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 Dec. 19. 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 realize 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 stabilize 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 labor market leads to companies bidding against each other for labor 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/media/3531