The Next US Recession + Stock Correction
I did not call a recession in a long time, and I actually don’t have one to call for now within the next year… BUT I can now say that the risk of recession is rising for 2020–2021. Here’s why…
Recessions happen when a few “planets” align. There are 3 broad categories of triggers:
- An impossible-to-foresee shock: terrorist attacks that cause enough panic to tip consumption and investment at least for a small while; stress about war that can unsettle markets and business investments; political risk, etc. These types of shocks are generally NOT causes for deep and severe recessions. Actually, they can even be great occasions to buy the dips.
- Something fundamentally wrong with a very large sector of the economy, which is generally either housing or banking or credit. These are the worst recessions and they happen very rarely. They are generally triggered by a period of “excessive accumulation” of whatever (too much credit or new real estate building activity or banking risk for whatever reason, etc.) followed by inflation and central bank tightening.
- A central bank disinflation program, which happens when a central bank decides to lower its inflation target and hammers the economy with tightening credit conditions. Note that this is NOT to be confused with normal monetary tightening when inflation is rising above target. In the USA and Canada, we had 2 major disinflation programs in the past 50 years: early 1980s and early 1990s. There is NO possibility of disinflation programs anywhere in the industrialized world for now and for a long time, since targets are at around 2% everywhere and will not be lowered to 1% or 0% any time soon.
Since “one-off shocks” are not really something you can “plan” AND since they are rare and have only mild effects, and since there will be no disinflation program, we are left with only one possible cause for a recession: something fundamentally wrong in a large market combined to increasing inflation that would cause a convincing central bank tightening…
The Output Gap
An economy can run below or near potential and generally not have much inflationary pressure. Once actual production activity starts to “outpace” production capacity (potential), you get increasing production costs due to “maxing out” production capacity and scarce labor that causes increasing wage pressure and production costs.
Where are we now? When looking to see where an economy stands, you look at 1) price pressures, 2) labor market indicators, 3) “capacity utilization”… Here are a few indicators that tell us where we stand in terms of output gap. Short story: we are close to “full employment”, which means production is roughly around potential, although my 2 cents is that there is STILL extra slack remaining in the economy that should be used up by approx 2020–2021. Scroll down for further discussion.
Core PCE inflation:
Standard core inflation:
Total inflation:
Wage growth:
Initial jobless claims:
Unemployment rate:
Employment rate:
Participation rate:
Capacity utilization:
As you can see, unemployment may be low, but the participation rate, the employment rate, and capacity utilization suggest we are not totally out of steam yet. Given current trends, my 2 cents is that we should run out of slack by around 2020 and hence see more convincing inflation by then, which means increased risk of a convincing monetary tightening, stock correction, and recession, in that order.
Trump’s tax overhaul has given an extra boost to economic momentum that should bring us well into 2020–2021, but that tax stimulus came at a time of an already-improving economy and outlook, so it could tip the scale just enough to bring us above potential by 2020. Given this backdrop, my take is that there is little risk of major stock correction or recession until 2020.
US stock prices are high and could have limited upward potential going forward, but still do have some steam left. Europe seems a better bet going forward, as I have been saying to people around me for a while now.
I do not see major imbalances in housing, credit, or banking. There are issues in commercial real estate and car loans, but these are not big enough to significantly derail the broad economy. So where could it come from?
The bond market
Trump’s fiscal overhaul gives a boost to the economy, but will eventually cause a hole in the budget, which is already very much in the red for as long as the eye can see.
From the Congressional Budget Office:
“CBO projects that over the next decade, if current laws remained generally unchanged, budget deficits would eventually follow an upward trajectory in relation to the nation’s economic output, and federal debt would rise. Economic growth is projected to remain modest, averaging slightly above 2.0 percent through 2018 and averaging somewhat below that rate for the rest of the period through 2027. The budgetary and economic trends discussed in this report are similar to those CBO described in January, when the agency issued its previous estimates.”
The GOP may have a “hidden” agenda to “starve the beast” but it may end up messing things up badly. The “starve the beast” approach is to cause a debt “crisis” that gives the political “excuse” to make tough choices. The “tough choices” are never popular, and if you want to starve the State, you use the crisis to cut in major social programs, because that’s where the real money is (and in the military, but that is never cut under GOP watch).
If it gets to a point where cuts must be made in major programs, social tension could rise again and roil markets due to policy and political uncertainty. If Democrats are in power in all major spots (White House, Congress, Senate, Supreme Court), then you could see increasing taxes, which also roil markets.
So either way, the next shock seems to be shaping up to be related to fiscal and debt issues, because it does NOT seem to be shaping up in major “systemically important” markets.
With aging populations in many countries, fiscal problems could become the next big issue for many countries, while the rest of the economy works relatively well. Some may not have debt problems but could be stuck with eternal economic stagnation, which could increase social tension and political tensions.
These problems will be worse for countries with a combo of 1) high debt-to-GDP ratio and 2) high external debt (negative international investment position relative to GDP). The countries with the deadly combo of high and increasing debt-to-GDP and lots of external debt are Greece, Portugal, Spain, USA.
The USA can stretch things quite a bit, since they have the world “reference” currency used in oil, commodities, and international debt contracts, but there is a limit even for them. At one point, the fiscal outlook will meet the bond market.
US debt-to-GDP is constantly rising and is on an unsustainable path, given that they have huge deficits while the economy is doing very well. Given that a non negligible proportion of US debt is financed from external sources (contrary to Japan) and given that demographics are not as inflation-killing as Japan, the USA can’t “pull a Japan” and rack up debt like there’s no tomorrow. At one point, bond holders will start worrying, especially the ones holding the 10+ year maturities.
Since most of the US federal debt is within the 0–5 maturity range, debt will be rolled over at increasing rates as inflation and yields rise within the next 2–3 years. This will naturally cause a change of holding strategies and could put upward pressures on long yields, which then will cause stress on stock markets. Once inflation starts to hover around 3%, the Fed will have less and less wiggle room and will have to let things happen, because it won’t have QE options anymore.
Asset prices could start falling, causing international holders to pull back and add depreciating pressure to the USD, hence adding exchange rate risk to the equation. This could be enough to bring the bond market to a mini selloff on the long maturities and panic stock holders… and that would be the beginning of the party: inflation + bond market correction + high asset prices = selloff = recession within 1 year. I doubt it would be a deep and severe recession as in 2007–2009, but we will see once we get there. Just keep your eyes on inflation and the 10-year bond yield… Clap, like, comment, and share! Regards.
Pascal Bedard
pbedard@yourpersonaleconomist.com
