The economy may be off the boil but don’t expect a US recession

The Fed’s plan to cease trimming the balance sheet if the economy evolves “about as expected” and more cautious “dot plots” that hint the central bank may not hike again in 2019 has got bond traders chomping at the bit. Fixed income traders prior to this morning were projecting a cut in the Fed Funds rate in September, with another 25% chance of a second cut before year end.

Inversion of the US government bond yield curve out to the 5-year note has sparked talk of a recession and the FX market took that as a sign to dump the Dollar, at least for a while. Since then EUR/USD has plunged on the back of weak German data that was followed by soft EZ Mfg PMI (in contraction, 47.5) as well as lower than forecast CPI (1.4% y-on-y).

Cynics will point to this week’s soft US durable goods orders print but it’s a volatile series and the core data was flat, within 0.1% of market forecasts. (Non-defence capital orders ex-aircraft at -0.1% and durable goods ex- transportation +0.1%). The NY ISM was strong (66.9 vs 61.1 last) and as it was March data, gave a fresher view of the economy than February’s durable goods.

US Markit Mfg PMI was decent (52.4) and the US ISM Mfg PMI improved upon February’s 54.5 reading at 55.3. Furthermore, ISM’s prices paid index leapt from 50.1 to 54.3. Hardly signs of an impending recession, particularly with US construction spending +1.0% in February vs +0.2% forecast. Finally, today’s nonfarm payrolls data came in at 196k, 20k higher than forecast although wages ebbed to 3.2% y-on-y vs 3.4% market forecast. All in all the economy still looks healthy and there is a distinct lack of evidence (other than the yield curve inversion) to indicate a recession is in the offing.

The St Louis Fed’s GDP Now indicator was revised down on Monday to 1.7% for Q1 2019, off from Q4’s 2.2%, however Q1 is frequently one of the two weakest quarters of the year for economic growth. Over the past 20 years Q1 has been one of the two weakest quarters 60% of the time and the weakest quarter more frequently than any other quarter irrespective of the existing economic cycle (40% over the past 20 years).

The Fed’s Randal Quarles stated a week ago “My estimate of the neutral policy rate is north of where we are now” citing strong labor market conditions and improving productivity. Quarles is the vice chair for supervision and is no lightweight, so his view of the US economy is probably representative of the Fed’s leadership.

It’s a bit of a puzzle as to how negative the market has gotten on growth prospects and it mainly seems to be related to the Trump Administration’s heavy handed approach to international trade at the same time that growth in the European Union and China is ebbing. So we decided to do some research on how much impact slowing exports would have on the US economy

According to the World Bank, between 2012-2016 US exports contributed somewhere between 12-13.65% to US GDP and if you go further back that percentage drops. Out of all of the major economies and countries with the largest populations, only Japan comes close to the US economy’s low dependence on overseas demand. Japan’s goods and services exports were last estimated by the World Bank to contribute 16% to GDP.

The EZ comes in north of 44%, with Germany at 41% and France almost 31%. If world growth fizzles it’ll have the least impact on the US. China’s dependence on exports has ebbed to just below 20% but given the size of its population vs the US, in monetary terms they have a much higher reliance on exports than the US and have more to lose in a trade war.

Ironically, if trade negotiations remain at an impasse it’ll be American consumers that’ll suffer more than anyone as the price of imported goods raises domestic prices, yet another reason for the Fed not to lower rates. So if world growth dips, does that necessarily mean the US economy has to enter a recession? Less than 7.5% of US jobs are related to exports of goods and services of which less than 4.2% are in Asia and Europe (according to the International Trade Administration that tracks these things).

On the assumption a slide in international trade knocked exports down 10% (which would be a huge drop), assuming a one-for-one drop in goods and services jobs lost, the US economy would lose roughly 0.75% of the overall work force. However members of NAFTA and other FTA countries would be somewhat insulated and services exports tend to be less sensitive than goods to downturns in international trade volumes. As many of the US exports to the Caribbean, South and Central America are somewhat inelastic (as are exports to the Middle East) the probability is the net effect of a 10% drop in US exports on US domestic employment would likely be 0.5% or less.

The conclusion one draws from the above is that unless there is an exogenous shock to the US economy that seriously impacts financial markets and consequently the availability of credit to businesses and consumers that constrains future spending, the likelihood of a recession is a lot less than the market believes.

In reality the negative yield curve has more to do with a world awash with liquidity desperately seeking yield, particularly with 10-year Bund yields straddling “0%” again.

There are however two real threats to US economic growth, firstly the contentious relationship between the Administration and the Democratic Party leadership which threatens the 2020 budget negotiations and the extension of the US Treasury’s debt ceiling. The wild card here it seems will be how far does the schism damage US growth prospects in the event of either another government shutdown or the ability of the federal government to fund itself?

The other risk is President Trump’s threat to shut down the border with Mexico which he seems to have back pedaled from as it would be extremely disruptive to the US auto industry and auto parts supplies. Private economists estimate such action would lop some 0.4% off GDP, however that would still not throw the economy into recession.

Providing the above negotiations do not boil over and damage economic prospects, continued low US yields will sustain demand for real estate and underpin US equity values. which should support private spending patterns and and GDP. Fed staffers are projecting US GDP at 2.1% this year and 1.9% in 2020. Private forecasters are a little more optimistic and are looking around 2.5% for 2019. The Fed is unlikely to cut rates in such an environment and as the ECB continues to add to its balance sheet, albeit at a slower pace, whilst the Fed is in the process of slashing another $220-255bn off its balance sheet, divergent monetary policy should continue to cap EUR/USD advances.

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