"The Two Track Economy," UCLA Anderson Forecast, December 2019

The Two Track Economy

David Shulman

Senior Economist

UCLA Anderson Forecast

December 2019

We have become a bit more optimistic since our last forecast.[i] Several of our worries have been mitigated. They include:

·        After being locked in a 21 month trading range, stock prices have broken out and made decisive new highs. (See Figure 1)

·        The Fed cut its policy rate by 25 basis points and is supplying additional reserves into the banking system to solve a “plumbing” problem. (See Figure 2) Although the purpose of supplying additional reserves is not a new quantitative easing program, it might have the same effect with respect to the financial markets.

·        The yield curve has returned to a positive slope. (See Figure 3) Although a yield curve reversal usually occurs prior to a recession, the shortness of the inversion period might very well mute its recession signal.

·        Housing activity doing better than previously forecast.

·        Better than anticipated employment growth revealed by the October jobs report signaling somewhat faster growth going forward.

·        There is less pessimism on both an interim U.S./China trade deal and passage of the USMCA trade treaty with Mexico and Canada.

Figure 1. S&P 500, 16Nov14 – 15Nov19, Weekly Data

Source: BigCharts.com

Figure 2. Federal Reserve Assets, 13Nov09 -13Nov19, In $Millions, Wednesday Level

    

Source: Federal Reserve Board via FRED

Figure 3. Yield Curve, 10-Year U.S Treasury Bond minus 3 Month Treasury Bill, 4Jan82 -13Nov19

Source: Federal Reserve Board via Fred

As a result we are backing away from our long held forecast of a 3-2-1 economy where real GDP growth on a fourth quarter – fourth quarter basis would be 3% in 2018, 2% in 2019 and 1% in 2020. We now anticipate that growth in 2020 will be 1.7% compared to 1.25% previously. So call it roughly a 3-2-2 forecast with 1.9% growth in 2021. But make no mistake there remains a significant risk of recession in late 2020, albeit somewhat less than we previously thought. For those who say that we can’t have a recession in a presidential election year, I would note that recessions occurred in 1960, 1980, and 2008; all presidential election years.[ii]

For the past year economic performance has diverged as strong consumer spending has masked significant weakness in business investment. (See Figures 4 and 5) You can characterize this as a two track economy. This result is somewhat surprising because most observers including us had assumed that the significant reduction in business taxation coming from the 2017 tax act would spur a capital spending boom. Obviously that has not occurred as growing trade tensions have made it difficult for businesses to plan ahead especially with respect to global supply chains. Indeed real business fixed investment actually declined in both the second and third quarters of this year. Nevertheless we think the worst is over and we anticipated a modest recovery over the next two years.

Aside from strong spending on intellectual property, the outlook for overall business fixed investment growth will remain modest with actual declines in structures investment which is being dampened by weak spending in the oil patch. We would note that the strong increase of 4.1% in the first quarter of 2020 is due to our assumption that Boeing begins to ship its long grounded 737-Max airplane to airline customers that quarter.

Figure 4. Real Consumption Spending, 2011Q1-2021Q4F, Percent Change, SAAR

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

Figure 5. Real Business Fixed investment, 2011Q1-2021Q4, Percent Change, SAAR

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

As you will note from Figure 4 we are forecasting a reduction in the growth in real consumer spending that will work to eliminate the recent divergence between it and business spending. Why? There is a real problem emerging in automobile credit. Lending terms have been extended to seven years and many automobile loans are underwater at the initial underwriting.[iii] Would you believe a $27,000 Jeep Cherokee with a $45,000 loan? This type of behavior is very reminiscent of home lending during the 2004-2007 bubble years. As a result with delinquencies rising, we expect there will be an agonizing reappraisal of lending standards in the second half of 2020 that will likely reduce the current run rate of 17 million units a year to below 15 million units in late 2020. (See Figure 6)

Figure 6. Light Vehicle Sales, 2011Q1 -2021Q4F, In Millions of Units, SAAR

Sources: Bureau of Economic Analysis

As was mentioned above we believe that the economy will remain on a 2% growth path from 2019 – 2021. (See Figure 7) In this environment payroll employment growth will decelerate from the 170,000/month averaged this year through October to about 80,000/month in 2020 and 50,000/month in 2021. (See Figure 8) Temporary census hiring will positively affect the data in the second quarter and negatively affect it in the third quarter of next year. In our view the unemployment rate will bottom at 3.4% in the second quarter of 2020 and then gradually rise to 3.8% by late 2021. (See Figure 9)

Figure 7. Real GDP Growth, 2011Q1 -2012Q4F, Percent Change, SAAR

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

Figure 8. Payroll Employment, 2011Q1 – 2021Q4F, Millions, SA

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

Figure 9. Unemployment Rate, 2011Q1 -2021Q4F, Percent, SA

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Federal Reserve Policy

Federal Reserve Board Chairman Jerome Powell effectively made a major policy announcement at his press conference after the September meeting of the Federal Open Market Committee. In essence he said that there will a very high bar for the Fed to further lower its benchmark federal funds rate and that there will be an even higher bar to raise the rate. Thus the markets should not expect further cuts. We previously forecast that the Fed would cut in December, instead the Fed cut in September. Because we forecast a significant weakening in economy in the second half of 2020 we have penciled in another 25 basis point cut in the fourth quarter of that year. (See Figure 10)

His higher bar for a rate increase is based on inflation consistently exceeding the Fed’s 2% target. We expect that to happen in late 2021, hence we expect a 25 basis point increase late in that year. (See Figures 10 and 11) We do this only to signal that the Fed Funds rate won’t remain at 1.38% forever.  In this environment we expect that yields the 10-Year U.S. Treasury bond remain in a low 1.5% - 2.25% range.

Figure 10. Federal Funds vs. 10- Year U.S. Treasury Bonds, 2011Q1 -2021Q4F, Percent

Sources: Federal Reserve Board and UCLA Anderson Forecast

Figure 11. Consumer Price Index vs. Core CPI, 2011Q1-2021Q4F, Percent Change Year Ago

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

Housing Activity Plateaus

Housing activity continues to be range bound between 1.25 million and 1.3 million starts. (See Figure 12) Although this level of activity is more than double the lows reached during the Great Recession it still remains somewhat below the  long term historical average of 1.4-1.5 million units and well below the two million plus years associated with booms. Although our current forecast can be characterized as tepid it is 6% and 4% above what we forecast just three months ago for 2020 and 2021, respectively.

Figure 12. Housing Starts, 2011Q1- 2021Q4F, Thousands of Units, SAAR

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

Export Growth Stays Weak

The combination of trade tensions (apparently lessening), near recession conditions in Europe, sluggish growth in Latin America and softer growth in China along with a strong dollar make for a hostile environment for U.S exporters. After being essentially flat in 2019 real export growth is forecast to be 3.3% and 1.9% in 2020 and 2021, respectively. (See Figure 12) The reason for the uptick in the first quarter of 2020 is again our assumption that the 737-Max will ship to customers in the first quarter of 2020 as most of those customers are foreign air carriers.

Figure 12. Real Export Growth, 2011Q1 -2021Q4F, Percent Change, SAAR

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

$Trillion Federal Deficits

Given an existing imbalance between federal revenues and federal expenditures along with an economy plodding along at a 2% growth path, the era of trillion dollar federal deficits is up on us. (See Figure 13) Remember that there is no recession in the forecast horizon which means that should the economy fall into recession the deficit will double. Moreover, because interest rates are already very low, there can be very little relief coming from a further fall in rates.

Figure 13. Federal Deficit, FY2011 –FY 2021F, $Billions, Annual Data

Sources: Congressional Budget Office and UCLA Anderson Forecast

Conclusion

We modestly upgraded our forecast from last quarter to reflect improved financial conditions, a better housing and employment outlook, some relaxation of trade tensions and a modest improvement in business fixed investment.  As a result instead of forecasting 1% real growth for 2020, we expect growth to be on the order of 2% on a fourth quarter to fourth quarter basis. After going on a separate track from business investment, we forecast a slowdown in consumer spending largely coming from much weaker automobile sales as credit tightens in that sector. Overall the interest rate environment, aside from auto credit, will remain benign. But make no mistake, although we have lowered the risk of a recession, the second half of 2020 remains problematic for the economy.

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[i] See Shulman, David, “The Year of Living Dangerously,” UCLA Anderson forecast, September 2019

[ii] The recession of 2001 started in the first quarter of that year making the 2000 election year a close call.

[iii] See Andriotis, Anna Maria and Ben Eisen, “Car Loans Force more Borrowers Underwater,” The Wall Street Journal (online), November 9, 2019 and Chaney, Sarah, Auto Borrowing Rises Amid low Interest Rates, Solid Economy,” The Wall Street Journal(online), November 14,2019