"Downshifting to Slower Growth," UCLA Anderson Forecast, December 2018

Downshifting to Slower Growth

David Shulman

Senior Economist, UCLA Anderson Forecast

December 2018

After growing at a 3.1% pace on fourth quarter to fourth quarter basis, the growth in real GDP is down shifting to 2.1% in 2019 and 1% in 2020. (See Figure 1) This is consistent with our prior forecasts characterizing a 3-2-1 growth path for the economy.[i] The down shift in growth is based upon our view that above-trend growth is difficult to achieve for an economy operating at full employment given the sub-1% growth rate in the labor force and productivity gains just above 1%. So unless we witness surprising gains in productivity, the speed limit for the economy is around 2%. Then you might ask, why are you forecasting a further slowdown to 1% in 2020?

Our explanation is that the benefits coming from the huge fiscal stimulus of tax cuts and spending increases will wane by the end of 2019 and the lagged effects of the Federal Reserve’s normalization of interest rates along with the negative effects of the administration’s trade policies will dampen growth further.

Figure 1. Real GDP Growth, 2010Q1 -2020Q4F, Percent Change SAAR

                      

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

In this environment payrolls will continue to expand, but the 190,000/month average gain thus far this year will slow to 160,000/month in 2019 and a much weaker 40,000/month in 2020. (See Figure 2) The unemployment rate will continue to decline from the current 3.7% to about 3.5% for most 2019 and then gradually increase to 4% by the end of 2020. (See Figure 3)

Figure 2. Payroll Employment, 2010Q1- 2020Q4F, In Millions, SAAR

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2010Q- 2020Q4F, Percent, SAAR

         

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

The Fed Normalizes Policy

The Federal Reserve has been on a policy of gradually normalizing interest rates. After years of holding the Federal Funds rate at 0% - .25%, over the past two years the policy rate has increased to its current 2.0%- 2.25%  and we expect another 25 basis point increase to 2.25% -2.50% later this month. Further we anticipate three or four rate hikes in 2019 that will bring the funds rate up to 3.25% -3.50% by late 2019 or early 2020.

Why so high? We perceive that the normalized funds rate, what the Fed calls R*, to be equivalent to a real rate of 1%. With inflation running somewhat above 2%, that implies a normalized funds rate somewhat above 3%. We would note that prior to the financial crisis R* was perceived to be 4% (2% real) and in the post financial crisis environment it was perceived to be 2% (zero real). We split the difference at 1% real. Given the 2+% inflation environment we foresee along with the Fed’s balance sheet shrinkage and trillion dollar federal deficits, more on all of this below, we forecast that 10-Year U.S. Treasury yields will exceed 4% by yearend 2019, up from the current 3.2%. (See Figure 4)

Figure 4. Federal Funds vs. 10- Year U.S. Treasury Bonds. 2010Q1 -2020Q4, Percent

  

Sources: Federal Reserve Board and UCLA Anderson Forecast

Underpinning the Fed’s move to higher interest rates is that inflationary pressures in the economy are growing.  At long last wage rates are increasing and employee compensation is on track to increase 3.3% in 2019 and 4.0% in 2020. (See Figure 5). Simply put the tight labor market is now showing up in the form of higher wages and benefits. Similarly inflation as measured by the consumer price indices will approach 3% both 2019 and 2020 largely driven by higher service sector prices. (See Figure 6)

Figure 5. Employee Compensation/Hour, 2010Q1 -2020Q4, %CHYA

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 6. Consumer Price Index, Headline vs. Core Inflation, 2010Q1 – 2020Q4F,

%CHYA

 

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Moreover the long end of the Treasury curve will be pressured by the Fed’s balanced sheet normalization program and trillion dollar federal deficits as far as the eye can see. (See Figures 7 and 8) During the financial crisis and its aftermath the Fed increased its balance sheet through three round of quantitative easings from $800 billion to $4.5 trillion, an unsustainably high level for it to conduct monetary policy.  Now that policy is being reversed with the Fed selling government securities on the order of $40-$50 billion a month. You can call this policy quantitative tightening.

However the Fed is not the biggest seller in the market, the federal government is. The trillion dollar deficits that we envision means that the U.S. Treasury will be net new issuance of between $80- $100 billion a month. Thus the path for long term interest rates is higher. It also implies that interest payments on the debt will double from the current 1.4% to 3.1% of GDP thereby crowding out other federal spending.

Figure 7. Federal Reserve Assets, 12-18-02 to 11-14-18, In Millions $

    

Source: Federal Reserve Board, via FRED

Figure 8. Federal Deficit, FY 2010 – FY2028F, Billions $, Annual Data

Sources: Office of Management and Budget and UCLA Anderson Forecast

Financial Turbulence Ahead

The recent volatility in stock prices appears to be signaling that the era of benign financial markets we have been used to for the past several years is coming to an end. (See Figure 9) Although most market pundits blame the increased volatility of Fed policy and a peak in the growth rate in corporate profits, when you look under the hood you will notice perhaps more serious risks facing the financial markets, namely over-leveraged corporations and escalating trade tensions, especially with China. And don’t forget the energy, social media, banking and pharmaceutical industries will soon find themselves in the crosshairs of the newly elected Democratic House of Representatives.

Figure 9. S&P 500, 17 Nov 17- 16 Nov 18

 

Source: Standard and Poor’s via BigCharts.com

While the zero and low interest rate policy of the Federal Reserve helped pull the economy out of the Great Recession and later stimulated growth, it also induced corporations to leverage up. For example AT&T borrowed $190 billion to finance its acquisitions of Time Warner and DIRECTV.[ii] And AT&T was far from alone with such debt financed acquisitions made by Bayer, Verizon Communications, Abbott Laboratories, Walgreens Boots Alliance, CVS and Broadcom. As a result about half of all investment grade corporate bonds now rated Baa by Moody’s, their lowest tier. That means the slightest of economic downturns can force many of these credits into “junk” territory. And this data does not take into account the huge issuance of less than investment grade paper that has taken place over the past decade that now accounts for about half of the $9 trillion corporate bond market.

Further exacerbating the corporate credit situation has been the “huge deterioration,” in Janet Yellen’s words, in the $1.3 trillion leveraged loan market.[iii] Although not as over-extended as the mortgage market was in the mid-2000’s, the corporate debt market has the potential to trigger the next recession. We do note that the credit risks we are discussing have only just begun to materialize in the bond market with high yield credit rising from 3.22% in early October to 4.11% in mid-November as the market responded to problems at General Electric, PG&E and oil exploration companies. (See Figure 10) It is important to note here that the last three recessions had their origins in the financial markets with the 2001 recession being caused by the collapse in the high flying technology/telecom shares and the 1990 recession was caused by over-zealous lending to the commercial real estate sector.

Figure 10. BofAML U.S. High Yield Option Adjusted Spread

 

Source: BofA Merrill Lynch via Fred

With respect to trade it appears that we are in the process of entering an economic cold war with China. President Trump is threatening to impose tariffs on up to 25% on all $537 billion of Chinese imports. At an average rate of 20% that would amount to a $107 billion tax on the U.S. economy. Although most market participants cling to the hope that a reasonable deal can be made I would caution them to take careful note of the recent remarks made by Vice President Pence and  former Secretary of the Treasury and Goldman Sachs CEO Henry Paulson, a longtime friend of Beijing.

Pence speaking to Hudson Institute said the following:

   “America had hoped that economic liberalization would bring China into

     a greater partnership with us and with the world. Instead, China has chosen

    economic aggression (emphasis added), which has in in turn emboldened its             

     growing military.”[iv]

And:

   “Beijing provides funding to universities, think tanks and scholars, with

     the understanding that they will avoid ideas that the Communist Party

     finds dangerous or offensive. China experts know that their visas will be

     delayed or denied if their research contradicts Beijing’s talking points.”

Although the rhetoric coming from the Trump Administration might have been expected, Henry Paulson’s comments were not. Paulson has long championed engagement with China, but in his Singapore speech he noted that an “economic iron curtain” may soon descend between the two parties. The result of which would be “a long winter in U.S-China relations” and “systemic risk of monumental proportions.”[v]

In other words both countries are playing with fire. In fact China is already feeling the pain with slowing economic growth and a nearly 30% stock market decline. (See Figure 11) There are few winners in a trade war with lots of collateral damage.

Figure 11. Shanghai Composite Index, 17 Nov 17 – 16 Nov 18

Source: MarketWatch.com

China is not the only trade issue the markets face. With the Democrats taking control of the House of Representatives in November it is not clear that the newly signed substitute for NAFTA, the USMCA Treaty will pass muster. Remember that the Democrats are less free trade oriented than the Republicans and it is our guess that come this spring the markets will once again be worried about the deal. Further the risks remain that BREXIT will blow-up and Italy will slug it out with the E.U. over its nonconforming budget. Thus unless cooler heads prevail the risks to our forecast coming from the trade sector are all on the downside.

Meantime the U.S. trade deficit continues to expand as the Trump administration unconsciously uses the trade deficit to finance the budget deficit. As long as the United States is a capital importer it has to, by definition, have a trade deficit. In real term the U.S. trade deficit will increase from $914 billion this year to $1.04 trillion and $1.1 trillion, in 2019 and 2020, respectively. (See Figure 12)

Figure 12. Real Net Exports, 2010 – 2020F, In Billions $, Annual Data

   

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Sources of Strength and Weakness

Our main theme is that growth will gradually taper off in all of the major sectors of the economy. It looks like real consumer spending growth peaked at 4% in the second quarter and it will likely taper off to 2% by the fourth quarter of 2019 and 1.5% by the fourth quarter of 2020. (See Figure 13) Although consumer spending has been strong of late, we can’t say the same for housing activity. Put bluntly housing activity remains in a rut. Housing starts will advance to 1.26 million units this year up from 1.21 million units in 2017. We forecast further modest gains to 1.31 million and 1.32 million units in 2019 and 2020, respectively. (See Figure 14) This level of activity lags below the 1.4-1.5 million units that we believe to be consistent with long run demand.

Figure 13. Real Consumption Expenditures, 2010Q1 -2020Q4F, Percent Change, SAAR

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 14. Housing Starts, 2010Q1 -2020Q4, In Millions of Units, SAAR

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

A real bright spot in the economy has been investment in intellectual property which is forecast to increase a white hot annual rate of 9% this quarter. This broad category consists of computer software, research and development and filmed entertainment. To be sure growth in this sector will taper off, it will still be consistently growing faster than the economy as a whole. (See Figure 15)

Figure 15: Real Investment in Intellectual Property, 2010Q1 -2020Q4, Percent Change, SAAR

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Another bright spot for next year will be the continued strength in real defense spending. After increasing at 3.4% this year, real defense spending is forecast to rise by 4.9% in 2019 and level off with a 0.8% gain in 2020. (See Figure 16) The Trump defense buildup is for real.

Figure 16. Real Defense Purchases, 2010 -2020F, Percent Change, Annual Data

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Conclusion

The economy is in the process of down shifting from the 3% growth in real GDP this year to 2% in 2019 and 1% in 2020. At full employment 3% growth is not sustainable. With the Fed tightening, trade tensions rising and the impact of the fiscal stimulus coming from tax cuts and spending increase waning, financial markets will likely experience increased turbulence.  Over-leverage in the corporate sector represents the major financial risk to the economy. Nevertheless Main Street will likely experience higher real wages coming from a very tight labor market as evidenced by a 3.5% unemployment rate. Thus a good year for Main Street and choppy year for Wall Street.

    

   

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[i] See Shulman David, “Sunny 2018, Cloudy 2019,” UCLA Anderson Forecast, December 2017 and Shulman David, “Regime Change,” UCLA Anderson Forecast, March 2018.

[ii] Smith, Molly and Christopher Cannon, “A $1 Trillion Powder Keg Threatens the Corporate Bond Market,” Bloomberg, October 11, 2018.

[iii] Fleming, Sam,  “Janet Yellen Sounds Alarm Over Plunging Loan Standards,” Financial Times, October 24, 2018

[iv] Seib Gerald F., “The Significance of Pence’s China Broadside,” The Wall Street Journal, October 9, 2018.

[v] Ip, Greg, “Paulson Forewarns on China,” The Wall Street Journal, November 8, 2018