18th February 2020
Economic Outlook: The US Offers Stability with a Chance of Slowdown
By Scott J. Brown, PhD, Chief Economist, Raymond James
The US economy is expected to expand moderately in 2020
Many of the 2019 uncertainties seem likely to continue into the first half of the year, but the downside risks to the growth outlook appear to be less worrisome than they did in the summer last year. Consumer spending is likely to grow at a moderate pace, supported by job gains and wage growth, but limited by slower growth in the labour force. Business fixed investment is likely to be mixed and somewhat restrained, but we ought to see some general improvement. Federal Reserve (Fed) policy is expected to remain on hold until we get a material change in the economic outlook.
Job growth, while uneven, slowed in 2019, reflecting a tighter job market. Firms continue to report difficulties in finding skilled workers. The unemployment rate fell to a 50-year low. Demographic changes (an ageing population, slower growth in the working-age population, reduced immigration) imply that the workforce will grow at about 0.5% per year over the next ten years, slower than in previous decades. Workers are also consumers, so the potential upside on consumer spending growth is likely to be limited (labour force growth of 0.5% plus productivity growth of 1.0-1.5% gets you a potential GDP growth rate of 1.5-2.0%).
Tight labour markets have led to upward pressure on wages. Over the years, reduced union membership and a greater concentration of large firms have shifted wage bargaining power from workers to businesses. Skilled labour shortages have boosted wage gains for key employees, but firms have also used non-wage incentives to attract and retain workers, including signing bonuses and offering more vacation and other perks. Cost containment remains a key theme for corporate America.
Headwinds on the horizon
Business fixed investment weakened in 2019. Corporate tax cuts failed to deliver as advertised, and economists were surprised by the degree of the shortfall in business investment. A decrease in energy exploration and problems at Boeing restrained capital spending in 2019 and the halt in the production of the 737 Max will be a drag in the first half of 2020. Trade policy uncertainty and slower global growth, the two negative factors most widely cited across manufacturing industries, may continue to some extent. In contrast to consumer confidence, which has remained elevated, business sentiment weakened in 2019.
Trade policy uncertainty and slower global growth, the two negative factors most often cited across manufacturing industries, may continue.
While a full trade agreement that rolls back tariffs appears unlikely, there is hope for a truce in trade tensions between the US and China (i.e., an agreement not to escalate). However, there is a danger of a further separation of the world’s two largest economies, and protectionist sentiments have risen around the world. Tariffs raise costs for US consumers and businesses, invite retaliation, disrupt supply chains, and undermine business investment. Moreover, the administration has weakened the World Trade Organization, the arbiter of global trade disputes. Ahead of the 2020 election, there ought to be incentive for President Trump to put trade issues behind him. However, bashing China (and others) on trade plays to his base, and some of the Democratic contenders have adopted similar anti-China rhetoric.
Recession odds: from rising to retreating
A simple yield curve model of recession suggests about a 25% chance of a downturn within the next 12 months, down from 40% in August, but still a little too high for comfort. The main risk is that the factors that have restrained capital spending will worsen, leading to reduced hiring and increased layoffs, but there are currently few signs of a deterioration in labour market conditions. Consumer debt appears manageable, but business debt has risen significantly (especially for those with greater credit risk, which could make a downturn worse). Investors should focus on corporate layoff intentions and job offerings, two early indicators of labour market conditions.
It is a presidential election year, so political uncertainty will be a factor in 2020. The Democratic platform is expected to centre on universal healthcare, climate change, income inequality, tax policy, and antitrust/monopoly regulation – any of which would have repercussions for certain corners of the financial markets. Over the course of the year, investors may begin to fear change in Washington, but it is unlikely that the Democrats will gain a 60-seat supermajority in the Senate, making it extremely difficult to raise taxes or to shift the regulatory environment significantly.
Outside of the US, the advanced economies face the demographic challenges of ageing populations and slower growth in workforces. Disruptions from Brexit are a risk. Emerging economies were weaker than anticipated in 2019, but are likely to pick up in 2020. These countries face the same demographic challenges as the advanced economies. However, many have made significant strides in education and have more room for improvement in living standards. Over the last decade, emerging economies have become increasingly sensitive to US Federal Reserve policy. The Fed’s 2019 rate cuts will help. China’s current problems go far beyond trade policy issues; growth has been fuelled more by debt in recent years, there has been a greater reliance on state-owned enterprises, and the Chinese economy appears to be less sensitive to fiscal and monetary policy stimulus.
The Fed holds that its monetary policy is well-positioned to support economic growth, a strong labour market, and near-2% inflation in 2020. However, the Fed remains ready to deploy further monetary support should economic data deteriorate further.
US bond yields have been held down by low long-term interest rates abroad. Some increase in US bond yields is likely in 2020, reflecting somewhat higher bond yields outside the US, but probably not much given that inflation is expected to remain relatively low. Firms have generally had difficulties in passing along the added costs of tariffs and higher wages. The Phillips Curve, the trade-off between the unemployment rate and inflation, appears to have flattened significantly, largely due to well-anchored inflation expectations. Consumer price inflation, as measured by the deflator for personal consumption expenditures, has consistently been below the Fed’s 2% goal in recent years.
Fed policy well positioned
The Fed raised short-term interest rates in 2018 as part of its policy normalization. In December 2018, officials thought that monetary policy was still accommodative and most expected one or two further rate increases in the year ahead. Instead, the Fed lowered the federal funds target rate range three times in 2019 (to 1.50-1.75%) as it reacted to increased downside risks from trade policy uncertainty and slower global growth. These cuts were viewed largely as insurance against downside risks in 2020. Fed officials believe that monetary policy is currently well-positioned to support economic growth, a strong labour market, and near-2% inflation in 2020. No change in rates is anticipated through the first half of the year, but the Fed will respond if conditions warrant (that is, if we see deterioration in the labour market). The Fed values its independence and its policy decisions will not be influenced by political pressure.
The Fed was unwinding its balance sheet at the start of 2019, but expected to end that in October. In February, the Fed shifted its balance sheet policy framework from a specified size goal to one of maintaining an adequate level of reserves in the banking system and anticipated that the balance sheet would eventually expand in line with that goal. The Fed ended the unwinding of the balance sheet in July, three months early. In September, a squeeze developed in the repo market. The Fed stated that this was a technical issue, but the central bank seemed caught off guard and followed up with efforts to ensure liquidity in the money markets into early 2020.
In contrast to consumer confidence, which has remained elevated, business sentiment weakened in 2019.
In 2019, the Fed made a comprehensive review of its monetary policy strategies, tools, and communication practices. This review included academic conferences and town hall meetings. Some changes may be announced in 2020, but probably nothing major. One possibility would be a ‘catch-up’ policy, where inflation would be allowed to move above the 2% target for some specified period if it had fallen below 2%. However, comments from officials make this doubtful. The Fed has also been reviewing its strategies for fighting a recession. The Fed normally lowers the federal funds target rate by 500 basis points during a recession. Given the proximity to the effective lower bound (0-0.25%), the central bank should be more aggressive in lowering short-term interest rates, moving sooner and making larger cuts than it would otherwise. Officials have ruled out negative interest rates, but would rely on forward guidance and further asset purchases if warranted.
In town hall meetings, Fed Chair Powell was particularly impressed with the comments of those from low-income communities. These communities had been largely bypassed during the economic recovery, but were now seeing increased opportunities and the benefits of a tight labour market. With inflation below the Fed’s 2% goal, monetary policy is expected to remain accommodative for an extended period.