reported Tuesday, will be up in August but still below 50, signaling contraction.

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