Worries about the U.S. economy rank right up there among the myriad of risks constraining equity markets worldwide and keeping the U.S. indexes in correction mode.
Most U.S. economic data have been relatively sturdy in recent weeks and months, so it’s unlikely the business cycle will come to a screeching halt. But domestic economic momentum has moderated and factors could hasten an end to the business cycle earlier than previously thought—and consequently, halt the equity bull market.
Following are the most frequent questions about the U.S. economy that investors have been asking us lately. They make up an economic “worry list” of sorts, and are worth contemplating.
Why is growth still sluggish?
Q1 GDP growth of 2.3 percent was well below the 3.1 percent average of the prior three quarters and nearly equivalent to the subpar trend that has persisted throughout this unusually weak recovery period. The largest tax cut package of all time was supposed to boost the economy. What happened?
The economic benefits of tax cuts and other fiscal stimulus typically don’t materialize right away. They usually take at least a couple of quarters to kick in. There are anecdotal signs growth could accelerate in the second half of the year, if not sooner. Two examples: During Q1 earnings conference calls, we detected a pickup in small and medium-size business momentum, and homebuilders indicated new home purchases have been brisk despite the rise in mortgage rates.
Could inflation become a problem?
This is certainly a risk the bond market has been focused on, as has the stock market, to a lesser extent. First off, a disclaimer. When we talk about “rising inflation,” we’re not talking about 1970s- or early 1980s-style runaway, high inflation. We think inflation will rise further, probably moderately beyond the Federal Reserve’s 2 percent core inflation target (excludes volatile food and energy prices). Wages are moving up, as are prices of commodities that are used as inputs for industrial products.
The natural process of inflation rising back toward more normal levels after a lengthy period of ultra-low inflation will likely unfold. This would be positive, not negative, in our view. One of our favorite inflation indicators, the New York Fed’s Underlying Inflation Gauge, is pointing toward higher inflation. We think the Fed will allow core inflation to drift moderately beyond its 2 percent target. But if inflation seems headed well beyond that level, look for the Fed to actively intervene with additional rate hikes. The uncertainty surrounding inflation’s ultimate stopping point could put financial markets on their heels at times.
Are you concerned about tariffs?
Sentiment surveys, including those conducted by RBC Capital Markets, indicate the Trump administration’s tariff policies have the business sector and institutional investors on edge. It’s unclear how far the administration would go to implement a protectionist agenda and how trading partners would retaliate. We are concerned because tariffs normally bring negative economic implications with them, but the global economy is sturdy enough to absorb modest trade spats and targeted tariffs, in our view. We don’t think this will metastasize into an all-out trade war. That being said, trade risks are difficult to model and have the potential to become more intense in the coming year. For more about this topic, see our article, The year of the tariff.
What about the flat yield curve—is a recession coming?
When the spread between short- and long-term Treasury yields is narrow, like now, it doesn’t necessarily mean a recession is imminent. The yield curve can stay flat for a long time, sometimes years, like in the 1990s. The difference between 10-year and 2-year yields was only 35 basis points (bps), on average, from 1995–1999, and the curve even dipped slightly into negative territory for a brief time before clearly inverting in 2000. By comparison, the yield curve is currently at 46 bps. During the flat period in the 1990s, GDP grew at a strong 4.2 percent average rate and never fell into negative territory. Despite this period, flat yield curves are often accompanied by subpar GDP growth.
Inverted, or negative, yield curves are another matter entirely. When the difference between 10- and 2-year yields turns negative, it is typically a sign a recession is coming in the next six or 12 months, as the lower chart illustrates. Inversions matter most, and are the biggest threats to stock market performance because history shows that when a recession hits, corporate earnings plunge, and the equity bull market morphs into a bear market. The key takeaway is that an inverted yield curve usually gives investors time to become defensive because a recession doesn’t automatically happen right away.
One of our mantras has been “to stay vigilant” when it comes to market risks, so this “worry list” is important to contemplate. We think the business cycle has further to go and the U.S. economy can keep growing for the next 12 months, at least. But growth could be uneven or sub par, and the issues above could linger as headwinds for financial markets.