Last week brought a lot of talk of an American and even a global recession. A slew of weak economic data from China and the German industrial sector underpinned the negative narrative. The recession indicator from the Federal Reserve Bank of New York now shows a 31 percent chance of a recession in the US – the highest since the last recession. Even the Danish central bank has now become an expert on the American business cycle and has estimated the probability of a recession within two years to exceed 60 percent. For the euro area the probability is a whooping 65 percent. For economists – who notoriously hate to answer a straight “yes or no”-question – this is as close to a “done deal” as can be.
The models predicting recession rely heavily on the difference between long and short-dated yields – the so-called yield curve. The yield on 10-year US government bonds is now significantly lower than the monetary-policy rate and short-term interest rates; the yield curve has inverted. It was the inversion of the American yield curve that sent the equity markets into panic last week. This has been cast as an unequivocal proof of an upcoming recession, due to the yield curve’s strong predictive powers in the past.
Is it different this time?
There is no doubt that uncertainty about the US economic outlook – and the global economy – has moved to the downside, but much of the recent panic is probably also a reflection of too many analysts and strategists pretending all was fine for too long.
I think it strange to give such prominence to signals from the yield curve since bond markets are extremely manipulated by central banks. Central banks have directly purchased trillions of dollars, euros and yens worth of bonds. Tighter capital requirements for banks have forced them to buy billions worth of government bonds. Retirement funds have been forced to buy billions worth of government bonds. Indeed, some of the recent decline in yields could be due to asset-liability management issues in retirement funds as yields began to fall from already low levels.
Yes, the Federal Reserve (FED) has reduced its holdings of bonds a bit, but in 2018 ECB’s bond purchases exceed the reduction of FED holdings, and this year central banks have been falling over themselves to promise more easing.
The ECB is not afraid to take credit for pushing down yields. In a speech on 2 July, ECB’s chief economist Philip Lane noted that “the ten-year bond yield would have been around 95 basis points higher in the absence of the APP [Asset Purchase Programme]”. Hence, central banks have been pushing down yields globally and removed market liquidity. When panic sets in, it does not take as much as would otherwise have been the case for the yield curve to invert.
The signals from the American manufacturing sector has become increasingly bleak, which is not surprising considering that the global manufacturing PMI now indicates a decline in activity. But manufacturing in the US is not what it is in Germany. Only 8 percent of the labor force is employed in manufacturing – and only 5 percent in the durable goods sector. Indicators from the service sector have also declined in recent months but are still indicating growth.
I would not be surprised, if corporate investments in the US decline in coming quarters as business leaders hold back on new investment plans until the current uncertain outlook clears (which it actually may not). Businesses are complaining about the increased cost of tariffs, but tend to forget, that tariffs should be viewed in context with the very generous tax cuts they got in the December-2017 package. Postponed investment plan is also a temporary boost to profits.
The consumer to the rescue?
It is the American consumer, who will decide whether the economy tanks. Wherever I have travelled in the US – outside Washington and New York – people only tend to care about “the Washington noise”, when it affects them directly. Private consumption makes up 69 percent of total GDP with public demand (consumption and investments) another 17 percent – almost as much as all private investments (corporate and residential). So far, consumers have been beating expectations over the summer with three months of strong retail sales.
Consumer confidence is a great indicator for the most important part of the American economy, particularly consumer expectations for the future. And the American consumer is pretty happy. The expectations component of the Conference Board-indicator has increased significantly since the partial government shutdown in January. The assessment of the labor market has improved markedly since spring. However, the confidence indicator from University of Michigan declined sharply in August, but tend to be more influenced by movements in the equity market, whereas the Conference Board indicator is leaning more on the labor market. The indicator from the Conference Board does a slightly better job at predicting actual consumption growth. It should decline some in August as a response to more economic uncertainty but remain at an elevated level.
Consumption is based on income growth
Is optimism regarding the American consumer based on fantasy? There are import structural headwinds for the lower middle class and lowest income groups, which continues to weight on the outlook for the American economy in the longer run. But if we focus on the current business cycle and whether private consumption is going to pull the economy into recession, we can leave those issues aside for now and focus on the aggregates.
American households remain thrifty. Overall disposable incomes are growing around 5 percent – the same as compensation of employees, which is a better proxy for income growth in middle-class households. Corrected for inflation, real income gains are around 3 percent. The latest decline in oil prices reduces the household energy bill by about USD 25 billion compared to earlier this year. That matters a lot for lower income groups. Unemployment is close to all-time low, and there are more than 7 million vacant jobs, businesses struggle to fill.
Hence, households can sustain a 3 percent increase in consumption without reducing savings. The savings rate has actually been increasing during the last 2.5 years, which is the opposite of what normally happens before a recession. Credit-card debt has increased, but not alarmingly so. And the outstanding amount of home-equity lines, the quick and dirty way to convert bricks to cash, continues to decline by as much as credit card debt increases. Student debt and auto loans have been the main drivers of household debt in recent years.
Other indicators of financial strength in the households are also in stark contrast to what is usual before a recession. Overall household debt is declining as share of disposable income and GDP. Mortgage debt is increasing in absolute terms (so is the population), but at a rate which is less than a quarter of what is was prior to 2008.
The latest decline in yields has sent mortgage yields back to 2016-lows and set off another round of refinancing of mortgages; applications for refinancing have increased almost fourfold since turn-of-the-year, while applications for home purchases are unchanged. To take full advantage of the lower yields, I expect many homeowners to choose a 15-year mortgage, which will bring interest expenditure down significantly, but also increase principal payments. Household debt servicing ratio (interest and principal payments on all loans) remains at the lowest level in at least 40 years. It increased prior to the latest two recession. This reduces the risk of a sudden downturn in consumption.
Some news headlines have focused on an increase in delinquencies on household loans as a proxy for more financial difficulties. That has indeed happened, but the level remains extremely low. Importantly, delinquencies on conventional mortgages continues to drop as tight credit requirements of prospective buyers remain in place. Problems with repayments are most prominent for student loans and subprime auto loans issued by non-banks.
Trade wars will decide
What is different about the current expansion compared to previous cycles is that housing wealth and credit growth has played a lesser role in private consumption than usual. About half of the underperformance of this recovery compared to previous recoveries can be explained by a lack of debt accumulation in household. The American household sector is – on aggregate – in good shape, which is why I remain cautious about jumping on the recession bandwagon, and why I remain cautious about recession models, which rely heavily on housing components: housing did not create this recovery and will not bring it to an end.
The economic outcome is in the hands of the President.
Trump decides whether to give households a reason to step on the breaks. And it comes down to tariffs and a further escalation of the trade wars with collateral damage across the American and global economies. The recent postponement of some additional tariffs on Chinese consumer goods until after the Christmas shopping season is a clear indication that the danger is understood – although belatedly.
Take furniture, most of which originates in China and most of which has been hit by tariffs already. Furniture prices had been declining since 2012 but are now up 4 percent compared to last year. The additional tariffs will push up goods prices broadly, although the weaker yuan against the dollar offsets some of the effect.
How will consumers react? We do not know. The decline in equity prices is more of a problem for President Trump’s golf buddies at Bedminster and Mar-a-lago; average households own few stocks directly. If consumers move to buy fewer goods, but more services, it would not only support economic growth, but also reduce the trade deficit. If they dip into savings to compensate for higher goods prices, consumption growth can be sustained for a significant period of time. If they become cautious and start to feel like the trade war is hitting closer to home, consumption growth would wane – and the economic downturn becomes a reality. This is also why President Trump is allergic to negative headlines. Economic advisors Peter Navarro and Larry Kudlow were on the Sunday morning political shows dismissing the risk of a recession.
I doubt the consumers are going to pull back much, but it really depends on how much additional disruption is awaiting. A trade war with the EU is still on the table – and bold measures from the ECB in September could easily be viewed as yet another attempt to push the euro lower. The “currency manipulation” hammer has already been activated for China. President Trump’s war on the Federal Reserve – and the willingness to do whatever it takes to get lower interest rates – also risks creating new negative headlines and raise doubts about the strength of the American economy.
And the global economy could pull corporate pessimism (and equity markets) down further, if China is unable to stabilize growth. And then not a word about all the challenges facing Europe. Or Hong Kong. Or Argentina. All this could lead to even more cautious consumers.
Consumer confidence remains the most important indicator for the American economy in coming months.