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An Overheated Economy?

November 16, 2018

Despite the laundry list of potential threats to the economy—from political turmoil to trade disputes, inflation, and tighter monetary conditions—most market prognosticators and economists see continued strong financial conditions in 2019.

Confidence in the ability to ‘climb the wall of worry’ is, after all, supported by a strong backdrop. Look no further than the labor market, with monthly new jobs exceeding 200,000 for much of 2018 and the unemployment rate below 4 percent.

But a chorus of bullishness, supported by strong trend data points—from upbeat business sentiment to capacity utilization and the Institute for Supply Management—have preceded past recessions. And that includes the most recent two (2008 prompted by overheating in the housing market and 2001 by the dotcom bubble).

Ultimately, it’s not about whether or not a recession will come, but instead what will cause it or when it will happen. And with the recovery approaching 10 years, those looking at business plans must have on the top of their mind: Could a slowdown come this year?

First, let’s start with the bright spot of labor. While the return to ‘full-employment’ hasn’t seemed to cause a significant increase in wages (and correspondent fears about inflation), a spike from here could be looming. Even with a low so-called ‘participation rate’ (or the percentage of working age people either working or actively looking for work), the labor market is getting tighter. In fact, one of the biggest risks to the jobs market is low labor force supply. The biggest problem businesses are facing going forward is finding workers to fill jobs—and finding the skilled and educated workers they need to drive their businesses forward.

Second, tax reform (i.e. significant fiscal stimulus).

Given that loose monetary policy (and record-low interest rates) has been the market stimulant over the course of this recovery, the importance of gradual interest rate increases from the Federal Reserve will be key so as not to jolt markets. And while the rhetoric of Jerome Powell, who took over as Fed Chair at the beginning of 2018, has been generally dovish in tone, fiscal policy presents a wrinkle. Powell has noted that fiscal stimulus (and its accompanying growth) could prompt faster rate hikes. After all, the tax cuts passed at the end of 2017 ($1.5 trillion of fiscal stimulus) came at a time of already-strong growth.

That matters, because if more rapid increases seem necessary at a time when the core fundamentals of the economy aren’t sustainably strong, it could lead to what’s known as an “inverted yield curve,” which has preceded every recession since World War II.

This phenomenon, which occurs when interest rates on short-term debt (represented by the 3-month Treasury and largely determined by the Fed) are higher than those on long-term debt (represented by the 10-year Treasury and determined by the marketplace based on overall economic outlook), is an indication of economic weakness.

So while the fiscal stimulus has seemed to push the economy from late-cycle to mid-cycle, it could portend a downturn. A starker change in rates could be particularly impactful to the U.S. given that the eurozone and Asia are holding to a zero-interest rate policy.

Third, the risks surrounding a façade of strength. GDP, on track to hit 3 percent for the year, is largely driven by fiscal stimulus (i.e. tax reform) as opposed to strong underlying core demand. So again, if the Fed feels compelled to raise interest rates more rapidly to keep up with current growth (of which a good portion is a façade), the lack of sustainability of that growth (particularly when the fiscal stimulus ends) poses a risk.

Fourth, the looming trade threat: Trump has increasingly focused on protectionist policies when it comes to trade. His NAFTA renegotiation seems to point him to, again, going after China.

Near-term, higher tariffs threaten to hurt the economy through higher prices of imported goods. After all, tariffs act like a tax which puts downward pressure on the purchasing pressure of American consumers.

Additionally, there is a significant risk of a trade war, or retaliatory (“in-kind”) tariffs in response from other countries, and this would be particularly harmful to U.S. multinationals that have large portions of sales internationally (30 percent of the revenues for S&P 500 companies come from outside of the U.S.).

Trade tensions are already impacting the M&A market, with certain deals in the technology sector being called off and essentially putting a halt to many international deals in that sector, at least for the time being.

Plus, any slowdown in China affects us at home. The interconnectedness of the global economy means that it is in the interest of the U.S. for other countries to grow. China’s economic health is key to the global system, given the spending power and rising middle class. And if demand slows there significantly, it affects the U.S. For China, economists worry about a “hard landing” (versus more manageable easing) following years of high GDP.

Jim O’Neill, the former Chief Economist at Goldman Sachs who is famous for coining the term “BRIC” (Brazil, Russia, India and China), identified two decades ago the increased importance of these regions in the new global order and interconnected global system.

And fifth, there are fewer tools in the ‘tool kit.’ In other words, when a recession hits, there are less levers to employ to stabilize the economy. While the Federal Funds Rate has come off its zero percent level, it remains far below the five percent level in 2007. Meanwhile, the higher deficit—which is expected to reach $1 trillion by 2019—means there is less insulation if a stimulus package (like the 2009 American Recovery and Reinvestment Act) is needed.

The Bottom Line

The fundamentals of the U.S. and global economy are strong, creating a solid foundation for the market in 2019. However, questions around the sustainability of the economic growth at this point in the cycle, create some preliminary warning signs for a recession.

In the meantime, there is no question that the market has continued to climb the so-called “wall of worry” and shows no immediate signs of a shift from that trend. The economic recovery cycle has indeed been extended – the question is just for how long.