US 2019 outlook
Slow to catch on
- Leaving behind the fastest rate of growth since 2006, we expect growth to come in below consensus at 2.3% next year, before materially decelerating in 2020 at just 1.4% (consensus 1.9%)
- On balance, we expect the US to avoid recession in both 2019 and 2020, but the risks are rising in 2020. Soft landings are indeed historically rare. The Fed should tighten policy to 3.00-3.25% by the end of 2019. We change our call to expect a rate cut in H2 2020
Leaving behind the fastest growth since 2006
2018 looks set to deliver growth of 2.9% – our forecast since February this year – and the market consensus since mid-year (Exhibit 1). This would see US expansion at its fastest rate since 2006 and before the financial crisis. Some of this momentum looks likely to continue into 2019, and the large fiscal expansion that has underpinned growth in 2018 should continue to boost activity in 2019.
Source: Bloomberg and AXA IM R&IS calculations
But 2018 is likely to prove a peak for US economic growth. From next year, a number of factors are likely to weigh on activity, including a fading fiscal effect, restrictive trade policies, tighter financial conditions and modest economic overheating. We expect this to reduce growth in 2019 to 2.3% (consensus 2.5%). This process is likely to continue into 2020, when we expect to see a material deceleration, forecasting growth of just 1.4% – markedly lower than the current consensus of 1.9%.
Opposing growth trends rise
A ‘fiscal fade’ is likely to contribute to slower growth over the coming years. Part of 2018’s robust expansion was driven by fiscal expansion following the Tax reform and Bilateral Budget Act in 2018. Our estimates suggest that fiscal stimulus added around 0.6pp to GDP growth in 2018, but that this contribution will fade to 0.25pp in 2019 and to a mild contraction in 2020 (although a replacement two-year spending deal will be possible at that time).
Trade policy is also likely to weigh. The increase in protectionism has been one of the defining features of 2018 and its economic impacts are likely to be felt across the globe over the coming years. The outlook for trade policy is highly uncertain. However, our baseline assumption is that with the immediate political pressure removed, US President Donald Trump may be willing to accept concessions from China to consolidate gains in the trade war to date. We are pencilling in a deal struck between the US and China over the coming months, which would halt the escalation of the tariff war before it covers all Chinese imports, but not before the US raises tariffs to 25% on $250bn of Chinese exports at the start of the year. We also envisage the imposition of tariffs on US imports of autos and parts. While this accounted for $360bn in 2017, we would expect tariffs to exclude Canada and Mexico (50% of imports) because of the deal made in parallel to the US-Mexico-Canada Agreement trade pact. We would also expect this to exclude imports from Japan (15%) and the EU (16%) while these economies are independently negotiating trade deals with the US. It could also exclude China if a deal is struck here. This would mean tariffs applied to only 9% of US auto imports, some $50bn, with Korea the largest affected.
We estimate a relatively modest impact on US economic activity based on this outlook, reducing GDP growth by 0.1pp in both 2019 and 2020. However, we acknowledge that trade policy could escalate beyond our baseline scenario, leading to larger macroeconomic effects.
We also consider modest signs of overheating in the economy. Unemployment currently stands at 3.7%, much lower than the US Fed’s 4.3-4.6% central estimate of the longer-term rate. We expect the unemployment rate to fall further, below 3.5%, by end-2019. This ‘tight’ labour market is generating increasing evidence of skill and labour shortages and wage pressure. These are in turn likely to result in lower employment growth over the coming years – which would dampen household nominal income growth, despite firmer wage growth. An expectation of fading productivity growth, alongside accelerating wages, would push unit labour cost growth higher. This is likely to reduce corporate profitability, weigh on investment spending and lift inflation, further reducing household real disposable incomes. Modest overheating looks set to reduce activity.
Tighter financial conditions represent another headwind to growth. The Fed’s policy tightening is translating into tighter financial conditions, which in early 2018 remained as loose as they had been since 2000. Financial conditions are materially tighter at the time of writing, partly following a sharp correction in October 2018. Even factoring in a rebound, we expect part of the tightening to be permanent. Moreover, considering the trend toward mean reversion in IG credit markets , we expect credit spreads to rise by around 30bps in 2019 and 2020. Altogether, the tightening in financial conditions should reduce GDP growth by around 0.7pp in each of the coming two years.
Sharp slowdowns are historically more common than soft landings
Identification of these separate headwinds is not strictly additive but does suggest a material resistance to US growth over the coming years. The Fed and consensus forecasts envisage this resulting in a modest deceleration back towards trend for 2020. Such a deceleration would likely prove beneficial, resulting in a stabilisation of the labour market at high levels of employment and reducing the risks of significant over-heating.
Exhibit 2: 0.35pp rise in unemployment is a tipping point for the labour market
Source: BLS and AXA IM R&IS calculations
Yet economies faced with deceleration often develop a negative momentum that exacerbates the initial impulse. A tipping point then sees a viscous circle of falling confidence, rising precautionary savings, reduced spending and investment, a sharp unwind in inventories, rising unemployment – an exacerbated drop in demand confirming the initial shortfall in confidence in a self-fulfilling, self-reinforcing expectation. This particularly swift deteriorating momentum makes predicting the timing of recessions particularly difficult. For example, each of the last eight US recessions since the 1960s has been preceded by a relatively modest 0.35pp increase in the unemployment rate from its nadir (Exhibit 2). After this point, economic downturns have quickly gathered momentum.
Moreover, history is not replete with evidence of economic soft-landings. From the 1950s, only two periods could fit that definition.
1966 – growth dropped from 8.5%yoy at the end of 1965 to below 3% across 1967, with unemployment stabilising just under 4%. This followed a tightening in policy in 1966, but limited Fed action over the subsequent years.
1995 – activity slowed down from over 4% growth in 1994 to around 2.5% in 1995 following a 300bp Fed tightening with unemployment stabilising around the CBO’s estimate of the natural rate of unemployment (5.4%). However, the Fed immediately began to ease policy, reducing rates by 75bps over the next year and again in late 1998 as the Asian crisis emerged. This period also saw faster productivity. Although unrecognised at the time, this muted inflation pressures, allowing the Fed to persist with looser monetary policy.
Given the difficulty of building forecasts on essentially endogenous fundamentals, we use alternative signals to help us time any potential downturn. On our forecasts, unemployment only rises in excess of 0.35pp from its low at the start of 2021, suggesting a downturn thereafter. The yield curve has also provided a 12-month warning of recession after inversion1 (Exhibit 3). On our forecasts, inversion looks likely at the end of 2019, signalling a downturn in early 2021. Both tools are only indicators of recession. However, both suggest that the US should decelerate across the course of 2019 and 2020, but only risk recession in the following year.
The Fed unlikely to pre-empt the slowdown but hiking cycle over by end-2019
As described, the Fed has played a key role in previous soft landings. In the 1960s, it ‘failed’ to tighten policy sufficiently to manage inflation, while in the mid-1990s by pre-emptively easing policy in 1995 and 1998 to extend the cycle (albeit aided by productivity improvement muting inflation).
Exhibit 3: Watch for the UST yield curve inversion as another recession signal
Source: BLS and AXA IM R&IS calculations
We believe it will be more difficult for the Fed to ease policy this time. First, the Fed does not currently expect a meaningful deceleration in 2020 or 2021. Second, broader economic developments argue for more restrictive monetary policy, including low levels of unemployment, wage acceleration and expectations of rising inflation. Third, the Fed is also likely to be mindful of the financial stability implications of looser policy.
Hence the Fed could extend the cycle, but likely only at the cost of more obvious economic overheating over the coming years. This, in turn, could result in a more material downturn eventually reminiscent of the 1960s. Moreover, President Trump’s recent interjections have made the Fed’s job more difficult. Any easing in Fed policy could now be interpreted as bowing to political pressure, which could lift presently stable longer-term inflation expectations.
With the Fed Fund Rate (FFR) still estimated to be below neutral, further modest tightening appears on the cards and we forecast FFR rising to 3.00-3.25% by the end of 2019, which would mean three hikes after December 2018. However, as signs of economic deceleration gather momentum, we now expect the Fed’s third hike in 2019 to 3.00-3.25% to be its last in this cycle. We change our outlook from a final hike in 2020 to can now envisage the Fed beginning to cut rates in H2 of 2020 (to 2.75-3.00%), with the prospect of a more material reduction envisaged for 2021 if the slowdown continues.
Other known unknowns which could change this outlook
External events could change the timing and shape of the slowdown. Previous recessions were exacerbated by external shocks such as the first Iraq War and 9/11. Apart from such unpredictable geopolitical events we review below the main risk factors we would monitor throughout 2019.
A substantial acceleration in productivity. We forecast subdued productivity growth at 1% annualised as seen since 2012. Hence we assume the recent pick-up is a short-run boost associated with fiscal stimulus. Faster productivity, whether recognised in the official data or not, would allow similar economic resilience, but would witness more subdued inflation. This would also allow the Fed to adopt a slower pace of tightening (reminiscent of the 1990s).
Trade war escalation. The evolution of trade policy is uncertain. In the short-term we optimistically expect no further material escalation, but such hopes may prove misplaced if US incentives are more focused on strategic containment of China than Trump’s “Art of the Deal”. Short-term trade escalation would create more material headwinds for activity and inflation in 2020 and beyond. Conversely, our medium-term pessimism may prove misplaced if the White House is really striving to promote free trade, which could see anticipated headwinds become tailwinds.
The puzzle of US households’ savings. US saving estimates were revised materially higher in mid-2018, but we are sceptical that these can cushion expected income declines. Persistently higher saving, despite ebullient consumer confidence and rising wealth, suggests that desired saving levels are also now higher (potentially reflecting demographic factors). Moreover, saving may also be affected by changes in distribution: estimates suggest 80% of savings are held by the top 10% of household income (50% by the top 2%). In either case (demographics or inequalities), savings are unlikely to supplement any income deceleration. Yet, if this assessment proves false, households spending could persist despite slower income growth.
Moving through the late-cycle
In broader terms, the US appears to be travelling a familiar late-cycle path. Peak growth this year is likely to see the current expansion mark its second longest since the 1940s. The economy is in a position of excess demand and, with above-trend growth expected next year, should increasingly lead to signs of overheating. The Fed is gradually tightening policy to rein in growth and manage prospects of excess inflationary pressure. This reflects a Fed focused on its inflation mandate. Historically, however, such late cycle paths have ended in downturn. We suggest a similar outcome is likely this time, but for now our estimates suggest that growth for next year should still be solid, with deceleration only gaining momentum in 2020 and not facing outright contraction until the following year.
Table of contents:
 Page, D., Savage, J., Venizelos, G., “Is the yield curve pointing to recession?”, AXA IM Research, 25 October 2018.
 In 1967, Fed Chair William McChesney Martin supported a fiscal tightening with US Treasury Secretary Henry Fowler. While this was eventually delivered in June 1968, Martin was said to have considered this an error in policy and resumed tightening monetary policy in 1969, by which time inflation had risen materially. Source: Federal Reserve History.
 Wolff, E.N., “Household wealth trends in the US, 1962-2016: Has Middle Class Wealth Recovered?", NBER, Nov 2017.
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