The U.S. economy is expected to continue its slowdown in 2019 but not necessarily slip into recession as the trade war between the U.S. and China continues and the fiscal stimulus from the massive federal tax cut begins to fade along with the economic expansion.
The expansion, now in its 10th year, will become the longest ever recorded if it continues into July.
Forecasts for GDP growth in this late-cycle expansion, adjusted for inflation, range from 2.3% to 2.9% for next year, though there are some outliers including Goldman Sachs, which is forecasting U.S. growth closer to 2% next year.
How much the economy will slow will depend in large part on U.S.-China trade relations and Federal Reserve policy.
As of now, the U.S. and China have imposed tariffs on a portion of each other’s exports, but the two nations agreed in early December not to expand their tariffs for 90 days.
To date, the U.S. has imposed tariffs on $250 billion worth of Chinese imports. The White House has threatened to raise the tariffs from 10% to 25% and extend them to cover an additional $267 billion worth of Chinese imports, but refrained when both countries agreed to the time-out. China has retaliated with tariffs on about $110 billion worth of U.S. imports, including Harley-Davidson motorcycles and soybeans, but recently resumed some purchases of U.S. soybeans and cut tariffs on U.S. car imports from 25% to 15%.
“China will probably give way, but all-out protectionism would precipitate a global recession,” writes Gary Shilling in his latest market insights report. In mid-December, representatives from the U.S. and China sparred at the World Trade Organization, blaming each other for the trade war.
Expectations for Fed policy may be less uncertain than those for U.S.-China relations. In its last policymaking meeting for the year, the Fed raised short-term interest rates to a range between 2.25% and 2.5% and lowered expectations to two hikes next year from three previously, along with expectations for slower GDP growth and lower inflation. In his press conference following the rate hike announcement, Fed Chairman Jerome Powell said that the central bank’s unwinding of its quantitative easing asset purchases was on “autopilot.”
The 10-year Treasury note rallied on the news, as its yield fell to its lowest level since May, but the stock market cratered because hopes of no rate hikes next year were crushed.
Median expectations of Fed policymakers call for 2.3% GDP growth, 1.9% headline PCE (personal consumption expenditures), 2% core PCE, which excludes food and energy prices, and a 3.5% unemployment rate.
The Fed now sees the “rising trajectory for growth” that it forecast in early 2018 as “moderating,” said Powell in his press conference. But he noted that the economy in 2019 “may not be as kind” to the Fed’s forecast as it has been this year, suggesting some uncertainty about the Fed’s economic outlook.
In its statement at the conclusion of the meeting on Wednesday, the Fed noted that although “risks to the economic outlook are roughly balanced,” it “will continue to monitor global economic and financial developments and assess their implications for the economic outlook.”
“Given the stock market declines and negative international economic news — recognized in the statement — this still points to quite a bit of confidence at the Fed in the ability of the U.S. economy to withstand a few more rate hikes,” said Brian Coulton, chief economist at Fitch Ratings, about the Fed’s latest move.
Following the Fed’s decision, the yield spread between 2-year and 10-year Treasuries narrowed, to just 15 basis points.
The flattening of the yield curve has caught the attention of economists and strategists because an inversion of the curve — when long-term rates fall below short-term rates — has been a reliable indicator of a forthcoming recession, usually 12 to 18 months later.
The outlook for the yield curve is mixed. On one hand, long-term rates could fall further because of slowing U.S. growth coupled with a search for safe investments by investors concerned about the U.S.-China trade war, Brexit or other potential disruptive developments. On the other, continued economic growth in the U.S. coupled with a growing federal deficit and rising inflation could lead to higher long-term rates.
Some economists like Brett Wander, chief investment officer, fixed income at Charles Schwab Investment Management, aren’t concerned about a slight inversion of the curve. “What’s really meaningful is a significant inversion of 50 to 75 or 100 basis points,” said Wander in a recent outlook call with reporters. “The Fed is still normalizing policy. Don’t overreact to an inverted curve.”
A growing number of economists including Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, and John Mousseau, president and CEO and director of fixed income at Cumberland Advisors, said the 10-year Treasury yield has likely peaked at 3.25%, reached in early October.
“When markets look at this uncertainty, they tend to run to the safety of government debt and not away from it,” saids John Mousseau.
Others like Mark Zandi, chief economist at Moody’s Analytics, says long-term yields could rise as high as 3.5% by this time next year due to another spurt of government spending, from the $1.3 trillion stimulus bill that passed in February, coupled with continued growth and rising inflation as wages rise.
“People are underestimating the stimulus from government spending and the virtuous cycle of low unemployment, a strong economy, rising wage growth, more spending and more hiring,” Zandi said. He added that the growing budget deficit is a “corrosive” for the economy which “matters over the long run,” though not necessarily in the near term. “Like climate change if we don’t change it, it will be a disaster.”
The deficit is expected to approach $1 trillion in fiscal 2019, which ends Sept. 30.
The growing deficit “may act like a wet blanket on the economy next year” but also a catalyst for investors to “run to the safety of government debt and not away from it,” said Mousseau.
Given the backdrop of a slowing economy and rising short-term rates, many bond strategists are recommending that in the coming year investors favor higher quality corporate bonds and Treasuries and avoid more riskier fixed income securities such as bank loans, emerging market bonds and lower quality high yield debt. They generally favor short to medium-term maturities and a few like Jones suggest adding duration as bond yields rise in order to capture the additional yield.
Wander recommends that investors keep in mind the purpose of their fixed income investments — is it to reduce risk in a total portfolio or to collect yield? “Where investors get into trouble is when they become overly aggressive in pursuit of yield,” said Wander. “A 10-year Treasury will continue to be a good hedge stable for of a portfolio and cash should also be part of asset allocation.”