Macro

The consensus outlook for the US economy has become increasingly fearful in recent months. In particular, the bears point to renewed trade war concerns, which have been damaging confidence. At the same time, signs of heightened recession risk are emerging. These include:

  1. Inversions in parts of the US yield curve,
  2. A warning sign from the New York Fed's recession indicator, and
  3. A general deterioration in US economic data.
Source: Longview Economics, Macrobond

For the bears on the US economy, Fed easing (expected from July onwards) also adds to their case for heightened recession risk: Indeed, in 4 out of the past 5 recessions, the Fed started cutting rates a handful of quarters before the recession began. They therefore argue that the Fed has already overtightened monetary policy, and has therefore already ‘burst bubbles’ in the US economy.

For the bulls, though, recent weakness in the US economy is nothing more sinister than a mini (late cycle) soft patch, which we’ve described as a bout of ‘Eat, Sleep, Rinse, Repeat’. If correct, that weakness should be resolved by some Fed easing, which would then extend this economic cycle (as it probably did, for example, in the mid/late 1990s as well as more recently in this cycle).

In our view, the latter of those two scenarios is the most likely (i.e. recent weakness is a mini-cycle slowdown). In particular, the cash flow position of companies is relatively strong, which is not typical of recessions. Indeed, all post WWII recessions started after companies had become ‘overstretched’ on cashflow (i.e. in cashflow deficit). In addition there’s strong evidence that company margins are improving, which further reduces pressure on
companies to retrench, see point 1.

With that, several key sources of stimulus are increasingly at work in the US economy. These include low/falling oil prices, significantly lower mortgage rates, and looser Fed policy (point 2). Of note in that respect, housing activity is responding to lower mortgage rates (point 3) and, combined with other factors, adds to the case for improving household confidence and
consumption growth (see point 4). On top of that, productivity growth is reaccelerating (fig 7a). As we show in point 5, that’s ‘absorbing’ the rise in wage growth and, as such, broader inflationary pressures remain subdued. In that respect, there’s ample scope for the Fed to pursue looser monetary policy over coming months/quarters, further reducing the risk of a US recession.

Source: Longview Economics, Macrobond

Our traffic light indicators carry a similar message: Of the 23 indicators that we track, 18 are either flashing ‘GREEN’, ‘GREEN/AMBER’ or ‘AMBER’ while only 5 are flashing ‘RED’ or ‘AMBER/RED’ (see table 1). In other words, and while this economic expansion is probably in its latter stages, it’s likely to remain ongoing, at least for the next 12 months, and probably beyond.

Source: Longview Economics

Key points

(1) Cyclically, the US corporate sector is in strong health. In particular, the US corporate sector’s financing gap is not in deficit (fig 7g). The US hasn’t had a recession since the end of Bretton Woods without a significant cash flow deficit at the corporate sector level. In that respect recession risk is low.

On top of that, and aided and abetted by improving productivity growth (see point 5), pressure on corporate sector margins is easing. That’s captured neatly by the chart below, which shows that the use of the phrase ‘margin pressure’ in analyst reports has fallen to multi-year lows. It’s interesting to note that it’s remained at low levels while the use of the
word ‘automation’ has risen sharply in the past 5 years (fig 7b). Usually, a ‘tight labour’ market and rising ‘margin pressure’ move together (as higher wages squeeze margins). The recent increase in automation, though, confirmed by stronger productivity growth, has likely been a key factor breaking that relationship. In other words, increasing automation has probably offset margin pressure from a tight labour market/rising wages. That adds to the (cyclical) health of US companies. Our ‘margins model’ draws a similar conclusion (i.e. that margins are improving, fig 7h).

Source: Longview Economics, BlackRock Investment Institute, Thomson Reuters data, May 2019

The lines show the share of analyst research reports that mention a specific phrase within the Thomson Reuters global research database, expressed as a z-score, or the number of  standard deviations from the 2004-2019 average.

(2) Stimulus is increasingly at work in the US economy. Most notably, the Fed’s ‘pause’ (signalled in Q4 last year) marked the beginning of a sharp fall in both Treasury yields and mortgage rates. That’s now starting  to stimulate housing activity (see point 3 below). It also resulted in an easing of both financial and credit conditions. In addition, though, recent hints of rate cuts have been accompanied by yield curve steepening (albeit only modestly at this juncture). Usually, yield curve steepening is consistent with a re-acceleration of M1 money supply growth and signals a forthcoming credit impulse in the US economy. Other key sources of stimulus include the fall in the cost of oil for the US economy as well as a renewed positive wealth effect through rising asset prices (and illustrated by new record highs in net household wealth last quarter).

Source: Longview Economics, Macrobond

(3)  The housing cycle is turning up. With a large fall in mortgage rates in the past 6 months (fig 7), some of the ‘early stage’ housing cycle indicators have moved higher, suggesting that US house price growth should strengthen over coming months/quarters (having already begun to stabilise, see fig 7d). Of note, mortgage applications, which are highly sensitive to
mortgage rates, have risen sharply to new multi-year highs (fig 7i) while transaction volumes have started to stabilise/pick up (fig 7k). Usually, lower mortgage rates and higher sales volumes are followed by rising house prices and, eventually, stronger construction activity. Of note in that respect, the NAHB housing index has bounced sharply this year. In other words, and while the Fed has yet to cut rates, the Fed’s change in policy direction (in October ’18) was ‘enough’ to stimulate housing (i.e. via lower bond yields and mortgage rates). Of note in that respect, credit conditions for mortgages eased in Q2 to relatively loose levels (having tightened in Q1).

Source: Longview Economics, Macrobond

(4) Household consumption growth is stable (fig 7j) and is underpinned by (i) an ongoing wealth effect (i.e. from rising asset prices); (ii) lower mortgage rates (which increase household cash flow); (iii) low/falling oil prices; and (iv) ongoing (and relatively robust) income growth. We measure income growth using PCE income data, adjusted for ‘non-cash items’. Indeed, the outlook for both wage and employment components of income are reasonably encouraging at this juncture. Wage growth, for example, is trending up (helped by stronger productivity growth); while hiring intentions are also reasonably strong (e.g. as
reported by the NFIB).

(5) Inflationary pressures are low. Despite a doubling of wage inflation since 2012, service sector PCE inflation, broadly speaking, has not changed in that time (fig 7e). That’s reduced the pressure on the Fed to significantly tighten monetary policy. Indeed, it’s services inflation which the Fed is ultimately attempting (and able) to control, while goods inflation is largely out of the Fed’s direct control. The principal reason for stable service  sector inflation, in our view, is the pick-up in productivity growth (which has also occurred since 2012). That has absorbed the increase in wages. Softer growth in unit labour costs in recent months is interesting in that respect, as it typically leads PCE inflation (see fig 7f). An ongoing uptrend
in productivity growth, if it persists, should stave off inflation (and Fed tightening) and therefore help extend this economic cycle.

Source: Longview Economics, Macrobond

Key charts

Source: Longview Economics, Macrobond
Source: Longview Economics, Macrobond

*defined as internal funds less capex less dividends

Source: Longview Economics, Macrobond
Source: Longview Economics, Macrobond
Source: Longview Economics, Macrobond
Source: Longview Economics, Macrobond

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