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
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.
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
, 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.
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.
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.
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.
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
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.
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.
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.
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.
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.
Markets could correct if the economy slips into a
growth recession or worse, given the downward pressure
on profits associated with such a scenario.
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
Copyright © 2019 Diane Swonk – All rights reserved. The information provided herein is believed to be obtained from sources deemed to be accurate, timely and reliable. However, no assurance is given in that respect. The reader should not rely on this information in making economic, financial, investment or any other decisions. This communication does not constitute an offer or solicitation, or solicitation of any offer to buy or sell any security, investment or other product. Likewise, this communication serves to provide certain opinions on current market conditions, economic policy or trends and is not a recommendation to engage in, or refrain from engaging, in a particular course of action.