Flying at Low Altitude
Many of you know that I like themes in my economic work. Two years ago, I created the theme, Rounding Third and Heading Home. In your mind’s eye, I wanted to create the vision that the current economic cycle was becoming mature, eventually heading toward recession. We were not calling for a recession two years ago and that theme has remained consistent in our overall view toward the U.S. economy.
Today, we’re releasing a new theme, Flying at Low Altitude. Two factors are at work in this theme. First, the U.S. economy is still “flying” or growing. But like flying an airplane at low altitude, the risks of something bad happening are elevated. We think the U.S. economy will continue to grow more slowly than in the past as the current economic cycle winds down, but still grow. We are calling for gross domestic product (GDP) growth of 1.5 percent for 2020, with growth momentum slowing throughout most of the year.
Why such low and decelerating growth? Specifically, we believe the U.S. economy will continue to be negatively influenced by governmental policy uncertainties. Remember, the natural human reaction to uncertainties is to stand still or freeze. Specifically, while we will see some progress made on the trade/tariff front in 2020, the presidential election will throw another “bone” of uncertainty into the economic stew.
Additionally the current economic cycle is very mature by most historical measures. The boom phase, which we have been focused upon, should continue throughout much of 2020. We sense a cooling in overall economic activity, both domestically and abroad, may unfold as the year progresses.
To compare the economy’s current status to previous cycles, let me outline some points of evidence that our economy normally witnesses in the later stages of previous economic cycles.
- Time: The current economic expansion started in Q2 2009. The current cycle is the longest in our nation’s history. Previous expansions have lasted about seven years. This cycle, by historical standards, is aged.1
- Labor Market Cooling: The U.S. economy was creating an average of 235,000 jobs each month during the first half of 2018. So far this year, that average has fallen to 155,000. Still a good number, but the economy is creating about 40 percent fewer jobs now than was the case 18 months ago. We believe job creation rates will continue to slide throughout much of 2020.2
- Extended Bull Market: Rising stock prices tend to go hand in hand with economic expansions. There have been 2,702 trading days since the last 20+ percent decline in stock prices.3 The average period between bear markets has been 635 trading days. The stock market is reflecting the extension of time of the current record economic expansion.
- Federal Reserve Models and Actions: The people at the New York Federal Reserve model the economy. Their current model is stating a 29 percent probability of a recession occurring over the next 12 months. Historically, the economy has been in recession 12 percent of the time. The model’s output suggests that the Fed believes the probability of a recession over the next 12 months is much higher than normal, about 2.5x the typical expectation. The Fed wouldn’t have lowered rates in 2019 unless they were concerned about slowing overall growth. The Fed has lowered interest rates by 0.75 percent this year.
- Business Leaders Concerned: Business leaders tend to be an optimistic lot. They have to be. Duke University conducts a poll of the nation’s Chief Financial Officers. Currently, 67 percent of those polled believe the United States will be in recession by the end of 2020. By the way, this same group is looking for capital spending to increase at a very weak 0.6 percent rate over the next 12 months. This time last year, the results of the poll suggested a capital spending growth rate of 5.7 percent was in the cards.
- CEO Confidence Weak. The CEO confidence poll is now at 34, down from a read of 60 a year ago. The poll suggests the largest 12-month decline in more than 40 years has occurred with this important sentiment poll. This is stunning, in that this poll didn’t fall as much in 2008-2009, during the last serious economic contraction.
As a result of the factors just mentioned, GDP growth has slowed significantly over the last year. In 2018, the U.S. economy grew by a “real” (after inflation) rate of 2.9 percent. It appears economic growth has slowed to 2.1 percent this year (in line with our year-long forecast), with much of the slowing occurring in the second half of the year. It now appears our growth has slowed to an annual rate of 1.7 percent over the last half of 2019.
Below is our macro-economic forecast for the U.S. economy.
A couple of comments about the formal outlook, highlighted by the data points above. We suggest, as has historically been the case in boom phases of previous economic cycles, consumption activity will drive economic growth, which is positively affected by a mature, ripe jobs market. According to Ned Davis Research (NDR), U.S. consumers’ discretionary income is rising by about 5 percent year-over-year, and the consumer’s average net worth is up more than 5 percent over the last 12 months. Decent consumption growth rates are typical of previous late-cycle economic periods.
On the other hand, business investment spending (capital spending) tends to soften as the economic cycle matures. This has been happening, with tariff activities adding to the uncertainty of the business outlook for many.
With a reasonably robust consumption environment and a weak business spending outlook, we expect the economy to continue to grow slowly. So slowly that the risks of falling into a recession are elevated but certainly not our core outlook. With so much to worry over, why don’t we believe a recession is our core economic call for 2020? Consider the following:
- Yield Curve: The relationship between short- and long-term interest rates became inverted (short-term rates higher than long-term rates) earlier in 2019. The curve has since become un-inverted. This is typical of past cycles. Normally, when rates invert, the Fed takes action by lowering short-term rates, which happened earlier this year, driving short-term rates downward significantly. From a historical standpoint, investors eventually react to the Fed policy shift, and long-term rates tend to decline rather aggressively. As the chart shows, it isn’t unusual for the yield curve to un-invert prior to the start of a recession. As a matter of fact, it is common for this to occur. Recessions tend to start an average of 18 months following initial inversion, which would place the start of the next recession in 2021, not 2020. Please see the chart above, which shows the historical U.S. yield curve, with prior recessions highlighted by the shaded periods.
- Leading Economic Indicators (LEI): The LEI is an index of 10 different factors, which attempts to provide a guide to future economic activity. We have found that the six-month rate of change of the index has provided more accurate guidance as to recession timing. Indeed, over the last 10 business cycles, the six-month rate of change of the LEI has been -3 percent prior to the onset of nine recessions (90 percent accuracy history). Currently, the six-month rate of change is 0 percent, down from +5percent over the last 18 months. While the index has been weakening, we are still not at the critical -3 percent level on this recession indictor.
- Credit Spreads: Typically junk bond yields tend to rise rather significantly prior to the economy entering a recession, as bond investors, who by their nature are a nervous lot, become very wary of rising default rates prior to the onset of outright economic weakness. The chart above shows this to be the case. Note the rise in the spread between junk bonds and U.S. Treasury yields prior to the recession in 2001 and 2008—that type of increase in spreads isn’t currently present.
- ISM Indexes. While the manufacturing ISM index has been weakening on a global and domestic scale, the non-manufacturing ISM index hasn’t yet penetrated a reading of 50. Prior to past recessions, both indexes have come in at a read of less than 50. We are some ways away from this point.
Bottom Line – Slow Growth Rules the Day
The U.S. and the world in general have a lot to worry about as we head into 2020. These worries are reflected in very low overall macro-economic growth levels. Economic growth in the United States has slowed from a 3 percent annual rate to what we believe to be 1.5 percent for next year. All of this has happened in two years. Political actions have consequences. The trade war has created significant uncertainty in large-ticket spending. The upcoming impeachment debate may indeed add to this uncertainty. If capital allocators can’t forecast with strong conviction, they tend to freeze.
With this in mind, the U.S. economy is one of the most vibrant and the largest economies in the world. We suggest 2020 will prove to be another year of economic progress, albeit one with uncertainties as the economy is flying at a very low altitude.
2Bureau of Labor Statistics
3Ned Davis Research
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