While fiscal stimulus should provide near-term support, labor market conditions, Fed policy and trade uncertainty add complexities.
January 2, 2019
To read the full article from Chief Economist Scott Brown, see the Investment Strategy Quarterly publication linked below.
If the current economic expansion continues past June, it will become the longest expansionary period on record. So, many investors ask, when will the next recession occur? The likelihood of entering a recession, a period of declining economic activity, usually lasting two quarters or more, does not depend on the length of the expansion. That is, we are never “due” for a recession. There are few signs of a pending economic downturn on the immediate horizon, but economists have raised the odds of a recession beginning in late 2019 or 2020 – still not likely, but also not out of the question.
The Tax Cuts and Jobs Act of 2017 (TCJA) lowered the corporate tax rate and many economists remained doubtful of the impact it would have on the economy since firms were generally flush with cash and borrowing costs were low. Research has shown that corporate tax cuts are more likely to increase share buybacks and dividends than to fuel capital expenditures and, for the most part, that was the case in 2018. However, business fixed investment, while uneven from quarter to quarter, was generally stronger.
The other component of the TCJA was reductions in personal tax rates, which will expand in early 2019. While the impact will vary across income levels and regions, overall consumer spending, which accounts for 68% of overall economic activity, should see a boost in the first half of the year as a result. The impact of fiscal stimulus will fade over time, but job gains and wage increases are expected to drive consumer spending.
The Labor Market
The labor market continued to tighten in 2018, with job growth trending well above the pace needed to absorb new entrants to the workforce. The unemployment rate continued to fall, yet employers cited difficulty in finding skilled labor. Wage growth has picked up, and can be expected to rise further in 2019.
While investors continue to look to commodity prices as an early indicator, the labor market is the widest channel for inflation pressure. The Fed’s dilemma lies in the possibility that there may be more labor market slack than is generally believed. A tighter job market and rising wages should lead to a more efficient allocation of labor, reduce underemployment, and provide younger workers with opportunities to acquire important job skills. However, if firms are able to pass higher costs along, consumer price inflation will trend higher – and the Fed will have to work harder to suppress inflation.
The Fed continued to gradually move short-term interest rates toward a more normal level in 2018, and in the second half of the year began debating the risks of a policy error. Monetary policy affects the economy with a long and variable lag, so the Fed needs to account for the impact of previous actions. Policy decisions will remain data dependent, meaning how the incoming information affects the outlook for growth and inflation.
The Fed raised short-term interest rates once a quarter in 2018, but is likely to be more cautious with raising rates in 2019. The Fed has continued to reduce the size of its balance sheet, letting a certain amount of maturing Treasury securities and mortgage prepays roll off each month. The Fed views this as “background,” not “active” monetary policy. All else being equal, the unwinding of the balance sheet may add 50 basis points (0.50%) to long-term interest rates, but over a period of three years or more.
Inflation moderated in the second half of 2018 and Fed officials are more concerned with future inflation than past inflation. The low trend heading into the new year should allow the central bank more leeway in deciding how quickly to raise short-term interest rates. Starting in 2019, the Fed chairman will conduct a press conference after every monetary policy meeting (eight times per year), rather than after every other meeting.
Trade policy will be a major uncertainty in early 2019. Tariffs on Chinese goods were set to expand at the start of the year, but that has been postponed, allowing more time for negotiations. It’s unclear whether an agreement will be reached. An escalation of trade tensions would further disrupt supply chains, add to inflationary pressures, and dampen overall growth through retaliatory efforts abroad. The worst-case scenario, in isolation, would not be enough to cause a recession – but it would likely restrain growth to some extent, possibly offsetting the impact of the fiscal stimulus.
Fiscal Stimulus and the Budget Deficit
The tradeoff to fiscal stimulus in 2019 is a larger federal budget deficit. Recall that the deficit rose to $1.4 trillion, 9.8% of GDP, in fiscal 2009, reflecting the severity of the 2008-09 recession, but then fell to 2.5% of GDP in fiscal 2014 as the economy recovered. The deficit is now expected to approach $1 trillion in fiscal 2019, about 4.6% of GDP.
Additional pressure will arise as the aging population will continue to boost spending on entitlements (Social Security and Medicare) in the years ahead and higher interest rates will add to the government’s interest expense. If we don’t reduce entitlements and defense spending, there’s not a lot left to cut. Nondefense discretionary spending is a little over 3% of GDP.
Tough choices lie ahead. There’s no reason to believe that the national debt is a burden to our children and grandchildren. It doesn’t have to be paid off. The key issue is whether the U.S. can service its debt and roll over existing debt as it matures. No problem there. However, prudent management of the budget would require lawmakers to work to stabilize the debt-to-GDP ratio over time.
“This Time Is Different?”
All else being equal, a strong economy, the Fed’s unwinding of its balance sheet, and the increase in government borrowing should put upward pressure on bond yields, yet long-term interest rates have remained moderate, due in part to global rate disparity and demand. The slope of the yield curve (the difference between long- and short-term interest rates) is, by far, the best single indicator of a pending recession. The flattening of the yield curve was a significant concern for investors in 2018 as it typically signals increased uncertainty about where the economy is headed. We could see an inversion of the yield curve in 2019, which has historically signaled that a recession is on the way. Some economists, and even a few Fed officials, have suggested that “this time is different,” as there are a variety of factors keeping U.S. bond yields low including the fact that long-term interest rates remain low outside of the U.S. We’ll see.
Economic growth was strong in 2018, but beyond a sustainable pace. We know this because the unemployment rate fell, which clearly can’t go on forever. The transition to a slower, more sustainable pace of growth may be a challenge for investors, as such transitions are rarely smooth. However, the economic expansion should continue.
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