In recent months there has been much debate about whether the U.S. economy is heading for a recession. While there is no denying a slowdown is taking place, we believe the U.S. economy remains healthy and the probability of a recession is low. Our assessment is based on a review of the factors affecting the U.S. economy, both positive and negative.
On the positive side, a couple of the major headwinds that contributed to market volatility now appear to be tailwinds. Most notably, the Federal Reserve (Fed) has adopted a more dovish stance regarding the future course of monetary policy. In addition to maintaining the target for the federal funds rate at 2.25% – 2.50% at its January meeting, the Fed noted in its January minutes that it will be “patient” regarding the future course of monetary policy. Moreover, the Fed noted it will be flexible regarding its balance sheet normalization. Both positions reflect an acknowledgement of the current environment and stand in stark contrast to 2018. In 2018, the Fed raised the target for the federal funds rate 4 times to the current range of 2.25% – 2.50%. Additionally, the Fed’s position as late as December 2018 reflected the continuation of its path of federal funds rate increases and balance sheet normalization. The shift in policy and a more pragmatic approach going forward will provide support to the economy. In the event the economy decelerates more than anticipated, the Fed will be able to apply expansionary monetary policy to temper the decline.
Another positive factor is the progress made concerning trade with China. As compared to the bellicose environment of 2018, relations this year have improved, and a trade deal appears likely. While some of the thornier issues may remain unsolved, such as those surrounding technology transfers, a preliminary deal and an ongoing dialogue with China is a positive development for future negotiations. What appears evident is that China will figure prominently in both economic and geopolitical considerations for years to come.
On the negative side, U.S. economic and corporate profit growth are decelerating given the waning effect of the tax cuts and a slowing global economy. However, the deceleration is from a relatively high level. While the rate of growth is slowing, we still anticipate growth for both the U.S. economy and corporate profits in 2019.
While U.S. real GDP growth is slowing, growth is still projected to be in the 2% range, consistent with the real GDP growth rate throughout this economic expansion (2009 – 2018). Based on initial estimates from the Bureau of Economic Analysis (BEA), real GDP increased at a strong 2.6% annual rate in Q4 2018 and 2.9% in 2018 (3.1% real GDP growth from Q4 2017 to Q4 2018). A slowdown in real GDP growth need not automatically result in a recession, as witnessed in 2015 and 2016 when real GDP growth decelerated from a 3.3% annual rate in Q2 2015 to a .4% annual rate in Q4 2015 before rebounding to a 2.3% annual rate in Q2 2016. While the drivers of the slowdown are different today, we have seen periods of decelerating economic growth that did not result in recession.
As for other economic data, the figures are consistent with slowing, but positive, economic growth. The Conference Board’s Leading Economic Index (LEI) has flattened over the course of the last several months but is still holding at current levels. While the most recent employment report was disappointing with 20,000 jobs added in February 2019, previous month’s figures were revised higher and overall employment trends remain positive with the unemployment rate at a historically low 3.8%. Inflation appears contained with measures close to the Fed’s 2% target. The most recent PCE price index increased at a 1.5% annual rate in Q4 2018 (core increase of 1.7%) and a 2% rate in 2018 (core increase of 1.9%). As for the CPI, the January 2019 figure was flat (core increase of .2%) and the year over year increase was 1.6% (core increase of 2.2%). Taken as a whole, the economic data justify the Fed’s patient approach to monetary policy going forward.
As for corporate earnings, after a stellar 2018, corporate profit growth is projected to moderate this year. Given the current environment, a growth rate in the low to mid-single digits seems reasonable in 2019.
In addition to a slowing U.S. economy, foreign economies are also showing signs of slowing. Economic data out of China has been weak, based both on weakening domestic factors and the imposition of tariffs by the Trump administration in 2018. The outlook for European economic growth was recently downgraded by the European Central Bank (ECB). The ECB downgraded its 2019 growth forecast from 1.7% to 1.1%, a decrease of .6%. Further compounding Europe’s troubles is Brexit, with Britain set to exit the European Union on March 29th. In the event of a hard Brexit, additional uncertainties will be cast on the European and British economies. To combat these developments, monetary authorities in China, Europe, and the U.K. have kept monetary policy accommodative.
The volatility witnessed in Q4 2018 was based on a confluence of factors. Chiefly among those factors were concerns about the Fed, the trade and tariff standoff with China, and the threat of a U.S. recession. These factors resulted in a peak to trough decline in the Dow, Nasdaq, and S&P 500 of approximately 20%, 24%, and 20%, respectively. As we survey the environment today, the picture is much improved. The Federal Reserve had shifted its position and will now be patient regarding the future course of monetary policy. Progress has been made with China and we remain optimistic that a trade deal can be reached. As for the U.S. economy, while growth is slowing, the economy remains healthy and we do not anticipate a recession in 2019. The U.S. equity markets have rebounded from their 2018 lows with the Dow, Nasdaq, and S&P 500 up approximately 10%, 14%, and 11%, respectively, in 2019. As we move forward, we remain positive on U.S. equities and select foreign equity markets. While foreign economic growth is slowing, valuations remain attractive in many developed and emerging markets.
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