The US economy seems to have peaked around the end of 2014/early 2015. Tightening in financial and monetary conditions appears to have been the driver.
Profits are now in significantly negative y/y territory and in our view signal the S&P is likely to continue to struggle, especially if there are further shocks or risk premia rise.
With net trade a drag on GDP and investment by private business contracting, everything rests on consumers holding strong, which is why consumption weakness is so concerning.
Our below-consensus growth forecast risks coming good earlier than we anticipated, reinforcing our very dovish Fed call. The economy looks vulnerable to a shock.
Why is the economy slowing and should we expect it to slow further? Our view is that the economy is still adjusting to multiple shocks, including a significant tightening in US financial and monetary conditions since 2014. That has likely been an important factor behind the slowdown. Related to the tightening in financial conditions, the price of oil has fallen more than 60% since 2014 at the same time as growth in China has slowed for cyclical and structural reasons. The value of the dollar has surged. Meanwhile, U.S. growth never quite picked up in line with expectations and growth in productivity has stalled. Oil price falls have hit investment, but since the US is a net oil importer, the larger effect has been to boost real incomes and consumption. In fact, were it not for the fact that consumer incomes had been temporarily boosted by low oil prices, growth would already have been significantly weaker.
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All recessions are different and have varied greatly in terms of their length and severity. For example, the recession of 2001 lasted only 3 quarters and brought only one quarter of negative growth (-1.3% q/q saar in 2001 Q3). GDP growth was actually positive (0.7%) on average during this downturn). The 2008 recession was twice as long as the one in 2001 and more than twice as severe, with growth contracting 2.8% on average (from 2008q1 to 2009q2).
If a recession were to occur, a repeat of 2008 seems unlikely since we have not seen a housing credit bubble this cycle - no over-building like in the last boom. If we were to have a recession, the magnitude of retrenchment would probably be a lot less in the consumer sector, which makes up about two-thirds of our economy. Our view continues to be that if a downturn does materialize, it will be led by the corporate sector. While the total amount of consumer retrenchment might be less in the next recession, it still has the potential to be large if policymakers cannot halt negative expectations from spreading and becoming self-reinforcing. With interest rates already at zero, monetary policy is less able to cushion the economy from negative shocks. This constraint could amplify the effects of even a small negative shock and produce a breeding ground for negative feedback loops. You could argue that we got a taste of this in January and early February. At this stage, a recession is a risk scenario for us.
Our central forecast is for a slowdown but for the economy to remain above its stall speed. We are not sure whether Q1 data are suffering from the ‘residual seasonality’ issue that has dogged Q1 data in recent years – though particularly absent in 2016 is an adverse weather effect. There are warning signals flashing – consumer confidence and spending, both ISMs and NFIB, as well as investment and corporate profits. Data are coming in softer than we expected and sooner than expected. That makes us nervous and it seems from Chair Yellen’s most recent speech she is nervous too. The Fed’s apparent reluctance to force the pace of hikes and its endorsement of recent market moves – pricing out hikes – is good insurance against recession risks, as financial and monetary conditions have begun to ease again.