The current quarter, which ends in less than two weeks, is likely to be as good as it gets for the U.S. economy and possibly the U.S. stock market, according to growing sentiment on Wall Street.

That’s not so shocking when you consider that the economic expansion is on the verge of starting its tenth year and the U.S. bull market in stocks reached that milestone in March.

GDP growth could potentially top 4% in the second quarter, then retreat to end the year with growth between 2.8% and 3%, said Brian Nick, chief investment strategist at Nuveen, relaying the firm’s midyear outlook based on the forecast from its global investment committee. They don’t expect a recession until at least 2020 or 2021, in keeping with the consensus on Wall Street.

But it could come sooner if the Federal Reserve raises rates too aggressively or an asset bubble bursts. To date, there are no signs of either, but Nick Colas, co-founder of DataTrek Research, says worry of a “ ‘Fed mistake’ is gaining real traction,” as the spread between long-term and short-term rate curves narrows.

Fears of an Inverted Yield Curve

The spread “seems destined to go to zero in the next three to six months,” which raises fears of an inverted yield curve followed by a recession, writes Colas in a recent market note.

“Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve,” write economists Michael D. Bauer and Thomas M. Mertens, in a recent paper from the Federal Reserve Bank of San Francisco. A recession could start between 6 and 24 months later, according to the authors.

Nuveen’s Nick is less concerned about an inverted yield curve, contending that long-term rates are artificially low because of foreign buying and the Fed’s still-huge reserves of Treasuries left over from its quantitative easing policy.

His canary in the coal mine for a sharp slowdown is declining business and consumer confidence along with weak or negative guidance on second-quarter earnings calls.

The Dangers of a Trade War

A trade war could be the catalyst for such a drop in confidence, and the odds of a trade war are increasing daily in sync with President Donald Trump’s threats for additional tariffs against U.S. trading partners.

“It would take a lot to derail the expansion, but an across-the-board hike in tariffs on U.S. – China trade could do it,” writes Mark Zandi, chief economist at Moody’s Analytics, in the firm’s latest monthly outlook report.

He continues:

“The U.S.-China trading relationship is the largest in the world, with Chinese imports to the U.S. running at more than $520 billion per annum — more than one-fifth of total U.S. imports. U.S. exports to China total more than $130 billion — close to one-tenth of total U.S. exports. A 10% tariff hike on this trade probably would not fully undermine the expansion …. Yet the fallout on business and investor confidence would surely be substantial as they contemplate the broad implications.

“A U.S. recession seems all but certain if there were a 25% tariff hike on all U.S.- China trade. The resulting increase in import prices and decline in exports would overwhelm the U.S. economy, particularly since the entire global economy and financial markets would also be reeling. This scenario is one of mutually assured global economic destruction.”

To date, the Trump White House has announced 25% tariffs on imported steel and 10% on imported aluminum from the European Union, Canada and Mexico and 25% tariffs on $50 billion worth of Chinese imports that will start July 6, and China has responded in kind. In addition, this week Trump threatened 10% tariffs on an additional $200 billion worth of Chinese imports and, if China responds in kind to that, tariffs on another $200 billion worth of Chinese imports. If all the proposed and threatened tariffs were implemented, they would impact over 85% of Chinese imports into the U.S.

U.S. stocks have had mixed reactions to the escalating trade tensions, with sharp declines one day followed by healthy gains or small gains the next. Stronger earnings, corporate tax cuts underpinning those earnings and a moderately strong economy have been supporting U.S. stocks, and those factors are expected to continue for the remainder on the year. But beyond that, slowing growth, continued rising interest rates and a budget deficit poised to top $1 trillion by 2020 as a result of $1.5 trillion tax cut and $300 billion increase in federal spending are expected to weigh on growth and U.S. stock prices.

Former Fed Chairman Ben Bernanke recently said the U.S. economy was setting up to “go off the cliff” in 2020 like Wile E. Coyote, the cartoon character, because Congress will have little room to borrow money to fight the next recession given the high levels of debt due to stimulus programs coming at “the wrong moment,” when unemployment is at historical lows.

Nuveen’s investment committee says the tax cuts on businesses and individuals coupled with an increase in government spending pulled growth forward, setting up for a downturn coming sooner than would happened otherwise.

How Investors Should Be Positioned

Given this outlook for relatively strong growth and earnings this year followed by a deceleration in both, investors have a choice to make, says Nuveen’s Nick: reduce expectations if you don’t want to adjust risk levels higher or take more risk in the hopes of higher returns.

The firm’s investment committee is leaning toward the latter, recommending higher quality assets overall, including bonds with less credit and rate risk, as well as diversification between and among asset classes, including real estate. “Dial back on goals,” said Nick. “Don’t count on excellent returns for the next 10 to 20 years.”

Michael Fredericks, head of Income Investing for the Blackrock Multi-Asset Strategies Group, says investors “have to be very specific in this market about how much risk” they’re taking.

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