Stock Market Correction or Bear Market?

 I certainly haven't covered myself with glory this year. My recession call in May, just ahead of a 5% GDP quarter is damning. (Shulmaven: Has the Recession Arrived?) Nevertheless with the S&P 500 now down a touch over 10% from its July 31st high, a correction has been signaled. Perhaps more troubling, notwithstanding the fact that the index is still up 7% on the year, the equal weighted index is down 6%, meaning more stocks are down than up. Just as in the early 1970's nifty fifty market, the leadership has been extraordinarily narrow. Indeed with the onset of a middle-east war we have yet again another parallel to the 1970's. (Shulmaven: Roaring 20's or That 70's Show)

To me my biggest concern is that the S&P 500 is still down 14% from its 4797 all-time high set on January 3, 2022. It can be argued, that just like in the 1970's, we are now in a structural bear market that began almost two years ago. If that is the case, the rally this year could be characterized as one of the biggest head fakes of all time. It remains to early to make that call, and a big tell will be whether or not the broader stock market rallies next month with the abatement of mutual fund tax selling.

"The Sum of All Fears," UCLA Anderson Forecast March 2020 Interim Forecast

As we noted in our quarterly March report, the forecast represented an “attempt to distill incomplete and rapidly evolving information into a framework about the future course of the economy.” We now have new information that has confirmed the coronavirus is spreading rapidly, the travel and recreation sectors of the economy are shutting down, oil prices continued to plunge in response to the Russian war on the American fracking industry, credit spreads have widened dramatically thereby tightening financial conditions and stocks remain volatile with a downward bias.

As a result we have changed our forecast. Simply put we believe that when the business cycle dating committee of the National Bureau of Economic Research meets they will note that the 2020 recession began this month. Significant increases in Federal spending to support individuals and industries damaged by the coronavirus and a new program of quantitative easing by the Fed will limit, but not avert the decline in economic activity that we foresee. In summary our new forecast is as follows:

·        Real GDP declines by 6.5% and 1.9% in 2Q and 3Q, respectively. Growth rebounds in the 4Q a 4% clip.  (Figure 1)

·        Social distancing causes real consumption to fall by 7.8% in 2Q. (Figure 2)

·        Real Business Fixed Investment declines throughout the year. (Figure 3)

·        Two million jobs are lost between 1Q20 to 1Q21. (Figure 4) 

·        The unemployment rate rises from 3.6% to 5.0%. (Figure 5)

·        The Fed responds with a zero interest rate policy and QE. (Figure 6)

·        Inflation remains muted. (Figure 7)

Note: No Figures in this post.

Links to Ziman Center version of UCLA Forecast + Video Presentation

Ziman Center version of December UCLA Anderson Forecast

https://www.anderson.ucla.edu/documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_12.09.19.pdf


Video of "The Two Track Economy" presentation:

https://www.youtube.com/watch?v=tCOETvmUoUs

"Fuzzy Data, a Slowing Economy and a Trade War," UCLA Anderson Forecast, June 2019

The Commerce Department delivered a surprise at the end of April by reporting a very strong annualized 3.2% growth rate for real GDP in the first quarter. However after looking under the hood, the core economy was only growing at a very modest 1.2% rate. (See Table 1)[i] The difference is a result of a huge inventory build-up, a substantial decline in imports, surprising strength in exports and a bulge in state and local spending due road repairs associated with this winter’s storms.

Similarly the recent employment data does not appear to be as robust as reported. For example as measured by the widely reported payroll series the U.S. economy added 2.62 million jobs over the year ending April 2019, while the household survey reported a far low gain of 1.43 million people employed. This nearly 1.2 million difference between the two series is unusually large. (See Figure 2) Ultimately the gap will close as the data gets revised. Similarly, fuzzy data appeared in the Consumer Price Index where declines of 1.9% and 0.8% in apparel prices in March and April respectively was due to a change in methodology. These price decline are not sustainable, especially with more tariffs on the way.

Figure 1. Reported vs. Underlying GDP Growth in 1Q2019

        

Reported Real GDP Change	3.2%
Less: Inventory Change	-0.6%
Export Increase	-0.4%
Import Decrease	-0.6%
State & Local Increase	-0.4%
Equals Gross Private Domestic Final Demand	1.2%

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

Figure 2. Annual Change in Payroll Employment vs. Household Employment, April 2014 – April 2019, Monthly Data, In thousands

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

As a result of the data issues mentioned above we are essentially maintaining our forecast calling for a 3-2-1 economy where growth on a fourth quarter to fourth quarter basis was reported at 3.1% in 2018 and is forecast to be 2.1% and 1.4% in 2019 and 2020, respectively. For 2021 we are forecasting a rebound to 2.1%. (See Figure 3) It is important to note that when the economy slows to 1% growth the risk of a recession become very real with the second half of 2020 being problematic.

Figure 3. Real GDP Growth, 2010Q1 -2021QF, Quarterly Data, Percent Change, SAAR

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

In this slowing environment employment growth will rapidly decelerate from the monthly run rate of 220,000 jobs a month in the year ending in April to about 130,000 a month in the second half and about 50,000 a month in 2020. (See Figure 4) Simply put we tend to believe that the household series mentioned above is telling the right story where over the past 12 months employment growth averaged 120,000 a month. Given our view that the economy is slowing it appears that the unemployment rate will bottom out at April’s 3.6% level and remain there for about a year before rising to 4% in late 2020 or early 2021. (See Figure 5)

Figure 4. Payroll Employment, 2010Q1 -2021Q4, Quarterly Data, In millions, SAAR

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

Figure 5. Unemployment Rate, 2010Q1-2021Q4, Quarterly Data, Percent, SAAR

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

The Fed, Trump and Interest Rates

With his call for the Fed to lower interest rates by 100 basis points at a time when the economy is booming, President Trump declared war on the Fed. President Trump escalated by preparing to nominate to unqualified nominees, Stephen Moore and Herman Cain, to the Fed’s board of governors. Fortunately those candidacies failed, but for personal, not professional reasons. His next choices likely will not have the personal difficulties of Moore and Cain, but would do his bidding just as well. This is not to say that the Fed board does not deserve a diversity of opinion, but its members should largely be independent of the White House as Trump’s earlier appointees of Jerome Powell and Richard Clarida are.

Nonetheless with inflation remaining benign, the Fed is on track to keep interest rates where they are and there seems to be a willingness to let the economy run “hot” for a while. Thus we are forecasting that the Fed Funds rate will remain at its 2.375% midpoint until the middle of 2020 with a total 50 basis points of rate cuts will take place as the central bank responds to a slowing economy. (Figure 6) In the environment we envision long term interest rates as measured by the 10-Year U.S. Treasury bond will remain range bound between 2.3% - 2.8% through 2020, a far cry from our earlier forecasts.

Figure 6. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2010Q1-2021Q4F, Percent

Sources: Federal Reserve Board and UCLA Anderson Forecast

Fed policy will be buttressed by inflation remaining somewhat above two percent as measure by the Consumer Price Index and at their target 2% for the price indices associated with GDP accounting. (Figure 7) Although wage compensation gains will rally from the current 3% to just under 4%, it will not set off inflationary alarms. In fact those gains will be welcomed. (See Figure 8)

Figure 7. Consumer Price Index, Headline vs. Core, 2010Q1 -2021Q4, Percent Change Year Ago

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 8. Employee Compensation, 2010Q1- 2021Q4, Percent Change Year Ago

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Trade WAR

With trade tensions with China going up and down like a yo-yo it is difficult to forecast what form the final policy will take on. But make no mistake, increasing the tariff from 10% to 25% on $200 billion worth of Chinese imports is not a policy that will enhance economic growth. To be sure there are real trade issues with China, but using artillery instead of a rifle will only make matter worse.  Put simply tariffs act like grains of sand in the gears of commerce. Output is reduced and prices rise, not a good thing. Remember a tariff is a tax on American consumers and as such is contractionary. And as China retaliates it becomes the stuff that global slumps are made of. Moreover adding insult to injury the successor to NAFTA the U.S.-Canada-Mexico Agreement (USMCA) looks like it is about to implode.

What the Administration doesn’t seem to understand that the overall trade deficit is not a matter of the trade balance with individual countries, but rather reflects the imbalance between domestic consumption and domestic production. A nation that consumes more than it produced imports the balance. Hence real net exports will exceed $900 billion this year and approach a trillion dollars in 2020. (See Figure 9)

Figure 9. Real Net Exports, 2010Q1 -2021Q4, Quarterly Data, In $billion, SAAR

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

The flip-side of the trade deficit is the budget deficit. In a sense the U.S. is using the trade deficit to finance the budget deficit because the offset to a trade deficit is a capital inflow of which part of it is used to purchase government debt.  After reach $873 billion in fiscal 2018, the budget deficit is forecast to rise to $1.02 trillion, $1.06 trillion and $1.1 trillion in 2019, 2020 and 2021, respectively. (See Figure 10)

Figure 10. Federal Budget Deficit, FY10-FY21F, In $billions, Annual Data

Sources: Office of Management and Budget and UCLA Anderson Forecast

The Housing Conundrum

One of the great conundrums of the long expansion is the failure of housing activity to launch. This is especially troubling because the recent 75 basis point decline in mortgage rates has failed to ignite demand. To be sure housing became way over-built from 2004-2007, but the failure of housing starts after a long expansion to reach the normalized level of between 1.4-1.5 million starts a year remains a mystery. Indeed housing starts have been locked in at level of around 1.2 million starts a year since 2016 and will stay at that level through 2020. (See Figure 11)

There are a host of explanations for this that involve, lagged effects of the financial crisis, student debt, delayed family formation, restrictive zoning in the job creating metropolitan areas and recently the limitation on state and local tax deductions. With respect to zoning the lack of supply has led to a spike in housing prices and rents which in turn has triggered demands for self-defeating rent control and stricter controls where they already exist.

See Figure 11. Housing Starts, 2010Q1-2021Q4F, Quarterly Data, In millions of Units, SAAR

Sources: U.S. Bureau of the Census and UCLA Anderson Forecast

Conclusion

Don’t be misled by the apparent strength in the recent jobs and GDP data. Although growing, the economy is weaker than it looks and has benefited from several one-off factors involving imports and trade. Thus we are maintaining our 3-2-1 forecast for real GDP growth with a realized 3.1% in 2018, and a forecast of 2.1% and 1.4% in 2019 and 2020, respectively. With job growth slowing to a crawl of about 40,000 a month in 2020 the risk of a recession in the latter part of that year is nontrivial. Inflation is forecast to run somewhat above 2% and the Fed will maintain stable interest rates until the second half of 2020 where we are forecasting two rate cuts. The downside risk to the economy comes from increased trade tensions and the upside risk would come from housing activity rising out of its stupor.

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[i] This data is for the April release and does not reflect the May revision which was not available when written.

"Global Slowdown," UCLA Anderson Forecast, March 2019

Global Slowdown

David Shulman

Senior Economist

UCLA Anderson Forecast

March 2019

A year ago we were looking forward to a synchronized global expansion; today we are staring a synchronized slowdown. The U.S. economy is part and parcel with the global slowdown, an eventuality we have been forecasting for over a year. After growing at 3.1% clip on a fourth quarter-to-fourth quarter basis in 2018, growth will slow to 1.7% in 2019 and to a near recession pace of 1.1% in 2020. However by mid-2021 growth is once again forecast to be around 2%. (See Figure 1) Similarly payroll employment growth is forecast to decline from the 220,000 a month recorded in 2018 to about 160,000 a month in 2019 to a negligible 20,000 a month in 2020 with actual declines occurring at the end of that year. (See Figure 2) In this environment the unemployment rate will initially decline from January’s 3.9% to 3.6% later in the year and then gradually rise to 4.2% in early 2021. (See Figure 3)

Figure 1. Real GDP Growth, 2011Q1 -2021Q4F, Percent Change SAAR

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

Figure 2. Payroll Employment, 2011Q1 -2021Q4, Millions, SAAR

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

Figure 3. Unemployment Rate, 2011Q1 -2021Q4, Percent, SAAR

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

Why the Slowdown?

Consistent with our view for the past several quarters we believe that the 3% growth in 2018 was a one-off based on the fiscal stimulus coming from the tax cuts and spending increases, especially for defense enacted in late 2017 and the lagged effects of the extraordinarily easy monetary policy pursued by the Federal Reserve. With the effects of the fiscal stimulus now waning combined with the partial normalization of interest rates it seemed inevitable to us that growth would slow. Further the failure of housing activity to provide a propellant for the expansion has been a distinct negative. We will discuss these points in greater detail later. The slowdown in U.S. economic activity will be exacerbated by concomitant weakness among our global trading partners.

 Global Economy Stalling

Although 2018 started out strong for the global economy, by yearend there seemed to be weakness everywhere. The weakness is being amplified by the protectionist policies being employed by the Trump Administration and the uncertainties associated with BREXIT. For example compared to 2018 German growth is expected to slow from 1.5% to 1.3%, China from 6.6% to 6.2% and Italy is for all practical purposes in recession. Although these declines in growth appear modest, recent data suggests that there will be substantial downward revisions to the outlook once first quarter data become available.[i]  The global weakness will be transmitted to the U.S. economy by a less than robust export environment and a reduction in corporate profits.

See Figure 4. Real GDP Growth for Major Economies, 2018 -2020, Percent

Region/Country	2018		2019		2020
U.S.	2.9		2.5		1.8
Euro Zone	1.8		1.6		1.7
Germany	1.5		1.3		1.6
France	1.5		1.5		1.6
Italy	1.0		0.6		0.9
UK	1.4		1.5		1.6
Japan	0.9		1.1		0.5
Developing Asia
China	6.6		6.2		6.2
India	7.3		7.5		7.7
Americas
Canada	2.1		1.9		1.7
Mexico	2.1		2.1		2.2
Brazil	1.3		2.5		2.2

Source: World Economic Outlook, International Monetary Fund, January 2019

This economic weakness has triggered a major contraction in global interest rates making it difficult for the Fed to conduct its normalization policy and has put a lid on long term interest rates. Would you believe .09% for the German 10-year Bund and a negative .60% for the 2-year. (See Figure 5) Where in the recent past we thought yields on 10-year U.S. Treasury would to top out over 4%, we now think that a 3.25% peak is more likely as German interest rates work to suppress U.S. yields. (See Fed discussion below)

Figure 5. Selected Global Interest Rates, 22Feb19, Percent

Country	2-Year	10-Yr.
U.S.	2.50	2.65
Germany	-0.60	0.09
France	-0.46	0.52
Italy	0.54	2.87
U.K.	0.74	1.15
Japan	-0.18	-0.05

                               

Source: CNBC

A Fundamental Shift in Fed Policy

The combination of the global slowdown, the 20% sell-off in stock prices in the fourth quarter and still quiescent inflation triggered a fundamental shift in Fed policy. Instead of penciling three or four rate hikes next year, it now looks like it will be zero or one. We are in the one rate hike camp for 2019 camp because we believe that inflation will be less than benign. However, because we are more pessimistic on the real economy than the Fed, we are forecasting that there will be three rate cuts of 25 basis points each in 2020. (See Figure 6) In this setting of very slow growth and an end to the Fed normalization process coupled with very low interest rates in Europe and Japan it is hard to see long term interest rates going much above 3.25%.

Figure 6. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2011Q1 -2021Q4F

Sources: Federal Reserve Board and UCLA Anderson Forecast

Moreover it now looks like the Fed is rethinking its balance sheet target. Instead or contracting its balance sheet from the $4.5 trillion peak to $3 trillion or below, it now looks like the shrinkage process will end this year with a balance sheet of around $3.5 trillion. (Figure 7) This change in policy will put less pressure on the long end of the treasury curve.

Figure 7. Federal Reserve Assets, 20Feb14 – 20Feb19, In $billions

 

Source: Federal Reserve Board via FRED

Although there has been much discussion of the potential for the treasury curve to become fully inverted (long rates lower than short rates), we do not believe that will be the case. To be sure the curve is currently inverted between one and five year maturities, but we do not believe that the all-important 90- Day Treasury Bill to the 10-Year Treasury bond will invert.(See Figure 8) Similarly we do not believe the 2-10 year spread will invert on a sustained basis as well.  

Figure 8. U.S. Treasury Yield Curve 22Feb19

Source: GuruFocus.com

Modestly Higher Inflation

Inflation may not be as quiescent as the Fed thinks. As a result of the very tight labor market wages are increasing at a 3%+ clip and it is likely that the year-over-year gains will soon be running around 4%. (See Figure 9) As a result, wage pressures, especially in the service sector, will keep the core consumer prices increasing at a rate above 2%. (See Figure 10) Moreover it appears that the benefits from the collapse in oil prices is now behind us and that will elevate the rate of change in the headline consumer price index to above 2% as well (See Figure 11)

Figure 9. Total Compensation per Hour, Percent Change Year Ago

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 10. Headline Consumer Price Index vs. Core CPI, 2011Q1 -2021Q4F, Percent Change a Year Ago

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 11. Oil Price, 2011Q1 – 2021Q4F, West Texas Intermediate, $/Barrel

Sources: Commodity Research Bureau and UCLA Anderson Forecast

Investment in Intellectual Property Remains the Bright Spot

The bright spot in the economy remains investment in intellectual property. This sector largely consists of software development, motion picture/TV production and corporate R&D. Although slowing from a torrid 7% pace in 2018, this sector will continue to grow much faster than the economy over the next few years. (See Figure 12) The continued movement of corporate computing to “the cloud” and a host of new entrants into motion picture production (i.e. Amazon, Netflix, and Hulu) are buoying this sector.

Figure 12. Real Investment in Intellectual Property, 2011Q1 -2021Q4F, Percent Change, SAAR

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

Housing Starts Remain Below Underlying Demographic Demand

We reckon that the underlying demographic demand for housing starts to be around 1.4 million – 1.5 million units a year. We have yet to achieve that level for over a decade and we forecast that it won’t be until late 2021 that housing starts exceed an annual run rate in excess of 1.4 million units. (See Figure 13) There are number of explanation for the housing’s failure to launch. They include the after effects of the Great Recession, high levels of student loan debt, the aging in place of baby boomers that is keeping housing units off the market, the concentration of job growth in high cost metropolitan areas and environmental/zoning restrictions that are restricting supply. We believe the main culprit is the last factor.

Figure 13. Housing Starts, 2011Q1 -2021Q4, Thousands of Units, SAAR

Source: U.S. Bureau of the Census and UCLA Anderson Forecast

The Twin Deficits: Federal and Trade

The consequence of the Trump Administration’s tax and spending policy is a rising fiscal deficit. After incurring a deficit of $836 billion in FY2018, the deficit will exceed a trillion dollars a year through 2021 and beyond. (See Figure 14) Part of the increase in the deficit is due to the surge in real defense spending, but as we noted above that form of spending will soon level off at a high level. (See Figure 15)

Figure 14. Federal Deficit, FY 2011-FY 2021, In $Billions, Annual Data

                                

Sources: Office of Management and Budget and UCLA Anderson Forecast

Figure 15. Real Defense Purchases, 2011 -2021, Annual Data, Percent Change

                                  

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

The flip side of the budget deficit is the trade deficit. In a sense the U.S. is financing our budget deficit with the trade deficit. How so? A trade deficit implies a capital inflow to finance it. As a result the real trade deficit will increase from $920 billion in 2018 to over a trillion dollars a year over the forecast period. (See Figure 16) So much for trade protection reducing the trade deficit.

Figure 16. Real Net Exports, 2011 -2021, In $Billions, Annual Data

    

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

Conclusion

Our forecast has been roughly consistent for over a year. We forecast that real GDP growth will slow to below 2% in 2019 and around 1% in 2020 with a modest rebound in 2021. The jolt from the very expansionary fiscal policies of the Trump Administration will soon exhaust itself and there is a very real risk of a recession in late 2020. Meantime the unemployment rate will continue to decline to 3.6%, before gradually returning to 4%. Inflation will remain modestly above 2% and after increasing the Fed Funds rate by 25 basis points mid-year, the Fed will embark on an easing policy in 2020. By 2021 real growth will return to a 2% track.

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[i] See Lafourcade, Pierre and Arend Kapteyn, “Global growth now-cast: a (very) preliminary estimate for Q1,” UBS, 18 February 2019.