"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.

"From Wall Street to Main Street," UCLA Anderson Forecast, December 2014

While stocks have tripled off of their financial crisis
lows of March 2009 and are now trading well above the
old high reached in November 2007, the feeling on Main
Street has been far less ebullient. (See Figure 1) As we have
noted in prior quarters, we believe that the tepid 2% growth
path experienced from 2009-2014 is now in the process of
ramping up to a sustained period of 3% growth in real GDP
which will bring with it a sense of economic progress on
Main Street. (See Figure 2) Specifically we are forecasting
2.8% growth in the current quarter and for growth to average
3.1% in both 2015 and 2016.

Figure 1 S&P 500 Index, November 2004 – November 2014, Weekly Data
Source: BigCharts.com

In this environment the economy will be generating
200,000 – 260,000 jobs a month and that will engender a
fall in the unemployment rate to 5% by the end of 2016.
(See Figures 3 and 4) We note that this forecast allows for
a decline of about 0.1% per quarter, half the 0.2% decline
experienced from 2012Q1 – 2013Q3. The reason for this
is that in response to the rising demand for labor, the labor
force participation rate will begin to increase. Our forecast is
consistent with the recent history where household employment
gains have averaged 315,000 jobs a month and payroll
employment gains have averaged 220,000 a month over the
past year ended in October. Perhaps more importantly, the
rate of increase in employee compensation will rise from an
average of 1.8% a year from 2009-2013 to 3.2% this year
and next and then to 3.9% in 2016. (See Figure 5)

Figure 2 Real GDP Growth, 2006Q1 – 2016Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 3. Payroll Employment, 2006Q1 – 2016Q4
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4. Unemployment Rate, 2006Q1 – 2016Q4F
Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 5. Total Compensation per Hour, 2006Q1 -2016Q4F
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Mostly Good News and Some Bad News from the
Drop in Oil Prices

In recent weeks, the price of oil went into a free fall.
After trading for much of the year in the $100 a barrel range,
the price of oil plummeted to around $75 a barrel. (See Figure
6) Should the oil price remain at this new level, and we
expect it will, there will be huge benefits to consumers. For
example, such a price reduction translates to at least a 50
cent a gallon price cut for gasoline. With the U.S. consuming
about 135 billion gallons of gasoline a year that calibrates
into a $67 billion a year boon to consumers.

With lower oil prices adding fuel to rising employment
and wages, consumer spending will ramp up from a 2% or
so pace to over 3% over the next two years. (See Figure 8)
Unlike prior cycles, these gains will not be funded out of a
lower savings because the income growth will be there to
support the higher level of spending.

On a more macro basis, the U.S. consumes about 19
million barrels a day of oil and natural gas liquids of which
we will produce about 11 million barrels and import about
8 million barrels each day. Thus, a $25 cut in the price of
oil yields a gross cost reduction of about $173 billion a
year; the net reduction is a far lower $73 billion. Simply
put, more than half the consumer benefit of lower oil prices
will be absorbed by U.S. producers.

That, in turn, will lead
to lower than otherwise incomes, employment and capital
spending in the oil producing regions of the United States
which have been the fastest growing regional economies
in recent years. We note that this has become a high class
problem as domestic oil and gas liquid production has surged
from seven million barrels a day in 2009 to an estimated ten
million barrels a day in 2014 and will likely reach 11 million
barrels a day in 2015.

Meantime, headline consumer prices will actually
decrease in the current quarter and will be flat first quarter of
2015. (See Figure 7) However, once the oil price reductions
run through the system we forecast that consumer prices
will begin to increase at a clip in excess of 2%. Why? The
higher wages we are forecasting along with rising rents will
work to elevate the core consumer price index that excludes
food and energy. Further, the broader consumption deflator
used in the GDP accounts, and the critical targeting variable
of the Federal Reserve will be running at a much cooler
1.8%-2.0% until late in 2016. A major difference between
the two measures is that housing costs have a lower weight
and healthcare costs have a much higher weight in the
consumption deflator.

Figure 6 West Texas Intermediate Oil Price, 2006Q1 -2016Q4
Sources: Commodity Research Bureau and UCLA Anderson Forecast

Figure 7 Consumer Price Index vs. Core CPI, 2006Q1 -2016Q4
Source: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 8 Real Consumption Spending, 2006Q1 – 2016Q4F
U.S. Department of Commerce and UCLA Anderson Forecast

In contrast, housing will not be as strong as we previously
forecast. To be sure, housing starts will advance at a
21% clip in 2015 to 1.21 million, up from an estimated 1.0
million units this year. (See Figure 9) Our 2015 forecast
is now far lower than the 1.38 million units we expected
as recently as June. Simply put, still tight credit standards
which are in the process of being eased, the lack of cash for
down payments and the impact of the Great Recession and
recovery on delaying major life events have rendered housing
activity far more modest than we expected. Nevertheless,

Figure 9 Housing Starts, 2006Q1 -2016Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10 U.S. Trade Weighted Dollar with Major Currencies,
2006Q1 – 2016Q4

Figure 11 Federal Reserve Balance Sheet, 18 Dec 02 – 19 Nov 14, In $ millions
Sources: Federal Reserve Board and UCLA Anderson Forecast
Source: Federal Reserve Board via Fred

the multi-family housing boom that we have been talking
about for years will continue unabated.

The Fed Waits until June

Although the Fed ended its third and largest quantitative
easing program in October as we expected, with falling
oil prices and a strong dollar suppressing near-term inflation,
the Fed will take longer than we previously thought to start
normalizing interest rates. (Figures 10 and 11) For over
year we thought the first increase in the Federal Funds rate
would take place in March; we now think it will be June
2015. (See Figure 12) Thereafter, we anticipate that the Fed
will be on a gradual path to return the economy to more
normal interest rates. However, our forecast for the fourth
quarter of 2016 calls for a still low Fed Funds rate of 2.8%.
This is just barely above the 2.3% (2.1% core) increase in
the consumption deflator that we expect at that time--hardly
a “normal” funds rate, especially when the unemployment
rate will be approximating 5% then.

The big surprise to us and to most forecasters this year
has been the decline in long-term interest rates. Like most
forecasters, we predicted a substantial rate rise, but instead
we got a substantial decline. In our view, the rate decline
has its origins internationally as long-term rates dropped
across Europe and Japan. As of mid-November, European
and Japanese sovereign were plumbing record lows as both
the Bank of Japan and the European Central Bank announced
further easing programs. (See Figure 13) Thus, in order for
our 4% forecast for long-term interest rates in 2016, there
almost has to be at least a modest revival in Europe and
Japan that will begin to elevate their rates.

Figure 12 Federal Funds vs. 10-Year U.S. Treasury Bonds, 2006Q1
– 2016Q4F
Sources: Federal Reserve Board and UCLA Anderson Forecast

Not A Lot of Help from Exports

With the strong dollar, Japan in recession and Europe
stalled, we do not expect much help to come from the export
sector. Thus, we forecast that real exports will grow modestly
in the 3-4% range over the next two years

Figure 13 10-Year Yields in Selected Countries,
November 28, 2014
Source: Bloomberg

Figure 14 Real Exports, 2006Q1 -2016Q4
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Capital Spending Strengthening, Ex-Energy

A major source of strength in 2015 will be strong
gains in equipment and software spending as corporations
shift from buying back stock to increasing capital spending.
Specifically we forecast equipment and software spending
to increase 8.8% and 6.6% in 2015 and 2016, respectively.
(See Figure 15) By contrast, investment in nonresidential
structures will stall with a gain of only 1.5% overall in 2015
as oil drilling declines in response to lower prices. (See
Figure 16) What few people realize is that mining-related
construction will account for 30% of nonresidential activity
in 2014. Put simply, it is a big sector and much larger than
all of commercial construction. The decline here is the flipside
of the gains to consumers coming from lower oil prices.

Defense Spending on the Rise

The three-year decline in real defense spending is over.
(See Figure 17) The rise of ISIL in Iraq and Syria along with
what appears to be an emerging Cold War with Russia will
cause defense spending to modestly increase in 2015 and
2016. Moreover, with the Republican takeover of the U.S.
Senate it is likely that the “sequestration” of defense department
funding will either be modified or ended. As a result,
overall Federal purchases will increase modestly in 2015
and 2016. And real state and local spending will increase at
a 1.3% rate over the next two years.

Conclusion

Overall, the economy appears on track to grow at a
3% growth path over the next two years. Lower oil prices
and higher wages will buttress consumer spending as the
unemployment rate declines to 5%. Growth will be led by
strong gains in consumer spending along with more aggressive
corporate investment in equipment and software. In
response, the Fed will begin to normalize interest rates in
next year’s second quarter, but the Fed Funds rate will remain
at historically low levels. Housing activity will increase,
but it will be far less than what we previously thought and
oil related capital spending will decline. All in, Main Street
will begin to feel the recovery that Wall Street has already
experienced over the past several years.