Services: The Fire Is Not Out

The service sector continues to be the driving force of the economy. The manufacturing sector has been in the doldrums since last autumn as households have shifted spending to services and away from goods, and depleted inventories from the early pandemic days have been replenished.

The ISM-manufacturing index, which measures the change in manufacturing and production, has been below 50.0 (indicating contraction) for the past ten months (Chart 1).

 

Based on history, this has always led to a recession, apart from the mid-1990s, when the Fed navigated a “soft landing.” The manufacturing sector is far more sensitive than the service sector to the Fed’s movement of interest rates. In this case, higher financing costs can often sway the purchase of big-ticket items that require financing, like vehicles, furniture, appliances, etc. 

The ISM service index, on the other hand, has been growing at a blistering pace. It has been in the expansion territory almost the entire time since the pandemic (Chart 2).

 

This summer, the spending on travel and entertainment has been robust. This has helped drive overall economic growth since the service sector accounts for about 75% of GDP and 86% of the workforce.

However, many fundamental economic changes do not support continued strong growth.

• Income: Gains in income are expected to slow as the number of new hires has been cooling, there are fewer job offerings and wage gains have been weakening. This is noticeable with fewer workers switching jobs, which is due to the decline in the wage premium for job switchers which has returned to pre-recession levels.

• Savings: The formidable savings increase created during the pandemic has decreased significantly. The San Francisco Fed estimates it will be gone this month, and Goldman Sachs believes it will be gone next June. With less savings to tap, the focus on continued economic growth will be on credit.

• Credit: The deleveraging that occurred in the early stages of the pandemic has reversed. The total amount of consumer debt is now 20% larger than at the end of 2019, just before the pandemic. Access to credit has become more difficult, and financing costs are much higher now than before the pandemic or even just a year ago. One cohort will be having a sudden increase in credit payments: those with student loans. After a three-year hiatus, student debt payments will begin in October. There is $1.75 trillion in student debt and about $29,000 owed per borrower on average¹. This will lead to reduced spending on goods and services.

Speaking of credit, defaults have been picking up. Several retailers have noted this (Macy’s, Nordstrom and Kohl’s). This is the first step in the cycle of an increase in distressed consumers. Store credit cards are usually the first wave of delinquency and default before they happen to regular credit cards, auto payments and mortgages (there is a hierarchy to debt payments, and retailers are at the bottom). Although delinquencies are picking up (Chart 3), they are well below long-term averages and do not pose a macroeconomic risk (Chart 4).