The Purim War - Part 4, The Ceasefire Fog*

The rally in the stock and bond markets and the collapse in oil prices is signaling that the Purim War is all but over. That, indeed, may be true, but we are a long way from a final settlement and there is a nontrivial chance that fighting will resume.  In fact, both sides have already reported ceasefire violations. We will know more this weekend when the U.S. and Iranian negotiators meet in Pakistan.

In the meantime, ships aren’t traversing the Hormuz Strait, and it looks like Iran wants to set up a tollway. Should that happen, it would represent a severe challenge to “freedom of navigation” on an international waterway, a concept that the U.S. went to war three times in its history. (War on the Barbary Pirates, The War of 1812, and World War I) If Iran prevails on this issue, it could rightly claim, that despite its enormous tactical defeat, it won a significant strategic victory enabling it to hold the global oil market hostage.

Although President Trump has stated that Iran will give up its enriched uranium and end its nuclear program, this hasn’t been confirmed by word and deed by the Iranians. Remember that ending the Iran nuclear program was the primary goal of the war to begin with. We will learn much on this point in a few days.

 

As we previously noted Israel would take the opportunity to take care of its unfinished business in Lebanon. ( See: https://shulmaven.blogspot.com/2026/02/the-purim-war.html ) As we speak Israel is pounding Hezbollah in Lebanon and both the Iranians and the Pakistanis are saying Israel’s war in Lebanon are part of the overall cease fire. Both the U.S. and Israel believe that it is separate issue.

 

Thus, the way I see it, the war is far from over with the ultimate winner being determined by the Hormuz and nuclear issues.

 

*- See: https://shulmaven.blogspot.com/2026/03/purim-war-part-3-end-game.html

The Purim War: Part 2

 We are now nine days into the Purim War (See: https://shulmaven.blogspot.com/2026/02/the-purim-war.html ) where the U.S. and Israeli air forces are pounding the Islamic Republic of Iran. With Iran attacking Saudi Arabia and the Gulf States the war has widened to encompass the entire Persian Gulf with shipping all but shut down in the Straits of Hormuz. At this writing the price of WTI Oil has skyrocketed to $106/barrel. The attacks on the Sunni Arab states are all part of Iran's plan to create chaos in the Gulf to force the U.S. to backdown. In addition as we noted Israel has taken the opportunity to respond to Hezbollah attacks to pound them in Lebanon with the Lebanese government intervening on the side of Israel for the first time.

All of this was expected, but if we step back the Israelis and the Americans have made great progress. Iran's air defenses have been neutralized, weapons warehouses have been bombed, police stations have been taken out and earlier today a major oil depot in Tehran was set ablaze. Tehran was suffering from a severe water shortage before the war, the hit to the depot will only exacerbate an already bad situation.

Make not mistake, from both the Israeli and the American points of view the war is progressing well. Within in two weeks much of Iran's offensive capabilities will be eliminated and with that the Straits of Hormuz will have been cleared.

Today Iran selected Motjaba Khamenei, the son of Ali Khamenei, as its supreme leader thereby undoing a promise of the 1979 revolution to not allow hereditary changes in the leadership. The delay in his appointment signaled major divisions within Iran's ruling circles. By the way Motjaba just happens to own a mansion in London.  My guess is that Motjaba will soon have the same fate as his late father. Once that happens the way will be open for disgruntled members of the Islamic Revolutionary Guard Corps to seize power and open the way for a political settlement. They will be pushed into it when they lose control of the streets of Tehran to the populace and the oil workers at the giant Abadan refinery strike.

"Corona Virus: Supply Shock and Demand Shock," UCLA Anderson Forecast, March 2020

This forecast was put together on March 1 and represented our thinking at the time. Subsequent to that the Saudi oil price war broke out and the COVID-19 pandemic intensified and the U.S. government policy response has been found wanting. Thus if we were to do the forecast today we would likely have declines in real GDP in the second and third quarters of this year.

The realization that the coronavirus known as COVID-19 has the potential to wreak havoc with the global economy hit the securities markets like a shock wave in the last week of February. Just as we thought that after the signing of the USMCA agreement and the temporary truce in the U.S.-China trade war would put both the U.S. and the global economy on the path to moderate growth in 2020 and beyond, we were struck with the realization that the public health emergency would morph into an economic emergency as portions of the Chinese, South Korean, Japanese and northern Italian economies began to shut down.

What makes COVID-19 different from the prior epidemics SARS (2002-03), MERS (2012), Ebola (1976- ) and especially H1N1 (swine flew of 2009-10 which killed 12,500 Americans alone) is that although less fatal, it is potentially far more contagious. It is in the contagious nature of COVID-19 that triggered the economic shutdowns that have become so disruptive to the global economy. Remember China is far more integrated into the global economy than it was during the SARS epidemic.

In the last week of February the U.S. stock market as measured by the S&P 500 decline by 11.5%, its biggest decline since the height of the financial crisis in October 2008; the yield on the 10-year U.S. Treasury bond dropped 35 basis points to a record low of 1.15% and oil prices plummeted. (See Figures 1, 2 and 3) As a result we tore up the forecast we were about to present and very quickly produced what you are about to read. And as a consequence take this forecast as an attempt to distill incomplete and rapidly evolving information into framework for making reasonable judgments about the future course of the economy.

Figure 1.  S&P 500, 1MAR19 – 28FEB20

Source: BigCharts.com

Figure 2. 10-Year U.S. Treasury Yield, 1MAR19- 28FEB20

Source: BigCharts.com

Figure 3. West Texas Intermediate Crude Oil – Front Month Contract,        1MAR19-28FEB20

BigCharts.com

We view the COVID-19 epidemic and likely pandemic to work as both a supply shock and a demand shock on the economy. It affects supply by shutting down factories making critical products and decreases demand for travel, hotel and recreational services. For modeling purposes we looked at the demand response to the 9/11 event in 2001 to get sense of the magnitudes. On the supply side we looked at the risks to automobile, clothing and capital goods production.

As a result we are assuming a two quarter hit to real GDP growth in the second and third quarters of this year with very modest increases of 1.3% and 0.6% respectively compared the 2% plus growth we previously forecast. (See Figure 3)  That would put 2020 growth on a fourth quarter to fourth quarter basis to a low 1.5%. You can view our forecast as the midpoint between the coronavirus having a very minimal effect to it causing a full blown recession. Time will tell.  Very slow growth combined with the ending of temporary employment associated with the 2020 census will lead to about a drop of 300,000 jobs in the third quarter. Thereafter we anticipate employment growth to resume. (See Figure 4) Concomitantly the unemployment rate is forecast to increase modestly from 3.5% in the first quarter to 3.8% in the third quarter. (See Figure 5) As an aside, do not be misled by the very strong 225,000 job gain reported for January which was influenced by unusually warm weather throughout the country. (See Figure 7)

Figure 4. Real GDP Growth, 2011Q1 -2022Q4, Percent Change, SAAR

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

Figure 5. Payroll Employment, 2011Q1 -2022Q4F, Change in Thousands, SA

  

U.S Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 6. Unemployment Rate, 2011Q1-2022Q4F, Percent SA

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

Figure 7. January 2020, Average Temperature Divergence

Source: National Oceanic and Atmospheric Administration

Monetary Policy to Become Super-Accomodative

Monetary policy is not a cure for COVID-19 nor a vaccine for COVID-19. It cannot reopen factories in China or Italy and it cannot convince frightened people to travel, but it might reduce fears that something worse could happen to the economy and might alleviate the pain of stressed business facing supply shortages. We expect that the Fed will cut its benchmark federal funds rate by a full 50 basis points in the second quarter, from the current mid-point of 1.625% to 1.125%. We do note that as of March 2 the futures markets were expecting cuts on the order of 75 basis points.

Figure 8. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2011Q1 – 2022Q4F, Rates

Sources: Federal Reserve Board and UCLA Anderson Forecast

Further the balance sheet expansion process that the Fed undertook last September to solve a “plumbing problem” in the all-important repo market will, instead of winding down as planned, continue.( See Figure 9 ) Simply put the interaction between the Dodd-Frank regulatory regime and Fed’s reserve requirements left the system short of reserves. And although the reserve replenishment programs is not exactly like the three quantitative easing programs of the past decade, it sure looks like it on the chart.

Figure 9. Federal Reserve Bank Assets, 18Dec07 – 26Feb20, In $Millions

Source: Federal Reserve Board via FRED

At least in the short-run the Fed will be able to aggressively ease. Inflation remains quiescent and is likely to remain below its 2% target as measured by the consumption deflator. Here we chart the more familiar consumer price index which runs higher than the deflator.(See Figure 10) Further it is likely that the Fed will make its inflation target symmetric which means that prior undershoots will be offset by an overshoot in the inflation rate meaning that the near term target going forward could very well be 2.5%. Another wrinkle to Fed policy is the potential for Trump acolyte Judy Shelton to receive Senate confirmation for a seat on the Federal Reserve Board.  Put simply, she doesn’t play well with others. However the supply shock coming from COVID-19 and continued trade issues with China have caused many businesses to rethink their global supply chains into thinking more local. Thus over the long run de-globalization may work to increase inflation.

Figure 10. Consumer Price Index vs. Core CPI, 2011Q1-20122Q4F, Percent Change a Year Ago

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Consumption Growth Slows to a Crawl and then Rebounds

Since 2014 Consumer spending has been the mainstay of the economy. However the shock of the virus will likely dampened consumer spending in the second and third quarters with growth stalling out at 1.3% and 0.7%, respectively. (Figure 11) Thereafter we expect a rebound with automobile sales lagging as a result of credit problems in that sector.

Figure 11. Real Consumption Expenditures, 2011Q1-2022Q4F, Percent
Change, SAAR

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

Housing Comes Alive

Although far from booming housing starts are ratcheting up on the order of 100,000 units a year. Instead of a previously forecast 1.25 million/year, we now envision starts to come in at somewhat above 1.35 million units a year. (See Figure 12) Rising income and the allure of 3.25% 30-year fixed rate mortgages are beginning to overcome the supply constraints caused by local zoning and do not forget that the low interest rate environment is bringing a torrent of money into the rental apartment market as investors hunt for yield in yield starved world. Indeed, in some states, local zoning restrictions are being relaxed and that in the long run will enable housing starts to return to its historical run rate on the order of 1.4-1.5 million units/year. Far from a boom, but much better than the recent history.

Figure 12. Housing Starts, 2011Q1 – 2022Q4F, In Thousands of Units, SAAR

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

737-Max Deliveries to Rescue Business Fixed Investment

We are assuming that Boeing’s long grounded 737-MAX airplane will soon be certified to fly and deliveries will start taking place in the third quarter. Thus the full year decline in nonresidential fixed investment will soon come to an end. (See Figure 13) Those deliveries will likely offset the effects coming from the virus. If we are wrong here the outlook for the second half will decidedly worsen. Of course a lion’s share of the gain in fixed investment will be offset by a reduction in inventory levels. Just to note a good part of the recent weakness in this sector is coming from substantial declines in structures for the oil and gas industry as low oil and gas prices weigh on the decade long fracking boom.

Figure 13. Real Business fixed Investment, 2011Q1- 2022Q4, Percent Change, SAAR

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

Government Spending: The Good News and the Bad News

To look at the 3%+ real growth in federal government purchases (excludes entitlements) from 2018-2020 you would think the Democrats were in power, yet under a Republican administration we are witnessing dramatic growth in both defense and nondefense purchases. (See Figure 14) Contrast that to five years of annual declines from 2011-2015 under the prior Democratic administration. As a consequence instead of being a drag on real GDP growth, federal government purchases have been highly stimulative.

Figure 14. Real Federal Government Purchases, 2011Q1 – 2022Q4 F, Percent Change, Annual Data

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

The bad news is that the party will likely end in 2021 as the growth in government purchases crawl to a halt. Here we that the increases in public health spending associated with the virus will not be substantial. Defense spending is peaking and assuming gridlock in Washington in 2021, nondefense spending will be under pressure, but nowhere near the budget cuts the Trump administration has proposed. Further as a result of the late 2017 tax cuts and the increases in spending, the federal deficit will exceed a trillion dollars a year for as far as the eye can see. (See Figure 15)

Figure 15. Federal Deficit, 2011 – 2022F, In $Billions, Annual Data

Sources: U.S. Office of Management and Budget and UCLA Anderson Forecast

Conclusions

The forecast presented herein represents our very preliminary estimate of the impact of the Coronavirus on the U.S. economy. For the time being we view our 1.5% forecast for real GDP growth on a fourth quarter to fourth quarter basis as a midpoint between a minimal effect and a full blown recession. At this stage it is hard to model out the full effects of the supply and demand shocks that are now hitting the economy. In response we anticipate that the Fed will cut its policy rate by 50 basis points from 1.625% to 1.125% and interest rates will remain low for the entire forecast period. The one bright spot in response to the low interest rates will be a much stronger housing market than we previously forecast. Of course it goes without saying that this year’s presidential election, like 2016’s, will increase the risk of untested economic policies being put into place in 2021.

"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.