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The United States' Endless End of Cycle

BLOG - 4 February 2019

As in most parts of the world, the US economy slowed towards the end of 2018, after three quarters of strong growth (3.2% on average from the first to the third quarter of 2018). Despite the shutdown of many federal services imposed by the President, despite renowned economists such as Carmen Reinhart sounding the alarm, and despite the severe correction in financial markets in December, America’s economic fundamentals remain robust. While a slowdown is inevitable this year - given last year's budgetary stimulus - announcements predicting a recession and an end of cycle seem premature. The Federal Reserve will most likely break the circle of raising interest rates, despite a gradual rise in inflation; this will temporarily relieve financial markets and the real economy. American companies, which are highly profitable, will continue to invest, albeit at a slower pace than in 2018, given that the shock of the tax reform, which allows companies to fully deduct investment, has begun to wear off. In fact, this is the reason why the prospects for 2020 are darker, and the United States’ structural problems, such as low productivity growth, high levels of inequality or the deficiencies of its education system, remain ever-present, while China's technological competition steadily increases.

In the short term, signs hinting at a slowdown are visible. The Institute for Supply Management (ISM) Manufacturing Business Report from January reports a simultaneous rebound in both production and new orders in January, after a worrying weak spot in December. Yet, the ISM index remains lower than its 2018 average. Although less than that of its partners, the American industry is affected by the blows the Trump Administration's tariff war has struck against world trade and by the uncertainties it is creating. Yet it is also impacted by the significant slowdown in the Chinese domestic demand, which we have recently discussed in this blog.

We should thus not expect America to drive global growth in 2019.

But unlike in Germany or China, where it is severe, the American industrial slowdown is moderate, and the low stock levels reported in the ISM survey seem to rule out any risk of a contraction in GDP in the coming months. This is especially the case given that consumption, boosted by job creation, faster wages and lower oil prices, held up remarkably well in December, and business investment, boosted by the tax reform of December 2017, continues to grow strongly (6.3% in the third quarter 2018).

Nevertheless, beyond the serious uncertainties regarding world trade, the slowdown in the American domestic demand is inevitable. The 2018 budget provided a budgetary stimulus approximating 1.2% of GDP according to the OECD, which largely explains the acceleration in growth from 2.2% in 2017 to almost 3% in 2018. Yet the miracles of fiscal multipliers, which so many grandstanding politicians dream of, are short-lived. Once the money is spent, growth returns to its trend, which doesn’t exceed 2% in the case of the United States, or even goes below it. We should thus not expect America to drive global growth in 2019. From this point of view, the OECD forecasts (2.7%) are very optimistic.
 
Yet there is a thin line between slowdown and recession. Economists sometimes refer to the aeronautical concept of stall speed: below a certain growth rate, the economy would be so vulnerable to any unexpected shock that it would easily slip into recession. However, comparisons do not always involve necessary truths, and I have too often heard that the American economy was dangerously close to this hypothetical critical speed. The arguments in favor of recessive risk have stronger foundations. For instance, Carmen Reinhart emphasizes the strong growth in debt issued by risky companies (in both directions) since 2013, and particularly leveraged loans and their derivatives (CLOs). Others point out that fewer buyers are willing to purchase riskier, below investment grade bonds, and that the latter’s price is falling dangerously, or, if you will, that the associated borrowing rates are rising just as dangerously

All this is undeniable, and the first cracks on corporate debt markets were clearly audible in the last few weeks. Moreover, the concern is legitimate since the 2008 crisis was primarily caused by the accumulation of private debt in the United States. That of households rose from 96% of their income in 2001 to 133% at the end of 2007. Yet we must not lose sight of the forest for the trees: American households' debt has fallen down to 99% of income by the end of 2018, and it is still falling to this day. The debt of non-financial corporations hasn’t budged much since 2007, but at 73% of GDP, it is much less worrying than in the Eurozone, where it still reaches 106% of GDP, which is 20 percentage points higher than in 2007. As for the CLOs that worry Prof. Reinhart, their outstanding amount, i.e. $300 billion, is marginal (1.4% of GDP).

The negative impact of international trade barriers, which are subject to the interests of the "America first" policy, can only worsen over time.

Other analysts argue that the flattening of the yield curve - the difference between long- and short-term bond yields - is a clear sign of recession, as shown by Stock and Watson in 1992. In fact, the gap between 2- and 10-year yields has almost disappeared in recent months. But the work of economists such as Michael Woodford from Columbia University has demonstrated that the Federal Reserve's holding of federal bonds following its purchasing program ($2,220 million in January 2019, or 10% of the outstanding amount) has reduced their yield by approximately one percentage point. In fact, this was the very purpose of "quantitative easing". The yield curve is therefore strongly distorted by the Fed's past policy, and has thus lost its predictive power.

It is therefore more relevant to worry about the weakness of the US economy in the next cycle, which would be bad news for the global economy.

The American recession, so often forecasted - perhaps because economic cycles must eventually come to an end -, does not seem to be on the agenda, at least not in 2019. Nevertheless, clouds are gathering around the horizon line of 2020. Indeed, the stimulating impact of the US fiscal policy, including its most sustainable fiscal aspects, like the corporate tax reform, will be replaced by a restrictive effect. The latter will be caused by the exhaustion of the stimulus, but also because some measures, such as lower corporate taxes and deductibility of investment, only apply for a limited period, and should end in 2023.

Moreover, the negative impact of international trade barriers, which are subject to the interests of the "America first" policy, can only worsen over time, including through the inflationary effect it has in the United States. The Federal Reserve Bank of New York estimated that the rise in import tariffs had already added a third of a percentage point to inflation. Finally, it is highly unlikely that the equity markets will welcome the fact that monetary tightening has been suspended with a new surge - we can at best hope for less volatility. Hence, the positive wealth effect that has supported consumption so far will soon become history.
 
In an ideal world, politicians would take advantage of the temporary relief to address the economy’s structural weaknesses, in particular the insufficient qualification of the workforce, faced with the digital revolution and the pervasion of artificial intelligence in companies, and thus the deficiencies of the American education system. Even if the new Democrat-controlled Congress intended to do so, this will probably not be the President’s priority. It is therefore more relevant to worry about the weakness of the US economy in the next cycle, which would be bad news for the global economy, than about the end of a cycle announced too early

 

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