The Year of
Living Dangerously[i]
David
Shulman
Senior
Economist, UCLA Anderson Forecast
September
2019
With his tweets of August President
Trump escalated our trade war with China and attacked Federal Reserve Chairman
Jerome Powell as an “enemy.” All of this occurring against a backdrop of near
recessionary conditions in Europe with the potential for a Brexit disruption,
Brazil and Mexico, a slowdown in China, rising geopolitical tensions in the
Kashmir, the Middle-East, Hong Kong and the Korean Peninsula and a very real
slowing in the U.S. economy. It seems that we are sleepwalking into a recession
and perhaps quite a bit more geopolitically.
Although we are not calling for a
recession over the forecast horizon, as we have noted for over a year it is very
likely that economic growth will stall in the second half of 2020 as the
effects of the 2017 tax cuts wane and as trade tensions exact their toll on
corporate investment. On a fourth quarter to fourth quarter basis we are
forecasting real GDP growth of 2.1% and 1.2% in 2019 and 2020, respectively. Indeed in the second half of 2020 growth is
expected to decline to 0.4%, not quite a recession, but pretty close. (See
Figure 1.) For 2021 we forecast growth to return to 2.1%.
Figure 1.Real GDP Growth, 2011Q1-
2021Q4, Percent Change, SAAR
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
What
are we Worried About?
We are worried about the following:
·
The escalating
trade war with China.
·
The weakening of
business investment in equipment and structures.
·
The negatively
sloped yield curve.
·
The slowdown in
employment growth.
·
The inability of
housing activity to launch.
·
The stagnant
stock market.
We will discuss each of these factors in
turn.
Trade
Shock
At the recent Federal Reserve conference
in Jackson Hole, Wyoming Fed Chairman Jerome Powell noted:
“Moreover, while monetary policy
is a powerful tool that works to support
consumer spending, business investment,
and public confidence,
it
cannot provide a settled rulebook for international trade.” (Emphasis
added)
The reason why there is no rulebook is
that we haven’t experienced a trade shock since the imposition of the
Smoot-Hawley tariffs of 1930. We know how that turned out. Just after Powell
made those remarks, President Trump weighed in with a substantial increase in
the planned tariffs on Chinese goods (Increased to 10% and 25%, valued at about
$80 billion/year) that are scheduled to go into effect on September 1st
and December 15th. As we have
argued for two years tariffs are analogous to putting grains of sands into the
gears of commerce which work to reduce output and increase prices. Indeed
a recent Fed study noted that trade uncertainty lowered real GDP growth about
1% in 2019 and projected another equivalent drop in 2020.[ii]
And make no mistake American businesses and consumers will bear the brunt
of the tariffs. And despite all of the Administration’s heightened rhetoric the
real trade deficit will continue to rise as it approaches one trillion dollars
this year. (See Figure 2)
Figure 2. Real Net Exports, 2011Q1
-2021Q4, Annual Data, $Billions
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Further the introduction of President
Trump’s tariffs has greatly increased the uncertainty about the durability of
existing supply chains thereby dampening business investment, more on that
below. The Trump uncertainty is having pretty much the same effect of the
uncertainties introduced by President Obama earlier in the decade with a
multitude of regulatory changes coming from the Environmental Protection
Administration, the Department of Labor and the Department of Energy.[iii]
Weaker
Business Investment in Equipment and Structures
In response to the rise uncertainty the
growth in business investment in equipment has stalled. After increasing at a
solid 6.8% in 2018 real investment in equipment is forecast to grow at somewhat
less than 2% from 2019-2021 and there will be several negative quarters along
the way. (See Figure 3) The 11% increase in the first quarter of 2020 is based
on our assumption that Boeing will resume shipments of the now-grounded 737-MAX
in that quarter. Concomitantly real business investment in structures is
already in declining at a 3% annual rate and that trend is forecast to continue
through 2021. (See Figure 4) Much of the
decline is due to weakness in energy related investment especially related to
oil and gas development in response to a 25% decline in oil prices.
Figure 3. Real Business Investment in
Equipment, 2011Q1-20121Q4F, Quarterly Data, Percent Change, SAAR
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 4. Real Business Investment in
Structures, 2011Q1-2021Q4F, Quarterly Data, Percent Change, SAAR
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
The
Negatively Sloped Yield Curve
One of the most widely used and accurate
signals of an oncoming recession is a negatively sloped yield curve where the
return on short-term money is higher than the return on longer term money. Not
only is a negatively sloped yield curve a signal of an oncoming recession it is
also a cause because it eliminates the maturity transformation arbitrage
profits of the financial system thereby reducing the willingness to lend. The
indicator that the Fed uses is the difference between the yield on three month
U.S. Treasury Bills versus the yield on 10-Year U.S. Treasury Bonds. (See
Figure 5) Yes folks, we have been there since May. (See Figure 5). Aficionados
on Wall Street prefer to use the difference between the 2-Year U.S Treasury
Note versus the 10-Year U.S. Treasury Bond. That too turned negative in August.
Figure 5. Slope of the Yield Curve,
10-Year U.S. Treasuries minus Three Month Treasury Bills, Apr 1982 – Aug 2019, Daily
Data, Percent
Sources: Federal Reserve Board via FRED
Although we have great respect for the
signal coming from the bond market, we believe that the negatively sloped yield
curve this time may sending us a false positive signal. Why? In the past then
the yield curve was negatively sloped there was over-building in the housing
market. This cycle, if anything, there has been under-building. As a result this time we might just skate by and
avoid a recession.
Another cause of the negatively slope
yield curve is the pressure coming from the global bond market. As of late-August there were about $17
trillion of negative yielding sovereign debt concentrated in Europe and Japan. (See
Figure 6) With limited growth prospects, low inflation and aggressive buying
from the European Central Bank European investors have little choice than to
pay sovereigns a storage fee for their money. After all it hard to store a
trillion euros under the mattress. As a result of the gravity coming from
Europe the 10- Year U.S. Treasury yield has collapsed to 1.5%, about half of
what it was last fall.
Figure 6. Selected Sovereign Yields,
30Aug19, Percent
|
Country
|
|
2- Year
|
|
10 Year
|
|
|
|
|
|
|
United States
|
|
1.990
|
|
1.50
|
|
|
|
|
|
|
France
|
|
-0.850
|
|
-0.40
|
|
Germany
|
|
-0.900
|
|
-0.71
|
|
Italy
|
|
-0.170
|
|
1.03
|
|
Japan
|
|
-0.310
|
|
-0.28
|
|
UK
|
|
0.400
|
|
0.49
|
Source: CNBC
Because the Fed is very knowledgeable
about the yield curve and the contractionary forces coming from the trade war
and European weakness, we believe that Fed has entered a significant easing
cycle. Where the Fed Funds rate peaked at 2.625% last December, we now believe
that the rate will be 1.625% by this December and a very low 1.125% by December
2020. The drop in the Fed Funds rate in 2020 will be the result of the economic
weakness we forecast for later that year. (See Figure 7) Of course by then the
yield curve will be positively sloped.
Figure 7. Federal Funds vs. 10-Year U.S.
Treasury Bonds, 2011Q1 – 2021Q4F, Percent
Sources: Federal Reserve Board and UCLA
Anderson Forecast
The Fed will be able to be aggressive in
lowering rates because, although running somewhat above their target, overall inflation
will remain benign. (See Figure 8) However we would point out that the
imposition of tariffs means that there is upside risk to our 2%+ inflation
forecast.
Figure 8. Consumer Price Index vs. Core
CPI, 2011Q1- 2021Q4F, Percent Change a Year Ago
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Employment
Growth Softening
In
August the Bureau of Labor Statistics announced that the estimate for March 2019
payroll employment was overstated by 500,000 jobs. We will not how this preliminary estimate will
translate in actual monthly job growth until we get the January 2020 data, but
as a first approximation recent employment growth has been overstated by about
40,000 jobs a month. Our forecast for job growth is based on current data and
therefore it should be viewed as high. Nevertheless instead the recent normal
of job gains of 200,000 a month, we envision job growth in 2020 to be a tepid
70,000 a month. (See Figure 9)This eventuality will be a shock to those
business that have relied on the recent history of job growth. We would also
note that our forecast includes the temporary government hiring associated with
the census, especially in the second quarter of 2020. Given our GDP forecast
the unemployment rate will remain stable at around 3.6% through early 2020 and
then rise to about 4% at the end of that year. (See Figure 10)
Figure 9. Payroll Employment,
2011Q1-2021Q4, Quarter to Quarter Change, In Thousands, SAAR
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Figure 10. Unemployment Rate,
2011Q1-20121Q4F, Percent, SAAR
Sources: U.S. Bureau of Labor Statistic
and UCLA Anderson Forecast
Housing
Activity Remains Sluggish
As we have noted ad nausea, post the Great Recession housing activity has failed to
recover to what historically has been a normalized level of housing starts of
1.4 million – 1.5 million units. Activity has stalled out in the 1.2 million –
1.3 million range and we forecast that it will remain sluggish throughout the
forecast horizon. Specifically we are forecasting 1.25 million units for 2019
and for starts to average around 1.2 million units in 2020 and 2021. (See
Figure 11) This sluggishness is
especially noteworthy in light of the fact that mortgage interest rates have
declined from 5% in late 2018 to around 3.75% today. What this means is that unlike 2007 housing
activity is really not in position to trigger a recession this time around.
Figure 11. Housing Starts,
2011Q1-2012Q4F, Thousands of Units, SAAR
Sources: U.S. Bureau of the Census and
UCLA Anderson Forecast
Stock
Market Has Gone Nowhere Since January 2018
Although the S&P 500 stock index
remains very close to its all-time high, as a practical matter stock prices haven’t
gone anywhere since January 2018. (See Figure 12) We would note that in January
2018 the Trump Administration got very serious about imposing tariffs and in
March 2018 the first round of tariffs on steel and aluminum were put in place.
As a result the wealth effect associated with rising stock prices is waning.
Figure 12. S&P 500 Stock Index,
1Sep2017 – 30Aug2019
Sources: Standard and Poor’s via
BigCharts.com
What
seems to be OK?
Although there is much to be worried
about consumption, which accounts for about two thirds of GDP is chugging
along, federal spending is advancing smartly in response to the recent budget
deal and businesses continue to invest in intellectual property at a heady
pace. Spurred on by low unemployment and higher wage income real consumer
spending growth remains solid with gains of 2.5% this year and 2.1% in in 2020
and 2021, albeit with 1% growth in the second half of 2020. (See Figures 13 and
14) To be sure the pace is off from the 3% recorded in 2018, but still quite
respectable for this stage of the business cycle. As a result, if you are going to tell a story
about a recession in 2020 you would have to have consumer spending far weaker
than we now have it.
Figure 13. Employee Compensation,
2011Q1- 20121Q4F, Percent Change Year Ago
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Figure 14. Real Personal Consumption
Expenditures, 2011Q1- 2021Q4F, Percent Change, SAAR
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Unlike earlier in the decade federal
spending is now increasing at a 3% annual rate. (See Figure 15) As a result of
the recently approved budget deal that increases both defense and domestic
purchases the 3% growth rate established in 2018 will continue this year and
into 2020 before stalling out in 2021. However we might be low for 2021 as a
new Congress might aggressively respond to the weakness we expect to occur in
late 2020.
Figure 15. Real Federal Purchases, 2011
– 2021F, Annual Data, Percent Change
Sources: Office of Management and Budget
and UCLA Anderson Forecast
The flipside of higher government
spending will be the prospect of trillion dollar deficits thorough 2021 and
beyond. (See Figure 16) Although both the administration and the Congress do
not appear to be interested in the deficit today the day will come when the
deficit is interested in them.
Figure 16. Federal Deficit, FY
2011-FY2021F, Annual Data, In $Billions
Sources: Office of Management and Budget
and UCLA Anderson Forecast
The one bright spot in business
investment is the continuing growth in spending on intellectual property. That
category includes, among other things, computer software, research and
development expenditures and filmed entertainment. Unlike equipment and
structures this sector is being driven by technological imperatives that extend
well beyond the business cycle. Despite the slowdown we are forecasting real
intellectual property spending will continue to grow robustly, albeit off the
heady 8.4% forecast for this year. Specifically we are forecasting growth of
5.5% and 4.1% in 2020 and 2021, respectively. (See Figure 17)
Figure 17. Real Spending on Intellectual
Property, 2011Q1-2021Q4, Percent Change, SAAR
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Conclusion
Economic growth is dramatically slowing.
The near 3% pace of over a year ago is now a memory with fourth quarter –fourth
quarter real GDP growth for 2019 and 2020 now forecast to be 2.1% and 1.2%
respectively. Further job growth will slow to below 70,000 a month, a far cry
from the 200,000 plus we have been used to. The real risk is coming from the
Administration’s high and erratic tariff policies and its potential impact on
exports and business investment. As long has consumption remains firm we
believe that the U.S. economy will avoid a recession next year, but
nevertheless it will be “The Year of Living Dangerously.”
[i]
With apologies to Peter Weir and MGM(Released in the U.S. in 1983)
[ii]
See Caldera, Dario et.al, “Does Trade Policy Uncertainty Affect Global Economic
Activity?” Board of Governors of the Federal Reserve System, Sept 4, 2019.
[iii]
See Shulman, David, “The Uncertain Economy,”
UCLA Anderson Forecast, September 2010
