The Outlook: April 2019 economic commentary

Commentary
 


Is a US recession imminent?

The US is on the cusp of celebrating a notable economic record. If the current phase of economic expansion continues past July 2019, it will become the nation’s longest ever. Against this backdrop, and with the global economy having slowed markedly over the last year or so, observers have become increasingly vigilant to factors which could herald a recession in the world’s largest economy.

There is little doubt that the US economy has slowed in recent quarters. During the second quarter of 2018, annualised growth reached a near 4-year high of 4.2%, boosted in part by the Trump tax cuts. However, the fading impact of fiscal stimulus, along with tighter monetary policy from the US Federal Reserve (the Fed) and the negative ramifications of the US-China trade conflict have since contributed to a softening in growth. GDP, or growth domestic product, growth slowed to an annualised 2.2% in the fourth quarter, and is on track to ease below 2% in the first quarter of 2019.


The issue for investors is whether this moderation represents a ‘soft landing’ to a more sustainable pace of growth, or the start of a more worrying downturn which ends in recession. Although recessions can have different causes, the culprit is often monetary policy. A typical chain of events sees a central bank raising interest rates in order to curb inflationary pressures that have built up as economic slack diminishes. The central bank lifts interest rates too high, raising borrowing costs for businesses and consumers, thereby prompting a fall in demand which causes the economy to contract. In addition, higher interest rates might cause a housing or stock market bubble to burst, which in turn might depress spending and prompt a credit crunch, tipping the economy in to recession.

 

A warning from the yield curve

This then begs the question as to whether the Fed has overtightened policy during the current cycle. Some observers cite recent trends in the so-called ‘yield curve’ as evidence that it has. As we have discussed previously, an inversion of the yield curve – when long-term yields on US government bonds fall below short-term yields – has preceded every US recession since 1956 (see our July 2018 commentary). Concerns over an imminent recession have been heightened by the recent dip in to negative territory of one measure of the US yield curve. At the end of March, the yield on the 10-year US Treasury bond briefly fell below that on the 3-month equivalent (see chart below from the Federal Reserve Board of St Louis).

US 3m 10 yr yield curve

Although the recession warning from the yield curve should not be dismissed out of hand, there are good reasons why we should not be too concerned by recent developments. Firstly, the recent inversion of the 3-month to 10-year yield curve was only brief and shallow – a prolonged yield gap of more than 50 basis points would be more worrying. In addition, the historic lag between the yield curve inverting and the onset of recession has been variable and long, typically between eight and 22 months.

 

Furthermore, as we have noted before, several factors are weighing on long-term bond yields that might be dulling the predictive capacity of the yield curve. Central bank holdings of government bonds following post-crisis quantitative easing (QE) programmes, along with low/negative interest rates in the eurozone and Japan are keeping a lid on long-term yields. Post-crisis regulation and ageing populations have also boosted demand for government bonds from banks and pension funds alike. Central bank credibility, along with globalisation and de-unionisation have resulted in a structural downshift in inflation expectations.

 

A more dovish Fed

Moreover, even after four rate hikes in 2018, real US interest rates are still relatively accommodative. After adjusting for core inflation (2.0% in March), the Fed’s policy rate stands at around 0.5% in real terms. Analysts at J.P. Morgan point out that none of the last eight US recessions started when the real Fed Funds rate was below 1.8%.

 

Fed policymakers have turned decisively more dovish in recent months, and at their March meeting signalled that they no do not expect to hike rates any further in 2019.  With the Fed apparently no longer intent on mechanically hiking rates in response to firmer wage growth, while also seemingly content to tolerate a period of above-target inflation to compensate for earlier undershoots, the risk of a near-term ‘policy mistake’ that pushes the economy in to recession has arguably diminished. The Fed has also signalled that it will terminate its programme of quantitative tightening – i.e. running down its holding of bonds – in September.

 

In addition, there has been little evidence that lenders are restricting the flow of credit to the economy. An inverted yield curve can act as a disincentive to credit creation on the part of commercial banks, whose business models rely on borrowing short-term and lending long-term. However, there has yet to be any meaningful tightening in lending standards, and bank lending to businesses is currently growing at a 10% year-on-year pace. In the corporate bond markets, credit spreads widened out during the market volatility at the end of 2018, but have since narrowed considerably and are not far off post-crisis lows.

 

A 2019 recession looks unlikely

Other economic indicators which have previously provided an early warning sign of pending recession are not flashing red. Rising borrowing costs and changes to the tax benefits of home ownership resulted in a softening in the US housing market through 2018, but the fall in mortgage rates over the last five months has recently ushered in some firming of the data. The labour market generally remains strong, with the number of Americans filing applications for unemployment benefit recently dropping to its lowest level since 1969.

There are of course risks. This year’s global equity market rally has partly been based on the assumption that a US-China trade deal will be agreed. Any disappointment on this front, or a flare up in US-EU trade tensions, could knock markets back and jeopardise the emerging stabilisation in the global manufacturing sector witnessed in recent weeks.

A spike in the oil price could also dent real incomes and hit consumer spending. However, given the increased importance of the US shale oil industry in recent years, the impact of movements in the oil price on economic activity has become more ambiguous of late (see our April 2018 commentary). 


On balance, the narrative for 2019 should be one of the US economy slowing to a more sustainable pace rather than descending in to outright recession. The current expansion seems well placed to enter the record books as the longest ever. 

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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