Last night saw the US president’s State of the Union speech which addressed to a joint session of the Congress. During the 90 minute speech, he said he launched an “unprecedented economic boom” – despite taking office amid said booming economy. AXA IM’s David Page assesses the current state of the US economy.
US recession indicators began flashing red towards the end of last year and this, combined with tighter financial conditions and geopolitical uncertainty, meant almost all asset classes suffered as investors battened down the hatches.
There is now much focus on a potential US recession and having previously forecast a slowdown to 2.3 per cent in 2019, changes in conditions since then mean that from here we are expecting a material softening in US GDP growth.
However, for now, we do not forecast a recession this year or next, for several reasons.
Many commentators use the US yield curve as an estimated recession indicator, looking specifically for an inversion of the three-month/10-year reading.
Last year, US high yield spreads widened by 126 basis points by mid-December, and then blew out a further 102bps to 544bps – their highest level since February 2016 – to cause the three-month/10-year to invert like it had during previous recessions.
This, combined with a downbeat outlook for the US economy, meant enthusiasm dampened in the fourth quarter, with the S&P 500 seeing losses move from correction territory of circa 10 per cent to extend to a 20 per cent drop by Christmas Eve. The less-dovish-than-hoped US Federal Reserve hike in December and a shutdown of the US government added to fundamental concerns.
However, grim as this may sound, we argue that the estimated probability of recession is only coming close to – and importantly remains short of – levels that have historically preceded recessions in the 12 months prior to them taking place.
Our preferred indicator in this matter combines both the yield curve slope and the excess bond premium, and looking at this measure, our model also falls short of levels associated with previous recessions, such as the one in 2008.
As these indicators are close to previous thresholds, the US outlook will depend on the evolution or risk sentiment from here. However, as of now, markets have already priced in a lot of bad news, and we believe the outlook is likely to improve over coming months.
Uncertainty to abate
There are a number of uncertain situations adding to the downbeat sentiment which currently prevails, but clarity is likely to emerge as we move throughout 2019.
For example, the US government has undergone its longest ever government shutdown as president Donald Trump tries to secure funding for his wall. However, this is now drawing to a close, and only 25 per cent of government spending was affected. The economic impact is likely to be less than 0.1 percentage point of GDP in Q4 and 0.2 percentage points in Q1.
Elsewhere, Trump is also causing concerns with his trade war and markets have been alarmed by US protectionism. However, as investors react, evidence is there that Trump and China will come to a mutual agreement to avoid further deterioration in markets.
Worries also persist of a China slowdown, while the eurozone is showing evidence of weaker economic growth, but here again, steps are being taken.
In the former, the Chinese authorities unveiled additional stimulus plans – including reserve requirement rate cuts and tax cuts – which should be evident by the second quarter of 2019.
The challenge facing Europe should not be underestimated, with Italy already in a technical recession and Germany narrowly avoiding one last year.
Overall, the continent’s economic growth appears to be affected by a number of idiosyncratic factors – such as Italy’s budget spat with the European Commission, France’s gilet jaunes impact on Q4 consumer spending and Germany’s vehicle emission standards change – and, as a result, we believe the impact of these will fade. Indeed, we forecast a modest acceleration in quarterly growth from Q1 onwards.
Brexit has clearly been dominating the headlines in the UK but we stand by our view that a no-deal Brexit will be avoided, if indeed Brexit goes ahead as planned on 29 March.
All of these uncertainties are just that, but we consider them likely to improve this year and this would likely give a boost to risk sentiment generally. This in turn would have the effect of easing financial conditions and move the US further away from recession territory.
In November, our outlook for US growth was 2.3 per cent for 2019, preceding a more material fall to 1.4 per cent in 2020.
Since then, financial conditions have tightened further, and we have adjusted our forecasts down to 2.2 per cent for this year, although our 2020 outlook remains unchanged for now.
It is important to consider moves in financial conditions in the context of their impact on economic growth. The deceleration we have seen in these conditions, from their easiest at the start of 2018 to their tightest at the close of last year, has historically knocked 1 per cent off GDP growth.
We think that the US economy could therefore be further impacted by household spending reductions in particular as we move through 2019.
The question is whether that would be enough to tip it into recession. It could well be a close-run thing if the backdrop becomes yet more challenging, but for now, we still do not believe the US is heading for recession this year or next.
David Page is senior economist US at AXA Investment Managers