Stay of execution: Will the Fed's rate pause breathe more life into the U.S. expansion?
As we head deeper into the year, the U.S. economy continues to grind slowly forward despite trade concerns and Brexit worries. Markets have rebounded from their Christmas Eve lows, and the Fed has signaled that rate hikes are on hold for several months. Does this mean the all-clear has been sounded?
No. Our view is that the U.S. remains late in the economic cycle — and that the economy is still likely to roll over into a recession in 2020. While perhaps a little later than originally anticipated, the risk of an economic slump by the end of next year remains high, in our opinion. Why? Let’s start by taking a look back at the events of last December — a December better left un-remembered, in the minds of most.
2018’s wild December: The catalyst for the Fed’s rate pause
There’s a saying in our industry: economic expansions don’t die of old age, rather they are murdered … usually by the U.S Federal Reserve (the Fed). Late last year, it seemed that this old saying would come true again as the Fed continued to increase interest rates, hiking for the ninth time in three years on the 19th of December. The result of this tightening monetary policy was a flattening U.S. Treasury yield curve, with the yield curve threatening to invert in the immediate future. Yet, at the time, it seemed likely that given the ongoing strength of the U.S. economy, the Fed would continue to raise rates regularly, regardless of any possible inversion.
Then, something happened. Late in the fourth quarter, the strong economic data that powered the market for most of 2018 started to show weakness. This was punctuated by a significant drop in CEO confidence levels1, as companies faced the stark reality that the spectacular earnings growth of 2018 would slow dramatically as tailwinds from the late 2017 tax cuts faded. The market also began to realise that the very strong above-trend GDP (gross domestic product) growth rates of 20182 would face similar declines in 2019 as the effects of the fiscal stimulus package passed by Congress in February 2018 dissipated. The result? Underlying surveys of the economic landscape — such as the Institute for Supply Management’s Manufacturing Index and Purchasing Managers' Index (PMI® ) — plummeted, and consumer confidence fell in December.3
The good news? This weakness was not lost on the Fed. Early in January, Chairman Jerome Powell assured the market that the Fed was watching the numbers, and that weaker economic data would likely lead to a pause in interest-rate increases by the central bank. Markets celebrated the Fed’s forbearance, with the Russell 1000® Index climbing 8.38% during January. This marked yet another example of how bad economic news can be good news for equities — at least in the short term. In this particular instance, the reason for the market rally is straight-forward: if the Fed is going to pause its tightening regime, then it becomes less likely that the central bank will outright murder the economic expansion.
But, is this really good news? And how long will the stay of execution last?
It’s not just the Fed: Slumping confidence can also spark a recession
From the vantage point of the market, a Fed-induced recession appears to be the most likely way the next U.S. economic downturn will set in — but it’s not the only scenario. Negative sentiment can trigger a recession as well. Why? If everyone thinks a recession is likely to occur, consumers will begin spending less, stowing away more of their earnings for the rainy day to come. This, in turn, chips away at economic growth — especially in the U.S., where consumer spending drives roughly 70% of the economy.4 Companies, in turn, begin doing the same — squirreling away more of their income rather than re-investing it in new hires or business growth opportunities. Such a cycle can eventually snowball into a recession.
Will the U.S. escape a recession this year?
At Russell Investments, we believe that the soft spot in economic data we saw around the turn of the year will stabilise to generate a GDP growth rate of 2.25% for the U.S. in 2019. Recently released economic data also indicates that this is the path the economy is on this year. Does this mean we’re out of the woods when it comes to a U.S. recession in 2019?
Our answer: Not necessarily.
The key issue that continues to loom over the U.S. — and future Fed monetary policy in particular — is the nation’s extraordinary low unemployment rate, which is hovering at levels not seen since the 1960s.5 This means there are very few qualified candidates for the approximately 7 million current job openings.6
Generally, this tight of a labour market leads to companies bidding against each other for labour by raising employee wages. This competition for jobs tends to drive up wage inflation, as illustrated by the approximate 3% rise in year-over-year wage growth in the U.S.7 For point of reference, the Fed has an inflation target of 2%. This growing wage pressure makes it likely, in our minds, that the Fed will be forced off the sidelines in the not-too-distant future to once again raise interest rates to combat this potential source of inflation.
We see this happening later this year, perhaps as soon as the Federal Open Market Committee (FOMC)’s meeting in June or September. Should this occur, we believe a yield curve inversion would likely follow — and the recession countdown clock would begin to tick down.
On average, a recession follows a yield curve inversion by 14 months. Going by this measure, that would place the start of the next recession in the third quarter of 2020. However, as recent research by the San Francisco Fed shows, recessions have followed yield curve inversions by as little as six months.8 While that represents the extreme short-term end, if such a scenario were to repeat, the U.S. could fall into recession by December of this year.
All that said, at this point, we believe the third quarter of 2020 is the most likely start of the next recession — but it goes without saying that the Fed’s actions over the next several months bear close watching.
Because in the end, the story will likely conclude with: The Fed did it.
1 Source: https://www.vistage.com/research-center/wp-content/uploads/2019/01/WSJ-CEO-Survey-1218.pdf
2 Source: https://www.bea.gov/
8 Source: https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
The information on this website is only intended for use by professional clients, regulated financial advisers and intermediaries who are knowledgeable and experienced in the financial services market and in investment products of this nature. If you are a retail or individual investor then please leave this website immediately and consult your financial adviser.
You should not use this website unless you understand its nature and the extent of your exposure to risk. You should also be satisfied that the website and investments are suitable for your client in light of their circumstances and financial position.
The information contained on this website is for information purposes only and you should not take it as constituting an offer, solicitation, inducement, commitment or invitation to subscribe for or to purchase, sell or hold any interest in any of the investments mentioned herein.
This website is not intended for distribution or use by anyone in any jurisdiction in which such distribution or use would be prohibited. Nothing on this website or in the materials referred to therein constitutes, or is intended to constitute, financial, tax, legal or other advice.
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested. Any past performance figures are not necessarily a guide to future performance.
The website may contain forward-looking statements, which are based on a number of assumptions regarding present and future business strategies, which may or may not prove to be correct. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. Forward-looking statements are not guarantees of future performance.
Issued by Russell Investments Limited. Company No. 02086230 and Russell Investments Implementation Services Limited Company No. 3049880. Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone +44 (0)20 7024 6000. Authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London E20 1JN.
All reasonable care has been taken by us to ensure that the information contained on this website is accurate at the time of publication. However, we accept no responsibility for the accuracy, adequacy or completeness of the information and materials contained on this website and expressly disclaim liability for errors or omissions in such information and materials. We and our respective affiliates do not have any obligation to update the information contained in this website and reserve the right to change these terms and conditions at any time, without notice.
We will not regard you or any person who accesses this website as our client in relation to any of the investment products or services detailed therein, unless expressly agreed.