Is The U.S. Heading Toward a Recession?

With the market deciding to honor the late great Tom Petty this week with it’s cover version of Free Fallin, it would be unwise to stoke the fuels of fire by pointing out reasons why the U.S. could be heading toward a recession. Damn the torpedoes! Let’s do it anyway.

Why are we heading toward a recession? Because…

  1. Economies are Cyclical

This school of thought could be called the “We are due for a recession” theory. Since 1930, according to the National Bureau of Economic Research, the average economic expansion in the United States has lasted about 5 years. We are currently in an expansion that is 8.5 years long and is the third longest expansion since Prohibition ended. Only the expansion between 1991 and 2001 (120 months) and the one between 1961 and 1969 (106 months) have lasted longer.

At 4.1% the U.S. unemployment rate has been dropping steadily since it peaked at 10% in October 2009. According to the Bureau of Labor Statistics, the last time it was this low was at the end of 2000, when the rate sat at 3.9% in December of that year. Many economists believe the labor market has been at or near “full employment” for several months now, meaning there are very few people who want a job that don’t have one. For the unemployment rate to drop much further, wages would have to reach a level where those who don’t really want to work are lured into the work force.

With the length of the economic expansion and the once-a-generation unemployment rate at cyclical tipping points, “we are due for a recession.”

  1. Demand from abroad may have peaked.

The World Bank released its Global Economic Prospects report this month and the subtitle of the report says it all: Broad Based Upturn, But For How Long? Economies across the globe are relatively strong, but in some places like Europe growth and demand have likely peaked due to structural issues like a shrinking working age population and entrenched weak productivity limiting potential.  While the Euro Area saw better than expected growth of 2.4% in 2017, the The World Bank report expects growth to drop to 2.1% this year and below 2% for 2019 and 2020.

Economic growth in China also peaked several years ago as the country has undertaken a transition to an economy more balanced between exports and domestic consumption. The World Bank reports that growth in China will fall from 6.8% in 2017 to 6.2% in 2020.  Still strong growth, but well below the double-digit growth seen earlier in the decade.

  1. Wage growth continues to flounder

Wage growth in the U.S. continues to be less than dynamic. While wages seemed to be ticking upwards toward 3% annual growth near the end of 2016, 2017 saw growth slow down to about 2.5%. Growth in wages continues to outpace inflation, which the Bureau of Labor Statistics listed at 2.1% in December. However, if the gap between the two shrinks with rising inflation and stagnating wages, increases in wages will not make up for the higher costs of goods and services.

  1. Interest rates on the rise

As the economy continues to improve and a new regime takes over the Federal Reserve Board, expect interest rates to increase at a more rapid rate than they had during the Yellen years. Higher Interest rates bring with them a few side effects that could limit economic growth. First, higher interest rates make it more expensive to borrow money. Granted, even with a few ticks up, rates will still be at historically low levels, but the cost of borrowing money will be greater a year from now than it is today. Second, debt repayment becomes more expensive as rates rise. As variable rates rise, those with these types of loans will have a higher debt burden resulting in more of their disposable income going toward debt servicing. Third, while higher interest rates raise the debt burden, they also provide more incentive for personal saving if your money can earn more sitting in the bank. While saving more money is good for your household balance sheet, spending instead of saving is better for the economy.

  1. Black Swans

The data I have laid out points to several issues that are going to have a negative impact on the economy – issues we can see coming a mile away.  But unknowns can always hit the economy when it least expects them.  There are three Black Swans that I believe are most likely to shock the economy. First, some type of event that would impact the supply of oil to global markets would result in higher gas and heating oil prices and more consumer dollars being spent filling up fuel tanks in cars and for home heating. What we have found over the past several years is that such an event would have to be a major one, as minor disruptions to oil supply have not triggered significant price inflation since the Shale Gale.  Second, a hard landing for the Chinese economy, where economic growth stalls to below 3% would negatively impact global demand and hurt world economies. Finally, an increase of tension or potential military action on the Korean Peninsula could result in widespread market panic.

Saying all this, it is not my expectation that we will see a recession in the U.S. this year. The short-term benefits from tax cuts, the potential that the tight labor market results in an increase in wages and in turn disposable income, and the potential for an infrastructure investment package indicate the economy still has some ammunition left to fire. But if we do see a recession, some combination of the reasons I have listed will likely be the cause.

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