Winter Storm Watch

Read the January Economic Currents in PDF 

The policy landscape in the U.S. has become much like the weather in Chicago; it can change dramatically in the course of a day. That is what happened on January 2. The escalation of tensions with Iran following the killing of a top Iranian general by the U.S. has introduced a whole new host of downside risks to the outlook. I spent the past few days reading and talking to geopolitical experts to get a better sense of what may occur. It was not relaxing (understatement).

The Iranians have stated that their beef is with the president, not the American people; their goal was to attack U.S. military bases, which they did on January 7. There were no casualties or major damages, which the White House and the rest of the world read as an attempt by Iran to de-escalate.



The president has called upon NATO for support in sanctions against Iran, which is a heavy lift given the deterioration in relations with our closest allies. Iran has been a serial aggressor in the region and has threatened to continue to up the ante. Iran has several options:

• Targeted attacks and blockades in the Strait of Hormuz, which would trigger a spike in oil prices. Much of the oil from the Middle East traverses those waters.
• Attacks on Saudi oil fields. Iran used drones to attack a field in September as an extension of its proxy war with Saudi Arabia in Yemen.
• Fomenting a civil war in Iraq, disrupting oil exports.
• Cyber attacks.
• Terrorist attacks on American citizens.

The conflict has taken the focus off of ISIS, which is regaining momentum. During the Turkish invasion of Syria, hundreds of prisoners guarded by Kurds escaped.

The largest economic shocks from a conflict with Iran are likely to come from two sources: modestly higher oil prices and the blow to confidence associated with the uncertainty surrounding outcomes. There is really no road map to measure the impact a major cyber attack could have on the U.S. economy, except that it would feed fear and uncertainty about the future, which are already weighing on the economy.

The Federal Reserve is most concerned about the latter. Rising risks and the toll from uncertainty tied to trade wars were reasons that the Fed did a U-turn and cut rates in 2019. The boost to housing, mortgage refinancing and spending on big-ticket items is still visible today. However, the manufacturing sector remains weak.

Worse yet is the break between consumer confidence and CEO confidence, which remains in recessionary territory. (See Chart 1.) Even confidence in the service sector, which had largely escaped the weakness in manufacturing, plummeted in recent months. This begs the question, what do CEOs know that the rest of us are missing?

This edition of Economic Currents provides a deep dive into the economic outlook, paying special attention to downside risks. The economy is much better positioned to weather higher oil prices than it once was, while the Fed has proven its willingness to act quickly to hedge against downside risks. Those on the Fed would rather overstimulate an economy that is still undershooting on inflation than wait until the economy actually falters before taking action. We have adopted our slowdown scenario from last month as the base case for 2020, but a recession cannot be ruled out.



Growth Slows 2020 Outlook Real GDP is expected to slow from an average 2.4% in 2019 to 1.9% in 2020. The risk is that the economy slips into what economists call a “growth recession,” or worse. (See Chart 2.) A growth recession occurs when companies preserve profit margins with budget cuts. The pace of hiring slows below the pace of workers entering the labor market, causing the unemployment rate to rise.

The strongest argument for a slowdown in the pace of hiring in 2020 can again be found in the surveys of CEOs. The most recent survey of CEOs by the Business Roundtable, which actually asks about hiring plans, shows that 60% of participants plan to hold the line on hiring or cut workers over the next six months; that is up from 43% a year ago.

Consumer spending is expected to hold up best. Earlier rate cuts triggered a surge in mortgage refinancing and a pickup in home buying. Eventually, a slowdown in hiring and higher prices at the gas pump will drag on growth.

Consumers are more vulnerable to negative news shocks than they were in the past. Their expectations about the future have fallen well below their assessments of current economic conditions, which makes them more skittish during times of uncertainty. An extreme example of this phenomenon occurred when consumers and businesses came to a virtual standstill in the wake of the 9/11 attacks.

Home buying and building should start the year strong. We are still benefiting from low interest rates as pent-up demand for housing is ballooning and the backlog of home sales remains high. Construction on new homes continues to trail household formation, while the inventory of existing homes for sale continues to shrink.

Increasing concerns about job security, rising energy costs and slowing income growth are expected to take a toll on buying and construction later in the year. Affordability will remain a hurdle as tight inventories keep upward pressure on prices.

Business investment is expected to remain the Achilles heel of the outlook. A scheduled cut in production of the Boeing 737 Max will exacerbate losses at the start of the year. The collateral damage to suppliers is expected to be particularly large. Boeing still expects to bring the plane on line by mid-year, but even then there will be hurdles to overcome as pilots will need to be retrained and foreign governments will need to sign off on modifications before exports can resume.



More broadly, some short-term business investments that were delayed last year should move forward once a phase one agreement on trade with China is signed. Tariffs still place an ongoing uncertainty on the course of trade policy in an election year, which is expected to continue to hold back larger, long-term investments. It is hard to place a bet on where to invest your manufacturing capacity when you don’t know how your supply chain and sales could be further impacted by trade wars.

Higher oil prices are likely to add insult to injury as they will further squeeze profit margins. It is expected to take at least six months of higher oil prices for U.S. investment and production in the oil patch to pick up, while alternative energy sources remain limited. Production in the U.S. was still contracting at the end of 2019; the rig count dropped 30% from a year ago in December.

CEOs are even more susceptible to a negative news shock than consumers because their confidence in the economy is already low. The risk is that they start relying more on job cuts to boost margins in the year ahead.

Inventories are expected to drain, which will place a further drag on production and investment. Firms scrambled to load up on inventories ahead of tariffs and the GM strike last year; they are now liquidating inventories. The cut in production of the 737 Max will exacerbate the drawdown in inventories.

Government spending is expected to pick up now that the budget for fiscal year 2020 has been passed. There is also a boost in spending in the second quarter tied to the 2020 Census that reverses course again during the second half of the year as the Census winds down. State and local government spending is expected to slow slightly in response to a slowdown in both incomes and corporate tax revenues.

Trade is expected to place less of a drag on growth in 2020. The primary reason is the resumption of agricultural exports to China.

Separately, there are risks that the trade war with Europe could heat up. The European Union (EU) is expected to retaliate with tariffs tied to subsidies for Boeing after it was hit by tariffs for Airbus subsidies last fall. The administration has not ruled out vehicle and parts tariffs as a response to any additional tariffs from the EU. However, the deadline involving those tariffs for national security reasons expired last October; the Commerce Department may have to review the tariffs again before they can be implemented.

Downside Risks: The credible threat that tensions between the U.S. and Iran will worsen in the months to come means that risks are to the downside for economic growth. The toll associated with a massive cyber attack is particularly hard to quantify, but would no doubt hit consumer and business confidence.

Inflation Edges Higher Overall PCE (personal consumption expenditures) inflation is expected to move up slightly in 2020, largely in response to higher energy prices. Most of the rise in oil prices was already baked into the cake. OPEC cut production at the same time that production in the U.S. was falling. Any additional increase in prices from a conflict with Iran is expected to be small.

The core PCE measure of inflation, which excludes food and energy prices, is expected to move up slightly but remain below the Fed’s 2% target. Health care and shelter costs are expected to remain drivers of core inflation. Ongoing restructuring in retail and aggressive discounting in the vehicle sector will provide a drag on overall inflation.

“The Federal Open Market Committee (FOMC) is expected to cut short-term interest rates at least once in 2020 as inflation continues to fall short of its target.” The pace of tuition increases has moderated substantially, albeit from extremely high levels.

Risks: The risk is that inflation comes in hotter than expected, given the upside risks to oil prices and ongoing shortages in the housing market.

The Fed Cuts Rates The Federal Open Market Committee (FOMC) is expected to cut short-term interest rates at least once in 2020 as inflation continues to fall short of its target. Committee members want to avoid the disinflation and stagnation trap that Japan experienced in the 1990s and early 2000s.

Separately, the Fed is expected to continue to expand its balance sheet in the first half to provide more liquidity for overnight credit markets. This is one side effect from running much higher federal deficits. It is no coincidence that the yen overnight markets experienced acute liquidity problems at the very moment that Treasury issuances surged. The Fed has gone to great lengths to argue that the reversal of its balance sheet size is not quantitative easing but perception is reality in financial markets: If it walks like a duck and quacks like a duck, it’s a duck.

Risks: The Fed has already proven its willingness to cut preemptively and will not hesitate to cut more aggressively should tensions with Iran pose a more direct threat to the stability of financial markets and growth.

The Fed hopes to stem the growth in its balance sheet in 2020 as long as the overnight market for credit stabilizes. Fears of a crunch on overnight funding were overblown; the overnight markets corrected. A surge in uncertainty tied to a conflict with Iran could sideline those plans.

10-Year Treasury Yields Remain Low The yield on the 10-year Treasury bond is expected to dip to 1.6% by year-end. The Fed’s balance sheet operations and concern that growth will slow are expected to offset any upward pressure on rates associated with higher overall inflation. Much of the inflation tied to higher energy prices is expected to be transitory.

Risks: The yield curve could invert again (the 10-year yield could drop below the 3-month yield) if the Fed hesitates on cutting rates further. This is something that upped the risk of recession and prompted the Fed to cut more aggressively during the summer last year. (See Chart 3.)

Financial Markets Become More Turbulent Uncertainty is the enemy of financial markets, which means we could be in for a rocky year. Geopolitical risks have supplanted trade wars for financial markets. Risks include Iran and North Korea.

China also ranks high on the list of downside risks given the ongoing protests in Hong Kong. Military intervention by the Chinese could exacerbate capital flight and limit China’s access to global financial markets, which relies heavily on Hong Kong.

This is in addition to the volatility associated with a slowing economy and weaker profit growth. The broader stock indices are expected to end the year 5-8% higher, due largely to additional easing by the Fed.

It is important to note that the S&P 500 and the Dow Jones Industrial Average are driven by the largest and most profitable companies. This helps to explain at least part of the break between financial market optimism and broader CEO optimism. The stock market is even less reflective of overall economic conditions than it was in the past.

Risks: Markets could correct if the economy slips into a growth recession or worse, given the downward pressure on profits associated with such a scenario.

Bottom Line Something has to give. Either CEOs need to regain their mojo and commit more to investing in the future or growth will slow in 2020. The economy is better positioned to weather higher energy prices than it was in the past. A major blow to confidence dealt by the storm brewing in the Middle East would be much harder to survive. There is no precedent for how firms and individuals would respond to the kind of cyber attack the Iranians are capable of launching.