The Impact of the Economic Showdown

Good for movies but not for the consumer

Every good Western movie has an old-fashioned showdown. Following a conflict, everyone is out in the street drawing their six-shooters, and it ends with dramatic results. While this is a winning formula for cinema, the last thing we look forward to in global economics is a showdown. Economic showdowns can negatively impact growth, stock prices and inflation.

Today, there are several global economic issues and conflicts that could lead to a shoot-out. Some have a short-term impact, while others have a longer-term impact that will ultimately lead to an economic slowdown in the U.S.

Trade tensions

As we start 2019, trade tensions dominate the headlines. Will the trade showdown lead to a trade war? A history lesson may give us clues as to what a trade war looks like and the impact it would have on the economy.

Tariffs, which protect specific industries, have been part of U.S. history since our nation was founded. The most punitive tariffs were put in place in 1930 when President Hoover passed the Smoot-Hawley Act. This act placed an approximate 60 percent tariff on a broad basket of products and caused dozens of countries to retaliate. U.S. exports and imports to and from Europe declined by 66 percent between 1929 and 1932. Tariffs added to the already strained economy and prolonged the depression.

Today, U.S. tariffs are among the lowest in the world. Consider the following points of comparison:

According to the World Bank, the average U.S. import tariff across all products is 1.6 percent, compared with China’s average tariff of 3.5 percent and Mexico’s average tariff of 4.4 percent. The U.S. has only a 2.5 percent duty on imported automobiles from Europe and China. Europe has a 10 percent duty on automobiles imported from the U.S.; China recently cut the tariff on U.S. cars from 25 percent to 15 percent.

With these numbers in mind, it can be difficult to see free trade or even fair trade — let the showdown begin. This may lead to a slowdown in global growth. If not resolved, tariffs will increase prices, leading to margin pressure on corporate America and inflation for the consumer.

Tight labor market

Another showdown looming is the challenge that a tight labor market brings. According to the National Federation of Independent Businesses, two of the top concerns small business owners have are finding workers and the quality of workers. With unemployment at 3.9 percent, the labor market is tight, and if businesses can’t find workers, economic activity may slow while wages will continue to increase. 

Over the past nine years, business has been good. The economy has expanded at an average growth rate of 2.2 percent. The economy can continue expanding if there is labor force growth and productivity gains – but neither of these are increasing significantly. Labor force growth in the past year is a paltry 1.3 percent, and productivity gains are up a mere 1.3 percent. If businesses can’t find workers and there are limited productivity gains, economic growth will slow.

Average hourly earnings are up 3.2 percent year-over-year. This is good for workers, as they have more discretionary income. It can be challenging for companies, however, as the rising wages also increase their costs. If wages go up in a stagnant to slowing economy, it becomes difficult for companies to cover costs, let alone grow. Wage inflation can be a significant driver of overall inflation, something the Federal Reserve is watching closely. 

The Fed

The Fed may get a bad rap. It is blamed for ending economic expansions by increasing interest rates too fast or too much. In late 2018, data showed the economy was slowing, but the Fed communicated a steady-as-she-goes policy. As a result, the Dow Jones Industrial Average sold off sharply on Oct. 10, down 831 points and again on Dec. 19, tumbling 348 points — all due to the threat of higher interest rates.

In January 2019, however, the Fed said it will be patient and data-dependent. This sent the stock market up 747 points and the risk of a showdown dissipated. It is quite clear that the uncertainty around the Fed’s monetary policy continues to be a risk. 

In previous economic cycles, the Fed raised rates well over the neutral interest rate, which is the rate at which real gross domestic product (GDP) is growing at its trend rate and inflation is stable. Many think raising rates over the neutral interest rate is what ended previous economic expansions. In 2019, we expect GDP to grow very close to trend GDP. And in the last half of 2018, inflation — using the Consumer Price Index as a barometer — decreased. The Fed suggests that the neutral rate is around 2.8 percent. Therefore, we forecast a one-and-done Fed hike in 2019. If this happens, the current economic expansion will continue through 2019.

Pennsylvania Avenue

We will experience several politically-based showdowns this year. Government shutdowns are not new, as Presidents Carter, Reagan, Bush, Clinton and Obama all had periods of government shutdowns.

Economic activity slows down when the government is shut down. We estimate that GDP is reduced by 0.10 percent each week the government is closed. First quarter GDP growth could be cut in half or reduced to zero if the shutdown lingers, which may cause us to reduce our annual GDP forecast.

Another potential showdown in Washington, D.C. is the expanding fiscal deficit and our national debt.  Typically, the budget deficit is going down late in an economic cycle, which makes sense. Business is good, unemployment is down and tax revenue is up, so the deficit shrinks. But not this time around. Business is good, unemployment is down, yet the budget deficit is getting larger—and that means our national debt continues to grow.

This showdown will likely be political rhetoric this year but becomes a very serious economic showdown in years to come. Academic research looks specifically at the relationship between net debt, which is total debt minus intra-government owned debt, and GDP. Studies argue that if a country has more than 90 percent net debt to GDP ratio, it cannot experience economic growth greater than 2 percent. This appears to be true for Japan and Italy, which each have well over 100 percent net debt to GDP ratio. Both countries have grown their economies about 1.3 percent annually over the past three years. Today, the U.S. has 78 percent net debt to GDP ratio. It’s getting larger and may be a future showdown to keep an eye on.

Showdown to Slowdown

Economic Forecast

The global theme has changed, moving from synchronized global growth to synchronized global slowdown. The fundamentals in the U.S. are slowing, but only back to trend growth. We expect GDP growth to be between 2 and 2.4 percent in 2019, a slowdown from 2018. This is not a negative theme – if directionally correct, the U.S. economy will set the record for the longest expansion in history in July 2019. In addition, 2 to 2.4 percent growth will allow companies to be profitable and individuals to increase consumption.

Equity Expectations

An expanding economy should provide a positive backdrop for revenue and earnings growth. We forecast 7 percent earnings growth in 2019. The dramatic market sell-off in the fourth quarter created an oversold posture. Because of this opportunity, we anticipate 10 to 12 percent total returns in equites and the S&P 500 ending the year at 2800. Keep in mind, the market climbs a wall of worry. Today, there are plenty of things to worry about.

Fixed Income Outlook

We expect the Fed to hike rates only once in 2019, moving short rates to 2.75 percent by year-end. Due to the lack of inflation expectations, we anticipate the yield curve will remain relatively flat and the 10-year Treasury yield should finish the year around 3.1 percent.

Riding into the Sunset

As these showdowns escalate, confidence weakens and may have a temporary impact on economic activity. History tells us, however, that many of these showdowns are not new. Often, they are resolved and the impact on the economy is manageable. No doubt there will be volatility due to these showdowns, but overall, current data suggests another year of moderate GDP growth.

Categories: Finance