Debating the Likelihood of an Economic Recession, Interest Rake Hike, and Inflation Acceleration
I began the year with a game of “20 Questions” (and answers) related to the economic forces that I believed would be most likely to shape the markets over the course of 2019. I promised to revisit my predictions throughout the year and so, as we head into the final quarter of the year, it seems like an apt time to assess my responses related to the likelihoods of an economic recession, interest rate hike, and inflation acceleration. My original answers and theses are in italics, which can also be read here, followed by my updated analysis.
1) Will the US economy enter recession in 2019? 30% probability.
Recessions almost always precede or accompany bear markets. In that sense, December’s market rout, the recent deceleration in global economic growth, the lingering uncertainty associated with US/China trade tensions, and the unprecedented transition from quantitative easing to quantitative tightening have placed many on full recession watch. Despite those fears—and a litany of others, including those related to a highly unorthodox US presidency—our view is that 2019 will ultimately mark the longest period of sustained economic growth in US history. Most economic indicators related to employment trends, industrial sales, consumer spending, consumer confidence, consumer debt, and money supply remain far from levels associated with a looming recession. Still, we fully acknowledge that 30% is an uncomfortably high probability. The flattening of the yield curve and the recent downshift in auto sales are among the key indicators that bear watching. We also fear that a continued market sell-off could itself trigger a brief recession, much as what happened after the tech bubble burst in 2000. Finally, to the extent recent surveys indicate that nearly half of major US CFO’s expect a recession in 2019 (with over 80% expecting one by the end of 2020), we could see a self-fulfilling prophecy if corporate capital expenditure decelerates markedly.
That paragraph seems to have stood the test of time rather well. We’re now deep enough into 2019 to feel comfortable reducing the probability of a recession that begins this year to below 10%. Indeed, the Citibank Economic Surprise Index, which measures the pace at which economic indicators track relative to consensus forecasts, turned positive in August after one of its longest periods of decline (140 days) in the past 15 years.
The China trade tensions have clearly weighed on global growth and US business spending (last week’s disappointing September ISM manufacturing report being a case in point), but they have not done much to stymie the consumer spending that constitutes roughly 70% of the US economy. Simply put, the combination of a strong employment outlook, generally improving wage growth, and continued low rates has sustained a solid consumer spending environment.
Of the recession warning indicators we track most closely, the two that are flashing strong warning signs are generally weak commodity prices and the inverted yield curve. Commodities are under pressure due largely to the slowdown in global growth, exacerbated by the US/China trade tensions. The inverted yield curve strikes us as potentially more ominous as it has been a reliable US recessionary indicator for over 50 years—albeit usually with a 12- to 20-month lag. Perhaps then it is no wonder that the latest iteration of the Duke-led CFO survey highlighted in our January commentary found that nearly 70% of US CFO’s expect a recession in 2020. Still, it is worth noting that yield curve inversions have not been as reliable over the years in terms of predicting recessions outside the United States. Moreover, there is also the always uncomfortable “it’s different this time” argument that one cannot easily extrapolate from past to present given the extraordinarily low/negative interest rates throughout much of the world that are creating extra demand for US Treasuries.
2) Will the Federal Reserve raise interest rates the 2-3 times that it expects in 2019? 5% probability.
The key market mantra of the post-financial crisis era has been “don’t fight the Fed”—or more specifically, don’t fight the greatest monetary stimulus in recorded history, both in the US and globally. Hawkish rhetoric from Federal Reserve Chairman Powell unnerved investors in October, sparking that month’s steep sell-off. After taking a more dovish tone toward the so-called neutral level of rates in November, the Fed Chairman clearly was not as dovish as the bulls wanted in mid-December when investors were seemingly startled by the Fed’s “dot plots” and Chairman Powell’s apparent reluctance to reduce the rate of decline in the Fed’s balance sheet. While we are by no means fatalistic on the US economy for 2019, we do expect growth to revert toward the 2%—or “goldilocks” level—that prevailed during most of the Obama years. Simply put, in order to retain the Fed’s cherished sense of independence following President Trump’s persistent criticism, we believe the Fed had to take a somewhat hawkish tone in December. We expect that tone—and the resulting actions—to become far more dovish over the balance of the year. The economy simply is no longer strong enough to absorb several more rate hikes, along with the effective tightening created by $50 billion a month in Fed balance sheet reductions. We expect the Fed to come to that conclusion sooner rather than later.
My ninth-grade daughter recently came home distraught that her class was told to grade themselves on a paper instead of submitting it to the teacher. She thought she had written a particularly good paper but felt awkward about giving herself an A. We told her to try to be objective and fair and to grade herself accordingly. Along those lines—as for the January comments above—well, I’ll humbly take an A.
3) Will inflation accelerate meaningfully past the Fed’s 2% target in 2019? 15% probability.
Another reason that we believe the Fed moves toward the sidelines in 2019 is that we continue to see little inflationary pressure in the economy. The inflationistas (a nod to David Zervos at Jefferies for the catchy name) continue to point toward higher wage pressure due to low unemployment and the impact of a prolonged trade war as their primary fears. We believe most secular forces are aligned in the other direction due to global competition, technology (including the so-called Amazon effect), and demographics (US labor force growth is anemic with new entrants essentially flat versus 10%+ growth during the inflationary surge of the late 1970’s). Moreover, we believe that a prolonged tariff-driven trade war would tilt deflationary, not inflationary, due to demand destruction. In any event, the recent decline in most commodity prices should help quell any significant inflation fears, at least in the near-term.
Had The Princess Bride focused more on macroeconomics and less on say murderous six fingered swordsmen, the screenwriters would likely have noted that inflation may not be dead after all—perhaps just mostly dead. The ~$15 trillion in negative yielding debt throughout the world speaks to the reality that the broad deflation/disinflation fears among central bankers since the 2008 financial crisis remain very much in place. Still, just as the Street consensus became almost unanimous heading into this past summer that inflation was off the worry list (New York Fed President John Williams said in September, “low inflation is indeed the problem of this era”), prices have started to tick higher. Headline CPI is running at a moderate 1.7% but core CPI is now at 2.4% year-over-year, the highest in 11 years. The median rate over the past 60 years is 2.7%. The recent increase has been led by higher wages as three-month average hourly earnings is running at an annualized pace of just over 4%.
I believe investors have become overly complacent regarding inflation. While there are clearly many elements that will factor into the Fed’s upcoming rate decisions—ranging from trade tensions to seeking to avoid the perception of influencing the 2020 election—the recent inflation data may help explain why the September cumulative Fed “dot plots” point to no further cuts. The Street consensus is for 2-3 more rate cuts. At the margin, that should make it difficult for equities to break through the recent S&P 500 ceiling of around 3,000, barring a major change in the global growth outlook that is presumably linked to better trade sentiment.