Macro

The past few weeks have seen a fundamentally changed investment environment in the U.S.. Since July 31, the Federal Reserve has cut interest rates for the first time in a decade, the U.S.-China trade dispute has intensified and market volatility has returned with a vengeance.

Against this backdrop, Capital Group economists Darrell Spence and Jared Franz have revisited their outlook for the U.S. economy, including the prospects for a near-term recession. In the following Q&A, they offer their thoughts on the Fed’s dramatic policy shift, the potential impact of new tariffs on China, and what it could mean for investors.

How have these events influenced your assessment of the U.S. economy?

Darrell Spence: In many ways, the U.S. economy still looks fundamentally healthy. GDP growth is averaging above 2% on an annualised basis. Retail sales are solid. Wages are rising in excess of inflation. Job growth is strong and the unemployment rate is well below 4%. If we just look at the domestic data, the U.S. economy remains in good shape.

Given these conditions, our base case is that the decade-long U.S. economic expansion isn’t immediately threatened by China trade tensions or slowing economic growth elsewhere in the world. However, any further deterioration in the trade environment would, in our view, substantially raise the risk of a U.S. recession.

With the U.S. imposing new tariffs on China next month and China moving to devalue its currency, the situation is clearly getting worse. It’s hard to know where the tipping point lies.

Are falling bond yields and an inverted yield curve predicting a recession?

Jared Franz: One of the many reasons that bond yields have fallen so precipitously is that the market believes the Fed will reduce rates an additional five times between now and year-end 2020, assuming cuts of 25 basis points each. Including the July move, that would be 150 basis points over an 18-month period, a pace that has occurred only once outside of a recession. An inverted yield curve — where short-term rates exceed long-term rates — is sending the same signal.


That said, there are other factors pushing U.S. bond yields lower, including negative interest rates in Europe and Japan. Bonds trade in a global market, and it could be that investors are not satisfied with 10-year German bunds yielding around –0.6%. In that environment, U.S. Treasuries at 1.6% obviously look a lot more attractive.

With the European Central Bank likely to cut policy rates further into negative territory next month, global bond yields are effectively acting as an anchor on U.S. yields. That may help to explain why the bond market appears to be predicting a recession while U.S. stocks remain near all-time highs.

Are there any signs of weakness in the domestic economy?

Spence: We see a tale of two economies: strong domestic consumption but weaker industrial activity. Declining exports and pre-tariff inventory stocking are undoubtedly playing a role as the precarious trade environment weighs on industrial production. At the same time, the consumption side looks strong, and we’ve seen decent growth in U.S. retail sales. This is not unlike the economic environment we experienced in 2015–16.


The gap between industrial production and retail sales, in our view, will eventually narrow through a recovery in industrial activity rather than slowing domestic demand. Exports only account for about 13.2% of U.S. output, so domestic factors tend to drive the overall direction of the economy.

Again, though, this optimistic view is based on an assumption that the U.S. and China are able to avoid a full-blown trade war. If the U.S. imposes 25% tariffs on all Chinese imports, for instance, and China retaliates, then that would present a very difficult scenario that would almost guarantee recessionary conditions in the U.S. and globally.

Do you think the Fed would ever resort to negative interest rates?

Franz: I don’t think so. Negative interest rates are incredibly damaging to the banking sector, as we’ve seen in Europe and Japan. They also make it very difficult for central banks to respond if economic conditions deteriorate further. The Fed would likely use quantitative easing, forward guidance and other tools first, and only consider a negative-rate policy in the event of another global financial crisis on the scale of 2008–09.

In this declining rate environment, are stocks or bonds more attractive?

Spence: For most of this year, we’ve seen stocks and bonds rally at the same time. That’s not likely to continue. Barring a recession, we think adding equity exposure over bonds makes more sense in this environment. The Fed is adding monetary fuel to a growing economy, and that could propel risky asset prices higher, while it would be difficult for bond yields to move a lot lower than what is already priced into the market. Yes, equity valuations are relatively high, but lower bond yields help support those higher valuations.

Do you think U.S. stocks will end the year in positive territory?

Franz: Fed officials seem determined not to go against market expectations, so there is a good chance they will continue to ease, providing a favourable environment for stock prices to drift higher. Although U.S. corporate earnings have turned down slightly, as at 9 August, 76% of S&P 500 companies have reported second-quarter earnings per share above consensus estimates, so that bodes well for the earnings outlook.

Overall, U.S. markets and the economy appear to be taking the trade dispute in their stride, at least for now. Even with the announced tariff increases in early August and China’s currency manipulation, U.S. stocks are still up more than 17% on a year-to-date basis, and double-digit gains are likely to hold up through the end of the year.

Until some sort of trade compromise is reached, market volatility will likely remain elevated, but even that metric needs to be put in perspective. At current levels, the higher volatility we’ve seen recently is simply a return to normal after a period of relative calm. Those days appear to be over for now.


Barring a full-blown trade war, do you think a U.S. recession is on the horizon during the next few years?

Spence: We’ve been saying for quite a while now that the U.S. is exhibiting classic late-cycle economic conditions. At some point, this remarkable 11-year expansion will come to an end. But if we can avoid a trade war, and if the Fed continues to stimulate the economy, then it would not be surprising to see another year or two of uninterrupted growth. We could experience a downturn in 2021, but that’s really just a placeholder for now as we continue to evaluate key economic indicators. As the Fed likes to say, the outlook remains data dependent.

Key takeaways

  • The U.S. economy looks healthy based on underlying fundamentals.
  • It’s a tale of two economies: strong domestic demand but weaker industrial activity.
  • Federal Reserve rate cuts should provide a tailwind for stocks.
  • A brewing trade war with China remains the biggest wild card.

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