There is a lot of economic and political uncertainty swirling around the global economy right now. And, judging by many of the headlines, you would think we’re on the verge of recession. I don’t believe that’s the case. Instead, I believe the US and global economies are slowing, with recession an unlikely outcome for at least the next six months. But, I believe that slowing will mean more volatility in asset markets, with policy responses by central banks acting as the deciding factor over the medium-term.
So, we could hit recession late in 2019 or 2020. And if we do so, policy errors, so-called over-tightening, by central banks will be a large factor playing into this.
The Barron’s macro view
I laid this out in some detail on Friday. But, at the weekend, I caught Barron’s Matt Klein making some similar points in an article he wrote recently. So I wanted to share some snippets of that piece which are interesting. The title of his piece is Why the Economy Will Muddle Through in 2019.
The likeliest scenario is muddling through. While growth in the past year has been strong, it is also probably temporary. Tax changes passed at the end of 2017 boosted household incomes at the same time the government ramped up military spending. The price of oil rose by nearly 50% between mid-2017 and mid-2018, which increased capital investment in drilling, equipment, and housing for oil workers.
All of those forces are likely to dissipate or reverse next year. Taxes will not get cut again, but several of the 2017 changes are set to expire. The spending increases passed in 2017 were already scheduled to fade by next year, while a divided government is unlikely to approve any additional budgetary expansion. The price of oil, meanwhile, is now back to where it was in mid-2017.
While this would be somewhat disappointing, it would also be a return to the postcrisis norm…
The economy could also go into a recession next year. There are plenty of warning signs from the financial markets. Bank share prices have been hammered. Credit spreads, particularly on the lowest-rated corporate bonds, have widened dramatically. The difference between yields on three-month U.S. Treasury bills and 10-year notes continues to shrink and is now less than 0.5%. A negative spread implies the Fed will soon be lowering interest rates. Since this is how the central bank typically fights recessions, the spread has been an almost-perfect predictor of downturns since the 1950s.
There are also some signs of fragility in the economy. Sales of motor vehicles have been gradually declining for the past three years…
Perhaps most alarming is what is happening to the housing sector…
Weakening cyclical sectors are unlikely to produce a recession by themselves. The danger is that policy mistakes force the issue. While trade is a concern, the bigger downside risk is the Fed.
My take goes back to the Taper Tantrum of 2013
This is all very much in line with my thinking. I agree with pretty much everything there. But, here’s how I would put it.
Back in 2013, the Federal Reserve announced that it would taper its asset purchase program known colloquially as quantitative easing, or QE for short. Some investors were caught out by the announcement. And US Treasury bond yields began to rise. As US yields rose, many emerging market investments suffered because investors felt countries like Brazil, India, Indonesia, South Africa, and Turkey in particular – the so-called Fragile Five – had too much exposure to dollar denominated debt while running large external imbalances. Basically, they were too reliant on hot money flows to finance growth.
Immediately, growth in EM faltered. And starting in mid-2014, oil prices came crashing down as well due to the loss of demand from the emerging markets. Contrary to conventional wisdom, the drop in oil prices was not a boon for the US economy. Instead the swoon led to distress in the shale oil sector and a collapse in capital investment and the loss of thousands of jobs. Growth in the US tanked too.
Now, the Fed was already on track to hike rates multiple times a year when this happened. But, after an initial hike in late 2015, the Fed paused and waited out the weak incoming data – just as they are supposed to do. The Fed was “data dependent”.
When I look back at what I was saying at the time, a month after the Fed raised rates. I went on recession watch, saying this:
I am on recession watch. Recession is not a base case. But it is no longer a tail risk either. Recession in the US is a reasonable worst case outcome for the economy, especially if the Fed continues on a path of interest rate increases. Markets are sending this signal to the Fed right now. And I believe the Fed will probably stand down in March as a result. But that won’t be enough to ensure a positive outcome as prior tightening is still working with a lag.
I think we are at a similar juncture again today.
Timing-wise, this is more 2014 than 2016
The Fed stood down and the economy eventually recovered, as did the oil sector. In fact, the oil patch recovered so much that the US is now the world’s largest producer of oil.
But if you look at the sequence of events surrounding that mid-cycle pause in 2015 and 2016, the triggers for deceleration go all the way back to 2013 and 2014 with the taper tantrum, emerging market slowing and the collapse in oil price. Belatedly, the US felt economic pain as well. But it really wasn’t until 2016 that I became worried about a potential recession.
If I had to make a comparison to now, I would compare 2019 more to 2015 than 2016. It’s not a perfect comparison because the rate hike cycle that paused was in 2016. But the initial capital investment loss was in 2015, following a dip in prices that began in 2014. I think we need to get halfway through 2019 before we could see an analogous outcome in the present period.
So, as we prepare for 2019, I am thinking of 2018, the year we’re in now as more analogous to 2014, when oil prices began to falter than 2016, when growth began to falter. The big difference is that there are additional concerns that we should consider, particularly housing. And because the Fed is already in a rate hike train, monetary policy is more advanced relative to the economic cycle than it was during the mid-cycle pause.
For me, that makes 2019 the pivotal year. The near-term isn’t saying recession, not by a long shot. But still, the potential for a quicker deceleration is greater because more sectors of the economy are faltering, the credit cycle seems to have turned, and the Fed is actively engaged in rate hikes, just as the yield curve is threatening to invert. What the Fed decides to do matters a lot here. I would even call it the decisive factor in 2019.