A Wile E. Coyote Economy?
David Shulman
Senior Economist, UCLA Anderson Forecast
September
2018
“In
2020, Wile E. Coyote is going to go off the cliff, and
he’s going to look down, and that
(stimulus) will be
withdrawn at that point.”
Ben
Bernanke
Business Insider, June 8, 2018
Wile E. Coyote is, of course, a famous
Warner Brothers cartoon character who had a way of running well beyond a cliff
before looking down and then falling straight down. (See Figure 1) Our view is
perhaps not as dramatic, but directionally consistent with Bernanke’s remarks,
we are looking for a decided slowdown in 2020. For example on fourth quarter to fourth quarter basis our forecast call
for real GDP growth to sow from 3.1% this year to 1.9% in 2019 and a near
recession 1.0% in 2020. (See Figure 2)
Figure 1. A Wile E.
Coyote Moment
Source: WiffleGif.
com
Figure 2. Real GDP Growth, 2010Q1 –
2020Q4F
Sources: U.S.
Department of Commerce and UCLA Anderson Forecast
The obvious question here is why are we
so pessimistic about the outlook for growth beyond 2018, especially after
coming off a 4.2% real GDP growth rate in the second quarter? Too be sure there is enough momentum in the
economy to generate 3% growth in the second half, but growth will not be
sustainable. Simply put when an economy is already operating at full employment
it is very difficult for it grow above trend which we estimate to be somewhat
above 2%, which is higher than what the Federal Reserve is now forecasting.
Further, the economy is currently benefiting from the massive tax cut and
spending increases passed late last year. As Bernanke noted the stimulus coming
from that will run out in 2020, but the deficits it created will linger on for
over a decade. (See Figure 3) The
federal deficit, under current policy, will exceed a trillion dollars a year
for as far as the eye can see.
Figure 3. Federal
Deficit, FY 2010 – FY 2028F
Source: Congressional Budget Office and
UCLA Anderson Forecast
Meantime, employment growth continues to
chug along with job gains approximating 200,000 a month this year and then
declining to 125,000 a month and a much lower 30,000 a month in 2019 and 2020,
respectively. (See Figure 4) In this
environment, the unemployment rate will decline to 3.5% in early 2019 and then
gradually rise to around 4% in 2020. (See Figure 5) Although we have been
consistently wrong as to when wage inflation will ignite, we believe we are now
at that moment. Although it is only one data point average hourly earnings
increased by a very strong 0.4% in August over the prior month and are now up
2.9% on a year-over-year basis. We forecast that private sector wage
compensation will increase from 2.6% this year to 3.2% and 4.0% in 2019 and
2020, respectively. (See Figure 6)
Figure 4. Payroll
Employment, 2010Q1 -2020Q4F
Sources: U.S. Bureau
of Labor Statistics and UCLA Anderson Forecast
Figure 5. Unemployment
Rate, 2010Q1- 2020Q4F
Sources: U.S. Bureau
of Labor Statistics and UCLA Anderson Forecast
Figure 6. Employee
Compensation, 2010Q1 – 2020Q4F
Sources:
U.S. Bureau of Labor Statistics and UCLA Anderson Forecast
Fed Remains on Normalization Path
With most inflation measures running
above the Fed’s 2% target and with the economy operating at full employment, we
believe that the Fed will continue on its path of interest rate normalization.
(See Figure 7) Although our view might be a touch on the aggressive side, we
forecast that the federal funds rate will top out at 3.25%-3.50% in late 2019
or early 2020. (See Figure 8) Our reasoning is underpinned by our view that the
inflation rate will approach 3% in 2020.
Concomitantly, the Fed will continue on
its path of shrinking its bloated balance sheet from the current $4.2 trillion
to $3.5-3.8 trillion by the end of 2020. (See Figure 9) Although there are many
forecasters concerned that the yield curve will soon invert, we are not of that
view because longer dated treasury yields will rise to reflect the heightened
inflationary environment. However, we
would not rule out an inversion in 2020.
Figure 7. Consumer Price Index vs. Core
CPI, 2010Q1 -2020Q4
Sources: U.S. Bureau
of Labor Statistics and UCLA Anderson Forecast
Figure 8. Federal
Funds vs. 10-Year U.S. Treasury Bonds
Sources: Federal
Reserve Board and UCLA Anderson Forecast
Figure 9. Federal
Reserve Assets, Dec. 02-Sep. 18, Weekly Data- In $millions.
Source: Federal
Reserve Board via FRED
Strength in Consumption, Investment and Defense with
Housing Lagging
Over the near-term, the economy is
exhibiting broad-based strength. Real consumer spending has rebounded nicely
from 0.5% in the first quarter to 3.7% in the second quarter and it is on track
to grow at a 2.5% pace in the second half. (See Figure 10) Of particular note is the surprising strength the restaurant and bars
category, which was up 9.7% in nominal spending in July compared to a year ago.
(See Figure 11) Our cheeky explanation for this is that the Trump people are
out celebrating by eating and drinking and the anti-Trump people are acting out
their depression by drinking and eating. Nevertheless, regardless of your
political point of view the tax cuts are having an impact.
Figure 10. Real Personal Consumption
Expenditures
Sources: U.S.
Department of Commerce and UCLA Anderson Forecast
Figure 11. Retail Sales at Food Services
and Drinking Places, July 2013 – July 2018, Percent Change Year Ago.
Source: U.S.
Department of Commerce via FRED
Similarly, business investment,
especially equipment spending, remains a source of strength. After declining by
1.5% in 2016, equipment spending increased by 6.1% in 2017 and is on track to
increase by 7.5% this year, the best performance since 2013. The rebound in oil
and gas activity and the recently enacted corporate tax cuts are helping here.
(See Figure 12) However, as the tax cuts run their course and the oil activity
rebound slows, real equipment spending is forecast to increase at a more modest
pace of 5.9% and 4.0% in 2019 and 2020, respectively.
Figure 12. Real
Equipment Spending 2010 – 2020F, Annual Data
Sources: U.S.
Department of Commerce and UCLA Anderson Forecast
Adding to the private sector strength,
defense spending is surging. After years of decline, real defense purchases are
forecast to increase 3.7% this year and 4.7% in 2019. (See Figure 13) In 2020,
the surge will end with only a modest increase of 0.7%. Because most of the
increases involve long lived capital goods, the increase in defense purchases
is reinforcing the growth in private sector capital equipment.
Figure 13. Real
Defense Purchases, 2010 – 2020F
Sources: U.S.
Department of Commerce and UCLA Anderson Forecast
The one disappointing sector of the
economy remains housing. To be sure, housing starts are modestly increasing,
but because of growing affordability problems and restrictive zoning practices
in major employment centers, housing starts remain below the underlying
demographic demand. Instead of producing about 1.5 million units a year housing
starts are forecast to peak at around
1.35 million units in 2019 (quarterly peaks at 1.38 million units, SAAR) and
then rollover as higher mortgage rates exact their toll. (See Figure 14) This
is a far cry from the super boom level of in excess of two million units a year
over a decade ago. Moreover, multi-family starts will account for about one
third of the overall activity.
Figure 14. Housing
Starts, 2010Q1 -2020Q4F
Sources: U.S. Bureau
of Census and UCLA Anderson Forecast
The Trade and Currency Wild Cards
Looming over our forecast is the
uncertainty with respect to the trade policies of the Trump Administration and
the beginnings of a currency contagion that is enveloping a few of the
developing economies (.e.g. Turkish Lira and Argentine Peso). And do not forget
the Italian economy remains problematic and could spill over into the Euro at
any time. Although progress has been made with respect to renewing NAFTA, it
remains to be seen whether or not Canada will join Mexico in making a deal with
the U.S. Similarly, with tariffs expected to be extended to an additional $200
- 467 billion of goods (meaning 100% of imports from China), up from the
current $50 billion. With tariffs averaging about 15%, this could amount to
about an $80 billion tax on the U.S. economy. And with China retaliating, the U.S. farm economy
is in a world of hurt requiring the administration to offer aid to soybean
producers.
Further, although a trade war with the
European Union has been temporarily avoided, it still remains on the
administration’s plate, especially with regard to automobiles. Make no mistake
that in the short-run, the Trump tariff policies are both inflationary and
output restricting. Indeed, the open
question remains how uncertainty over trade policy will affect business
investment.
However, one thing remains clear. The
trade deficit is going to explode. Real net exports, a measure of the goods and
services trade balance in 2012 dollars, amounted to -$860 billion in 2017. That will rise to -$900 billion this year and it will exceed minus one trillion dollars in 2019 and 2020. (See Figure 14) Simply
put, instead of importing stuff from China the global supply chains will adjust
and import from other countries. What the administration doesn’t understand is
that the trade deficit is largely a result of macroeconomic policies caused by
the lack of domestic savings and the ever growing budget deficit.
Figure 15. Real Net
Exports, 2010 -2020F
Sources: U.S.
Department of Commerce and UCLA Anderson Forecast
Conclusion
Over the near-term, the economy remains
on a broad-based strong 3% growth track, but that will slow to 2% in 2019 and a
near recession 1% in 2020. The slowdown will be caused by the natural
constraints of a fully employed economy with a 3.5% unemployment rate next year
and a waning of the administration’s stimulus policies. Moreover, with the
inflation rate moving closer to 3% than 2%, the Federal Reserve will continue
to pursue its interest rate normalization policies that will bring the Fed
Funds rate to somewhat above 3%.
The major near-term risk to our forecast
remains the administrations trade policies that are both inflationary and
output restricting with yet unknown effects on business investment.
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