We do know from various data that the economy is slowing, especially globally. The IMF downgraded its growth estimates globally, and individually for most regions, including Europe and emerging markets. Forecasts for China and the U.S. were unchanged, but that is from previously-downgraded forecasts. A smattering of disappointing economic news recently include (among a host of other data):
- Sales of existing homes fell 6.9% in data released January 22, according to the National Association of Realtors.
- The Institute for Supply Management (ISM) gauge of manufacturing new orders plummeted 11 points to reach among the lowest levels since the end of the financial crisis, according to ISM.
- Consumer sentiment from the University of Michigan plunged to the lowest levels of Trump’s presidency, badly missing analysts’ estimates as tallied by Bloomberg.
- China’s growth slowed to the lowest level in years; Germany also witnessed a sharp drop in industrial production recently, according to data reported by Bloomberg.
And importantly, nearly half of U.S. CFOs believe the nation’s economy will enter a recession by the end of 2019, according to the Duke University/CFO Global Business Outlook. Worst-case projections would see capital spending drop in 2019, accompanied by flat hiring, according to the report. The CFO survey has been conducted for 91 consecutive quarters.
Politics and trade
The world economy is slowing in unison. Why? One big reason is that politics – and not just in the U.S. – is tanking sentiment. Remember that the decision to reopen the government is only temporary, with a new deadline of February 15 to complete negotiations. We do not know if a deal will be reached then, nor do we know what might happen if no deal transpires. And the U.S. and China have fundamental issues (intellectual property, state subsidies to companies, etc.) that pose significant challenges in negotiations. That deadline to complete negotiations, meanwhile, is in early March. Meanwhile, the U.K. has a very messy Brexit situation to contend with (and with yet another deadline of its own), and French protestors present yet another issue to address.
Now, about trade. Commerce Secretary Wilbur Ross downplayed expectations for an end to U.S.-China trade war, as both parties are a long way from resolving their differences. “We’re miles and miles from getting a resolution,” he said in an interview on CNBC recently. “Trade is very complicated. There are lots and lots of issues.”
Importantly, it’s not just China buying more U.S. goods to close the trade gap; there are other issues beyond simply dollars of imports and exports. These include, among other items, intellectual property protections and state subsidies to Chinese industries and companies, which the U.S. argues makes for an uneven playing field. The U.S. wants China to open its centrally-planned economy more to Western firms, which will presumably compete with already-established Chinese firms. China will never change its economic model, so the U.S. will need to decide what goals are achievable and which are not in negotiating an end to this trade war.
Delving into the U.S. consumers’ mindset
By all accounts, consumers should be in a positive mood, as employment growth has been strong and layoffs are at the lowest level since 1969, as tabulated by the Department of Labor. Their incomes are growing at an accelerating pace. Many economists cite the health of consumers and the strength of the labor market as a reason the economy can remain strong. But is that a guarantee?
Consumers may be losing their nerve, as we mentioned above. External factors play a big role, such as the market volatility in recent months. After all, fluctuations in the value of a 401(k) plan or personal savings portfolio certainly may affect consumers’ net worth by a greater degree that any pay raise they may receive. Political discord, regardless of which party one may belong to, adds to sense of dysfunction and disorder, whether one focuses on trade wars or policy wars between political parties in Washington.
The role of consumer confidence on household spending and the economy
With that in mind, let’s explore a graphical narrative of consumers’ mindset. First, we can turn to the Consumer Confidence report from The Conference Board and a similar measure from the University of Michigan. For the first study, we’ll look at where consumers expect the economy to be relative to where we are now. We can determine this by taking the “Expectations” component of the Consumer Confidence report and subtracting from it the “Present Situation” component.
In the nearby graph, you’ll observe that a recession has followed when this metric reached its nadir. We also can look at a separate statistic of the steepness of the yield curve, taking the difference in the yield of the 10-year U.S. Treasury and subtracting the yield of the 2-year U.S. Treasury. Historically, a recession has occurred when this level inverts (this metric is usually positive, as investors typically demand a higher yield on longer-term bonds for locking up their funds for a longer period). Interestingly, these two metrics line up very closely, but we can’t say that the future will follow historical patterns, or where these indicators might head in coming periods. As you consider this relationship, remember that consumer spending occupies over two-thirds of the U.S. economy.
Now, let’s tie consumers’ attitudes with their spending patterns. We can take a measure of consumer sentiment from the University of Michigan and the year over year returns of the S&P 500 and use a statistical method to determine the relationship that consumer spending (as reported by the Bureau of Economic Analysis at the U.S. Commerce Department) has had with a composite of these two variables.
We might intuitively know that consumers may factor in stock market fluctuations and their own attitudes in their spending decisions. Indeed, graphing actual consumer spending changes along with the composite representing stock market movements and consumer sentiment fluctuations leads to a very visually compelling graph, showing that stock market fluctuations and sentiment, measured as a combined metric, do lead consumer spending by about four months. In the nearby chart, it would seem that consumer spending would be set to slow sharply. Of course, we can’t know whether historical patterns will persist exactly into the future.
Recession? Not so fast.
We’ve explored the role of consumer confidence – in turn influenced by variables such as politics and the stock market (not to mention employment, wages, and a host of other variables) – on consumer spending, and thus, the economy. While these relationships may be valid, the underlying conditions may change (i.e., the market could rebound, political uncertainty could be resolved, etc.) or other variables altogether may play a greater role.
In that regard, consider other data The Conference Board publishes, particularly the Leading Economic Indicators and the Coincident Economic Indicators. If we take the LEI and subtract from it the CEI, we can derive a data series that has had a good degree of alerting investors to possible turning points in the economy. Indeed, it’s peaked shortly before a recession began and bottomed before a recovery ensued. This metric, which in turn incorporates a host of financial market and macroeconomic indicators, does not, by itself, point to an impending recession. We may indeed continue on a path of strong employment and lower, but still-sufficient growth.
What we can say, though, is that the economy may naturally slow. The tax cuts and fiscal spending stimulus gave the economy a “sugar high,” and growth may simply revert to what are its usual influences: how many more people are working and how much more each of them produce per hour (in other words, growth of the labor force plus productivity gains). While it’s hard to pinpoint exactly what the long term potential growth rate of the economy is, many believe it to be about 2% or so. That is, of course, less than what we’ve recently experienced, with 3.4% GDP growth in the third quarter 2018 and 4.2% in the second quarter, according to the Bureau of Economic Analysis.
The risk is that a natural slowing of the economy, with the added potential drags of tighter monetary policy, slower growth overseas, and the aforementioned politics at home, among other factors, is vulnerable to a meaningful further deterioration in confidence. In other words, a sharper slowdown (or worse) can result if, say, business leaders overreact to a natural slowing of the economy and believe it to be an oncoming recession, and slash hiring and investment plans. In that sense, it can be a self-fulfilling prophecy if negative sentiment extensively pervades decisions by consumers or business leaders.
Our hope, though, is that rational heads will prevail – among all parties involved.
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