The current economic expansion, which began in the summer of 2009, is turning into a marathon.Jul 2018
The current economic expansion, which began in the summer of 2009, is turning into a marathon. It has been remarkably long, yet refuses to quit. At 108 months, it is tied for the second longest expansion on record, and will likely go down as the longest before it ends. Initially fueled by monetary stimulus in the form of zero percent interest rates and central bank asset purchases, the U.S. economy is now benefitting from late-cycle fiscal stimulus. The fiscal boost has come mostly through the cut in corporate tax rates, as well as a more business-friendly administration. This combination of monetary and fiscal policy has contributed to a pickup in growth during the first half of the year. Through March, the U.S. economy grew 2.8% above the prior year, exceeding the average pace of 2.2% since the expansion began in 2009. Early indications are that the data through June will be even better, with growth above 3% as consumer spending remains strong and business investment spending picks up.
As we look ahead, we expect growth to remain positive through 2018 and into next year. However, as 2019 progresses, we expect the recent strength to moderate as we see several headwinds forming:
Rising Interest Rates
Under the direction of Fed Chair Jerome Powell, the U.S. has been tightening monetary policy – tapping the brakes on the economy’s expansion. Short-term interest rates have risen (which is great news for savers, but makes borrowing costs marginally higher), and will likely rise gradually in the coming months. In addition, the Fed has begun the process of “unwinding” its balance sheet, letting some of the four trillion dollars in bond holdings mature without reinvestment. So far, it has been an orderly process; total assets are down roughly 4% since the Fed began unwinding its portfolio last October. Mortgage rates have started to move higher while long-term U.S. Treasury bond yields have fallen back to where they were in October, as demand for U.S. debt remains strong amid a rally in the dollar. But it is not hard to imagine that if lowering interest rates over the years helped to sustain this economic expansion, then raising them will help to usher in its end.
Wage growth shows signs of picking up. At 4%, we are near the natural rate of unemployment, approaching the lowest level since the 1950s. Most skilled workers who want a job can find one, however, until recently, wage growth has remained very low. Yet with broader measures of goods inflation picking up, and the slack in the job market continuing to tighten, we expect upward pressure on wages. While this is positive for rising incomes, it could also turn into a drag on corporate profitability and earnings growth,which drive stock prices.
The U.S.’s Growing Deficit
The initial ‘feel-good’ effects of fiscal stimulus are behind us, and the positive boost from tax cuts will fade. It is likely that the recent pickup in growth will have pulled forward some demand, resulting in slower growth towards the end of this year and into 2019. Looking even further out, there will be a price to pay in the form of higher deficits. The fiscal deficit is unsustainable. The Congressional Budget Office (CBO) projects debt-service expenses alone will overwhelm all non-defense discretionary spending by the middle of next decade, yet the political will to address this problem remains low. Eventually, hard choices over entitlement spending and debt reduction will have to be made as the economy will not be able to simply grow its way out of indebtedness.
Potential Trade War
Tariffs remain the wildcard in the near term. The Trump Administration is engaged in high stakes maneuvering designed to reduce large global trade imbalances. To date, this has had little impact on the real economy in the U.S. Emerging market economies, however, are affected by trade barriers to a much greater degree than developed market economies via their export sectors (see chart on page 1). We see further risk of slowing growth in emerging markets should trade rhetoric escalate to further tariff implementation.
In summary, expect the current expansion will continue into next year, though a contraction will inevitably follow at some point. Compared to the last recession, the financial system is in a much stronger position to weather a downturn as banks and financial institutions carry more capital to cushion against the blow of the next recession. In the current cycle, leverage has largely built up on balance sheets outside of the banking system, as corporations have availed themselves of ultra-low rates to borrow and engage in M&A activity and share repurchases. While there are always unanticipated surprises, we do not see outsized risks to economic growth over the next twelve to eighteen months.0