Undramatic growth has characterised the longest economic expansion in US history. As trade tensions rise can the momentum be sustained?
- Analysts put the chance of a US recession by the end of 2020 at between 25% and 40%
- Low unemployment and consumer debt make recession less likely
- Strategic competition between China and the US, including trade tension, makes recession more likely
- US recession could hit growth stocks more than value stocks
Like a frail old man who has defied statistical probabilities to reach his hundredth birthday but slowed his pace to a plod, the US economy keeps inching forward. In the third quarter of 2019, it grew at an annualised rate of 1.9% – the second straight deceleration.
“This is already the longest expansion in American history”, says David Kelly, chief global strategist at JP Morgan Asset Management in New York. “We really don’t know what the maximum life expectancy of a US expansion is.” The current one became the longest ever in June, when it surpassed the previous record of 10 years.
But although the US economy is, in this sense entering unknown territory, in their base case scenarios economists still see a greater than even chance that it will keep growing and avoid recession over the next 18 months – even if this growth will not be particularly vigorous.
In justifying their base cases of continued growth, analysts point to the lack of extreme imbalances in the US economy. “There are pockets of imbalance you could argue, here and there, but nothing amounting in our view to a systemically important amount,” says Jean Boivin, head of the BlackRock Investment Institute in London, who calculates the chance of a US recession by the end of 2020 as between 30% to 40%. For example, although corporate debt is rising, consumer indebtedness is low and the credit quality of most consumer debt is high. This is in sharp contrast to the eve of the last US recession. Having peaked at 98% of GDP in the first quarter of 2009, US consumer debt has fallen steadily to 74%, the lowest total in 17 years. This gives the US consumer considerable leeway to shore up the economy through continued spending – particularly when unemployment is, at 3.6%, close to a 50-year low.
Kelly suggests a 40% chance of recession by the end of 2020. He says that one factor reducing its likelihood is the US economy itself: “It has become less cyclical: it tends to grow more slowly, but also to have fewer heart attacks”. It is dominated by the service sector, which is less cyclical than manufacturing. Manufacturing’s share of nominal GDP has dropped from 28% in 1953 to 12% in 2015. Manufacturing output has declined 0.9% year-on-year. However, as Andrew Catalan, head of long duration for the US at Insight Investment, puts it: “Given its small share of US output, it would take a much larger decline in manufacturing output to sufficiently bleed over into consumption activity and cause the US economy to contract.”
By this reasoning, the slow pace of US growth can be viewed in a partly positive light: growth may be low, but it is also stable. On the other hand, this decline in cyclicality works on the way up as well as the way down – it reduces the power of manufacturing upswings that have in the past helped restore economic growth after recessions.
But despite their positive outlooks, economists and strategists still warn against complacency. In the first place, growth is low that it will not take much of a shock to tip the US economy into negative territory, even if it is inherently more stable. Moreover, various threats to the US could cause recession, even if it is not the most likely outcome soon. “I still think recession is not the base case scenario, but the risk of recession is the highest since the financial crisis,” says Ron Temple, head of US equity at Lazard Asset Management in New York. “There is a 30 to 40% chance within the next 18 months.”
When asked about what threat might push the US economy into recession, every analyst mentions trade – and Temple is no exception. “The trade war has created a much more pervasive sense of uncertainty among businesses,” he says. Uncertainty has made US businesses more conservative in their projections for demand; they have responded by reining in capital spending.
Global trade tensions could eventually force US economic growth into negative territory through a number of channels, beyond capital spending. For example, tariffs could raise inflation, and hence interest rates, by increasing the cost of imports. Alternatively, if US businesses feel they lack the pricing power to pass increases onto their customers, they might lay workers off, depressing consumer spending, to shore up corporate profits.
If there were an outright recession, analysts agree that equities would be hit. Keith Wade, chief economist at Schroders in London, puts the chance of a recession by the end of 2020 at 25%. If there were one, he expects that in relative terms, value stocks might do better than growth stocks – reversing the trend of the past decade. “The one thing that value stocks have in their favour is that a lot of the returns are through dividends and income, so the higher-quality, less cyclical ones will probably be able to maintain payments,” he says. On the other hand, growth stocks such as tech companies would be hit by cuts in corporate spending, because companies would have less cashflow.
Kelly of JP Morgan AM makes a similar comment. Although some investors baulk at investing in cyclical stocks when fearing a recession, he demurs: “People think of financials and energy companies as cyclical, but the valuations are also cheap – and what really happens in a recession is a psychological change among investors from thinking about their hopes to thinking about their fears.” That, he says, “should help value stocks with low valuations outperform stocks with high valuations”.
Analysts do therefore see trade tension, generated by President Donald Trump’s aggressive approach, as a possible trigger for recession. However, they warn that the trouble does not stop there. “This is more than just ‘Donald Trump against China’,” says Temple of Lazard. “It has moved from a debate about the trade deficit to a bipartisan discussion about national security, so it’s much more enduring, persistent and difficult to predict.” This national security angle has disrupted both trade and foreign direct investment by China in the US. For example, the US has made it harder for Chinese companies to invest in sensitive parts of the US economy, involving critical technology or infrastructure.
Boivin of BlackRock takes a similar view. “It’s really about strategic competition between nations, and in particular two nations”, he says. “This goes beyond just the trade of goods: it’s about intellectual property, it’s about tech, it’s about national security.”
If these forces are so long-term, perhaps the question of whether the US will enter recession is not the most important one. Perhaps investors should be worrying more about whether the high economic growth that prevailed for decades up to the global financial crisis has come to an end. The decline in cooperation between the US and China is, as Boivin puts it, “a persistent headwind that shaves off some growth year after year, but doesn’t necessarily have to trigger an abrupt slowdown that is recessionary in nature.”