The US: From Slowdown to what?

Virtually every economic indicator confirms that the US economy has slowed over the last year. Pessimists extrapolate a further slowdown with the risk of a recession. Most optimists don’t really see any pick-up likely but expect the economy to putter along steadily, at around 1.5-2.5% growth, rather than continue to slow. I am in this camp because I can’t see the conditions for a recession yet, at least not without a new shock. Confidence among CEOs of large companies is down but for small business and consumers it remains high. Still, it is worth bearing in mind that the economy is more vulnerable to a shock now than it was a few years ago, simply because we are in the Late Upswing stage of the cycle.

Whether it is payrolls, purchasing managers’ indices, housing starts, car sales, capital goods orders or retail sales, or pretty much every indicator, the data are weaker than a year ago. Friday’s payrolls release surprised the market on the upside though it really shouldn’t have. Sub-100k numbers during this upswing have nearly always been followed by a strong number. That said the 3-month moving average at 171k confirms a clear slowdown from 2018 levels averaging 235k (which were boosted by the tax cuts) but remains in line with previous dips seen during this upswing and is still pretty good. The leading indicators index also confirms the slowdown though, crucially, shows no sign of an outright decline. Indeed, if anything it has picked up slightly since the winter.

Pessimists see a further slowdown. But what is the logic? It seems they are just extrapolating a continuation of the trend. Bear in mind that any analyst who predicts a recession now expects to be a hero if one turns up in the next 18 months but their prediction will tend to be forgotten otherwise. I find the ‘sinking into recession’ story due to declining confidence implausible. We can explain the economy’s strength in 2017-18 by the tax cuts helped by strong growth in China and Europe. All three have gone away but taxes haven’t risen and China and Europe are still growing (just slower).

US fundamentals still look pretty solid. Confidence among CEOs of large companies is down but small business confidence remains very high. So does consumer confidence. This is not surprising given that jobs are plentiful and incomes are growing, albeit modestly. President Trump’s trade war receives a lot of attention and certainly affects the thinking of many big companies, but not so much small companies. Weaker growth in China and Europe feeds through, but the US is not really driven by exports. Domestic consumer spending and investment are key. And the Fed is acting seriously dovish, which has allowed interest rates to fall sharply this year and for the stock market to recover its poise even if it hasn’t risen much beyond last October’s level.

In my view it would take a new shock to cause a recession now. There are a couple of potential candidates from the political side. One is a major confrontation with China such as for example a complete breakdown of trade talks or intense conflict over some geo-political issue. But neither side wants this. Another candidate is a blow-up into full-scale war in the Middle East which interrupted OPEC oil supplies. The pressure on Iran is intensifying which could lead to trouble but Iran does not want a war.

It is not so easy to see any strong candidates on the economic side. The US does not have wild exuberance in property the way it did in 2004-7. The mood is subdued rather than exuberant. Nor does it look as though there is massive over-extension on mortgages or derivatives the way there was in 2007. Meanwhile the financial system is much better-capitalised now and more cautious. I have some concerns about high levels of corporate debt particularly at the BBB level. This could mean that any trend to downgrades could quickly cause a big sell-off as investors limited to investment grade debt are forced to unload. There has also been a large issuance of collateralised loan obligations in recent years, with increasingly weak covenants. Much of this is held by hedge funds and pension funds rather than banks so the systemic risk is limited. Still, if these markets dried up for new issues then weaker and smaller companies would find it harder to raise capital.

If we do suffer an unexpected big shock, the economy is more vulnerable now, in the Late Upswing stage, than it would have been before 2016 (roughly the transition year between the two stages). This is for two main reasons. First, pent-up demand for cars, houses and business investment have been satisfied for most, so business and consumers are more likely to pull back sharply. Secondly, while financial fragility is not high enough to cause a recession on its own (as in 2007-8) it has advanced since 2016 which adds to the vulnerability.

But the pessimists are not arguing for a big shock to cause a recession. Their concern is that everyone will turn more cautious at the same time, consumers and business alike, turning a slowdown into recession. But I don’t see consumers doing this. Most don’t see past their own prospects which look as good or better than they have for 10 years. And those who look at the stock market are not going to be discouraged (though admittedly that can change very quickly as we saw last Fall).

Is there any chance of the economy re-accelerating, with a swing back to high confidence and potentially over-exuberance? It is hard to see that at present but this is exactly what often does happen in the Late Upswing stage of the cycle. Perhaps, if the trade issues really do get resolved, Brexit passes without too much trouble and, simply, everyone stops worrying, that could happen. If exuberance does return, expect faster growth for a year or two but then that would probably mark the end of the upswing as inflation takes off and the Fed responds.

But another big tax cut is not on the horizon, nor is a major boost to infrastructure spending, which anyway would take years to implement. Meanwhile the US/China trade dispute is more likely to be long and drawn out rather than be solved with a major deal. Indeed, even if it was, many analysts think President Trump might then pick a fight with Europe so anxiety about trade and globalisation now seems to be part of the environment, not just a temporary uncertainty.

So I conclude that a recession is unlikely at present barring a completely new shock. In that event then beware, because at this stage of the cycle, the upswing is more at risk than if it had happened in the Early Upswing stage. But the most likely outlook is that the upswing keeps going for a while, possibly accelerating again at some point for one final burst of fast growth. Its not a bad outlook for the next couple of years.