Oil markets are once again gripped by volatility as OPEC+ proceeds with its third production hike in as many months—adding 411,000 barrels per day in July—while prices linger near $65 per barrel. In this week’s Three on Thursday, we examine the economics of U.S. shale, focusing on the price levels needed to keep existing wells running and justify new drilling. 

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Implications: The U.S. trade deficit shrunk by a record $76.7 billion to $61.6 billion in April, as exports rose by $8.3 billion while imports plummeted by a record $68.4 billion. Imports jumped at an unprecedented rate in the first quarter as businesses were front-running President Trump’s new tariffs.  Now all that is reversing.  Pharmaceutical imports led the way higher in Q1, and led the way lower in April dropping by $26.0 billion alone for the month.  Because imports subtract from GDP in national accounting, the surge in Q1 became a major drag on growth; net exports alone shaved roughly five percentage points off Q1’s growth rate, pulling real GDP down at a 0.2% annualized pace.  But now, with tariff front-running peaking in March, imports should continue to be unusually soft for the next few months and so trade should add substantially to the GDP calculations for the current quarter.  However, erratic trade policy out of Washington adds a great deal of uncertainty in translating recent trade reports into GDP projections.  Vizion, a global container tracking firm, reported that twenty-foot equivalent unit (TEU) bookings from China to the U.S were down massively in April.  But once the President decided to drop tariffs on most goods from China to 30% from a peak of 145% a large pick up in bookings commenced in May.  Overall, U.S. trade volume (exports + imports) is up 5.7% from a year ago—exports are up 8.6%, while imports have climbed 3.4%.  Meanwhile, the landscape of global trade continues to shift.  China, once the top exporter to the U.S., has fallen to third place behind Mexico and Canada. Also in today’s report, the dollar value of US petroleum exports exceeded imports once again. This marks the 38th consecutive month of the US being a net exporter of petroleum products.  In other news this morning, initial jobless claims rose 7,000 last week to 247,000, while continuing claims fell 3,000 to 1.904 million.  These figures are consistent with our forecast of a 109,000 increase in nonfarm payrolls in May, to be reported tomorrow morning.

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Implications:  The ISM Services index missed consensus expectations in May, slipping below 50 for the first time in almost a year.  Before sounding the alarm, it’s important to remember that these Purchasing Manager’s surveys often capture sentiment mixed in with actual data.  Uncertainty about policy could be impacting them.  Nonetheless, the overall decline in May was driven by an abrupt fall in the new orders index, which moved to the lowest level since late 2022 at 46.4.  Uncertainty surrounding tariffs appears to be the major catalyst, as respondent comments continue to report difficulty in forecasting and planning and look to delay or minimize ordering until the effects become clearer.  This “wait and see” mentality was apparent in the business activity index, which registered an unchanged reading of 50.0 in May, down from 53.7 in April.  Service companies are in turn taking a cautious approach with their hiring efforts, as the index inched into expansion territory at 50.7 after two months of contraction, with an equal number of industries (seven) reporting an increase versus a decrease in employment.  The highest reading of any category was once again the prices index, which rose to 68.7 in May. That’s the highest level since late 2022, but still far from the worst we saw during the COVID supply chain disruptions, where the index reached the low 80s. Though official inflation data show a quiet past three months (PCE prices are now up only 2.1% from a year ago) that does not mean the inflation dragon has been tamed.  If the Fed were to dramatically loosen monetary policy, inflation could come back quickly.  In other news this morning, ADP’s measure of private payrolls increased 37,000 in May versus a consensus expected 114,000. We’re estimating Friday’s official report will show a nonfarm payroll gain of 109,000 with the unemployment rate remaining steady at 4.2%.  In other recent news, cars and light trucks were sold at a 15.6 million annual rate in May, down 9.3% from April, likely affected by buyers front-running tariffs.  Auto sales in spite of recent volatility have been weak and are down 1.1% from a year ago.

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Implications:  Activity in the manufacturing sector continued contracting in May, as the ISM Manufacturing index lagged expectations and fell to a six-month low. However, the details of the report make it surprising that the headline number declined to 48.5 from 48.7, as the major measures of activity moved higher in May.  The overall decline was entirely due to a fall in the inventories index, which dropped to 46.7 after two months of sitting in expansion territory, likely a reversal of the unprecedented surge in imports as companies stockpiled materials before tariffs were enacted (for more info on how that has distorted economic data, see today’s Monday Morning Outlook). Looking at the other details, the production index increased to 45.4 from 44.0, but besides last month, that is the lowest level since the height of the pandemic.  Order books were already weak before this year and the added business uncertainty from tariffs along with government spending cuts are forcing companies to continue revising their production plans downward. In turn this has impacted their hiring efforts, as the employment index remains firmly in contraction, with more than double the industries (nine) reporting lower employment in May versus higher (four).  On the supply chain front, one comment from the Electrical Equipment, Appliances, & Components industry wrote that tariffs alone have created supply chains disruptions rivaling that of COVID. The supplier deliveries index increased to 56.1 in May – a 35-month high – but that is far from the worst we saw during the COVID supply chain disruptions, where the index reached the high 70s.  In other words, supplier bottlenecks are significant, but not nearly as bad as COVID levels.  Finally, the worst part of the report is that inflation remains a problem, even while manufacturing stagnates.  The prices index declined to 69.4, but besides last month that is the highest level since 2022. Not a good sign for the economy.  In other new this morning, construction spending fell 0.5% in April, led by drops in homebuilding, manufacturing, and power projects.

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Conventional wisdom was that the tariffs imposed by the Trump Administration would cause higher inflation and slower growth – stagflation as far as the eye could see.  But this past week brought economic news that defied this prediction.

The trade deficit plummeted in April, signaling that economic growth could surge in the second quarter.  The Atlanta Fed GDPNow model has Q2 at a +3.8% for now.  Inflation also slowed sharply with the Federal Reserve’s preferred measure of inflation now up only 2.1% on a year-ago comparison basis, just a hair above the official target of 2.0%.

Investors can be forgiven for being confused.  After real GDP declined at a 0.2% annual rate in the first quarter, many (especially those opposed to Trump) thought this dip was a harbinger of recession, with more declining real GDP ahead.

But, as we said at the time, the decline in Q1 real GDP was largely due to an unprecedented surge in imports (front-running tariffs), and that would reverse in Q2 and beyond.  At this point, it looks like this is happening now.

We like to focus on “Core GDP” which is real GDP excluding government purchases, inventories, and international trade, each of which is volatile from quarter to quarter.  Core GDP grew at a 2.5% annual rate in Q1, faster than the average annual rate of 2.2% in the past twenty years.

Imagine a store that sells furniture manufactured in both the US and abroad.  Once President Trump was elected and seemed intent on eventually raising tariffs, it made sense for that store to “front-run” the tariffs by temporarily increasing orders from foreign suppliers while temporarily reducing orders from US suppliers.  Even if sales (consumption) did not change, the accelerated imports were subtracted from GDP, which is what caused the decline in real GDP in Q1.

With Friday’s advance report on international trade in April signaling the largest drop in the trade deficit for any month in modern US economic history, that process is reversing.  But even if growth comes in at 3.8%, or better, don’t be confused.

The economy was not in massive trouble in Q1, and it is not booming in Q2.  Now that some of the threatened tariffs have finally taken effect, firms selling goods in the US are back to ordering more from their domestic suppliers.

In the meantime, the fact that inflation continues to decline really shouldn’t surprise anyone.  The M2 money supply is basically flat since 2022.   Yes, tariffs can mean the items being tariffed cost more.  But inflation is ultimately a monetary phenomenon, and tariffs don’t change monetary policy.  So, if the tariffed goods cost more, that means less money is leftover to buy other goods and services, putting downward pressure on those other items.  Net, net, M2 growth says low inflation.

Inflation data show a quiet past three months, with PCE prices up a mere 0.1% in April.  They are now up only 2.1% from a year ago, a much slower increase versus last year.

None of this means we are out of the woods on recession risk or that the inflation dragon has been slain.  If the Fed were to dramatically loosen monetary policy, inflation could come back quickly.  What it does mean is that investors need to be wary of getting caught up in news about the economy that often has a partisan political angle.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Consumer spending power has been rising at a blazing pace to start 2025, with personal income up 0.8% in April following a strong 0.7% increase in March, 0.8% in February, and 0.6% in January.  Unfortunately, the gains have been primarily driven by government transfers.  In January, this was due to cost-of-living adjustments to Social Security benefits; in February it was premium tax credits for health insurance purchased through the Health Insurance Marketplace (Obamacare).  April’s income gains were once again led by government transfer payments, most notably payments related to the Social Security Fairness Act – one of the last items signed into law by the outgoing Biden administration – which increased benefits to public sector workers not typically covered by Social Security. That said, private sector wages and salaries, up 0.5% in April, have also been rising at a healthy pace.  In the past year, private sector wages and salaries are up 4.5%, which is keeping pace with inflation and then some.  For comparison, public sector pay has risen 5.3% and government benefit payments to individuals are up 11.1% in the past year.  We don’t think the growth in government pay – or massive government deficit spending – is either sustainable or good for the US economy, which is why we have been hoping policy changes in DC represent a shift in thinking on the growth of government. Long term, it’s the growth in private-sector earnings that sustain the economy.  Personal consumption rose a modest 0.2% in April as spending on services increased 0.4% while goods spending declined 0.1%.  Within services, the largest increases came in housing & utilities services, health care, and food services & accommodations.  Within goods, a rise in spending on energy was more than offset by pullbacks in spending in most major goods categories.  On the inflation front, PCE prices rose 0.1% in April and are up 2.1% in the past year, matching the lowest twelve-month change going back to early 2021. “Core” prices (which exclude food and energy) rose 0.1% in April and are up 2.5% versus a year ago, which also represents the lowest year-ago increase seen since early 2021. Some analysts claim official inflation figures continue to run above the Fed’s 2.0% target because of rents, but the “SuperCore” version of PCE prices, which excludes all goods, energy services, and rents, is up 3.0% in the past year, worse than headline inflation.  The Fed is unlikely to move at the June meeting, as it continues to fret about potential inflationary impacts from tariffs and increased uncertainty surrounding policy out of Washington, but we believe the Fed will resume rate cuts in the later part of 2025.  In other news this morning, the advance report on trade and inventories signaled a huge reduction in the trade deficit in April, which should boost second quarter Real GDP growth, offsetting the slight drop in Real GDP in Q1.  In recent news on the housing front, pending home sales, which are contracts on existing homes, fell 6.3% in April following a 5.5% increase in March, suggesting existing home sales (counted at closing) will tread water in May.

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In this week’s Three on Thursday, we take a closer look at the evolving role of tariffs in U.S. economic policy. In the latest development, a U.S. trade court ruled yesterday that President Trump did not have the authority to impose many of these tariffs. However, the ruling has been temporarily put on hold as the case moves through the appeals process. Click the link below to see where things stand in this highly fluid situation.

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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 declined 2.9% in the first quarter and fell 3.4% excluding the profits/losses of the Federal Reserve.  Excluding the Fed, profits are still up 3.6% from a year ago, but that is the slowest growth for any four-quarter period since 2020.  Leading the decline in Q1 were profits from domestic non-financial industries, which fell 3.5%.  Profits from the rest of the world fell as well.  Plugging in profits into our Capitalized Profits Model suggests stocks remain overvalued. Real GDP for the first quarter was revised slightly higher to a -0.2% annualized rate, as upward revisions to inventories, government spending, and business investment more than offset downward revisions to consumer spending (especially services), home building, and net exports. 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 down to a still-solid 2.5% annual rate from the initial 3.0%, though still marks the slowest pace in nearly two years. The downgrade was driven largely by weaker consumer spending, now estimated to have grown just 1.2%, down from 1.8%—also the slowest in almost two years. On the inflation front, the Fed’s fight isn’t over: the GDP price index held steady at a 3.7% annualized rate in Q1, with prices up 2.6% from a year ago, slightly higher than the 2.4% year-over-year increase in Q1 2024. In other news this morning, initial jobless claims rose by 14,000 last week to 240,000, while continuing claims rose 26,000 to 1.919 million.  These figures are consistent with continued job growth in May, but at a slower pace than last year. In other recent news, the M2 measure of the money supply hit a new record high growing 0.7% in April and is up 4.4% from a year ago.  This remains below the 6% growth that has been normal over the past few decades, and in combination with recent inflation reports, we think the Fed has room for modest rate cuts later this year. Finally, on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, increased to -9 in May from a reading of -13 in April.

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Implications:  New orders for durable goods plummeted in April, but beneath the headline lay a much more subdued picture.  The 6.3% decline in new orders was almost entirely due to the very volatile category of commercial aircraft, which came back down to earth after surging in March.  Tariffs certainly played a role here, as airlines front-ran orders before anticipated tariff increases, while President Trump’s recent tour through the Middle East resulted in the announcement of more than 200 Boeing aircraft ordered (so expect major revisions with next month’s report).  We anticipate these numbers to slow (and cancellations to increase) in the months ahead as companies and countries navigate the ever-shifting trade environment.  Excluding the transportation sector, orders for durable goods rose 0.2% in April.  Orders rose for computers & electronic products (+1.0%), machinery (+0.8%), and fabricated metal products (+0.8%), but were partially offset by declines in orders for electrical equipment (-0.2%), and primary metals (-0.1%).  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – declined 0.1% in April.  If unchanged in May and June, these shipments would be up at a 1.8% annualized rate in Q2 versus the Q1 average.  But, adjusting for inflation, little growth will be reported, and while core shipments fell at a modest pace in April, orders for these items declined a more notable 1.3% and are down at a 6.1% annualized rate in the past three months, signaling deliveries will be impacted in the future.  The current environment in Washington remains uncertain, and we expect volatility in the data to be the rule rather than the exception for the foreseeable future, as businesses navigate the new policy environment and how it may change the outlook for investment and growth.  In turn, the Federal Reserve must navigate what these changes mean for the path of inflation.  While we don’t expect any movement from the Fed at the meeting in June, we do believe that cuts are on the table for later in the year as economic weaknesses brings the employment side of the Fed’s mandate into more central focus.  In other news this morning, home prices declined in March but are up moderately versus a year ago.  The national Case-Shiller index declined 0.3% in March but is up 3.4% from a year ago; the FHFA index declined 0.1% in March but is up 3.8% from a year ago.  The decline in both indexes in March was the first time that’s happened since 2022.  Look for modest gains in national average home prices in the year ahead.

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Moody’s finally downgraded US government debt on May 16th to Aa1, its second highest rating.  With the US $36 trillion (and rising) in debt, it’s not hard to see why. But Moody’s was late to the party with S&P and Fitch (the other two major ratings agencies) having done so long ago.

The financial media went berserk, but long-term bond yields have not exactly soared.  The 10-year Treasury yield closed at 4.43% the night before the downgrade and 4.51% this past Friday, eight days later.  The 30-year Treasury yield moved up more but, again, didn’t skyrocket, closing at 4.89% on the eve before the downgrade and 5.04% as of last Friday.

What has received more attention is the gap between the yield on the 30-year and the 10-year, which has grown to 50+ basis points, noticeably higher than the 20 basis points it averaged in 2024.  However, the yield gap averaged 44 bps in the year prior to COVID, so not much change.

It's hard to separate the impact of all the moving parts affecting the bond market.  For example, Federal Reserve officials have made it clear that near-term rate cuts are, from their perspective, not warranted.  So, was it the downgrade or the Fed that put pressure on the market?

S&P downgraded US debt back in 2011 and Fitch in 2023, with no calamity as a result.  S&P’s downgrade came in the Obama Administration, Fitch’s during Biden/Harris.

Like then, the downgrade is being used to bash politicians, this time the Trump Administration and Republicans in Congress for moving ahead with efforts to extend the tax cuts originally enacted back in 2017.  Moody’s criticizes the extension as being fiscally irresponsible.  Wider deficits, according to the analysts, lead to higher interest rates on higher debt and a greater interest burden for the government to finance, leading to even bigger deficits, and so on and so forth.

The problem with this theory, though, is that the policies being pursued are not going to lift budget deficits beyond the policies that are already in place.  In other words, why wait until now to downgrade debt based on current policies?

Spending soared after COVID, even with the economy opening up and unemployment at 4% or less.  It was the spending that created $2 trillion deficits and the Biden Administration never talked about tax hikes.

The Big Beautiful Bill includes some spending cuts.  According to the Tax Foundation, a non-partisan think tank, the bill recently passed by the House will reduce the deficit by roughly $1.9 trillion in the next ten years compared to a simple alternative of passing a bill that merely extended the 2017 tax cuts for the next ten years.  That’s because the latest bill includes both higher expected revenues as well as some reforms to entitlements, like Medicaid.

In addition, tariffs should generate some extra receipts and the Trump Administration has proposed steep cuts to non-defense discretionary spending for Fiscal Year 2026 (starting October 1), calling for 32% less spending on these programs versus what the Congressional Budget Office assumed back in January.  If those cuts happen, the “baseline” for future spending could be a few trillion lower in the next decade.

None of this is to suggest that the US fiscal position is good; it’s certainly not.  In spite of record tax revenue, spending is so high that budget surpluses are nowhere in sight.  Back in 2007, the budget deficit was only about 6% of federal spending.  In other words, it wouldn’t have taken many spending cuts to get to a balanced budget.

But by 2019 (the year before COVID), the budget deficit was 22% of federal spending.  Now it’s 27% of federal spending.  Imagine cutting your household budget by 27%!

The good news is we don’t have to run surpluses to make our debt position manageable.  At a minimum we want overall debt to grow no faster than nominal GDP.

The more we reduce the deficit by cutting spending, the more resources stay in the private sector, setting off a virtuous cycle of more growth, more revenue, and smaller deficits. It happened under President Clinton.  Now that the Senate has the bill, can we do it again?

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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