Economic Insights - February 4 - 8, 2019
- What will cause the next US recession? With not a lot of excesses in the US economy, we don’t foresee a domestically driven recession. We expect the next downturn to come from trouble overseas, perhaps from China.
- Weekly Highlights: The trade deficit narrowed but this is likely not the start of a trend. Another week, another weak set of data from Germany.
- Investment Implications: While unlikely, if the next US recession did come about and it did come from abroad, we’d overweight US long-dated government bonds and domestically-oriented US stocks. We’d underweight ex-US stocks and high yield bonds.
What will cause the next US recession?
This expansion has lasted nearly 10 years and we expect it to last a while longer. But eventually it will end. We speculate on what may bring about its demise.
Recessions are typically triggered by imbalances in one or two parts of the economy. The housing sector caused the 2008 recession. The stock market crash led to the 2001 recession. A commercial real estate bust, and oil-price spike triggered the 1990-91 recession. Fed rate hikes to control inflation set off the double-dip recession of the early 1980s.
But right now, there are not a lot of excesses. Household balance sheets are in fine shape. Corporate debt is high, but so too are corporate cash levels. With ample US supply, oil prices will likely not spike. So, the next recession may come from outside the United States.
In fact, we may have gotten a preview of the next downturn. In 2015 and 2016, oil and commodity prices collapsed. World nominal gross domestic product (GDP) contracted. The US did not fall into a recession per say. But, manufacturing collapsed, corporate profits tanked, and investment dropped. Real GDP growth came to a near standstill at the end of 2015, growing just 0.5%.
External forces matter more for the US economy, as it becomes more open. The share of US corporate profits coming from overseas has been trending up for some time. With the booming energy sector, the United States is more exposed to downdrafts in commodity prices. In fact, the United States turned into a net exporter of oil last year.
A global growth slowdown would have to be severe to cause a US recession; China would be the most likely culprit. China’s share of the global economy has soared. According to IMF World Economic Outlook data, China now makes up 15% of world GDP compared to the US’s 24%. According to S&P Global, China comprises the largest share of foreign revenue of S&P 500 companies, at 4.3%.
A sharp Chinese slowdown would affect the US economy in a variety of ways. A decline in exports to China by itself would not be enough to cause a US recession. US exports to China make up less than 1% of GDP. But, a Chinese slowdown would cause shockwaves across the rest of the world, including to some of the US’s largest trading partners like Canada and Europe. Oil prices would likely tank hitting the US energy sector hard. The dollar would probably surge, a forced devaluation of the yuan would make matters worse. In turn, US corporate profits from overseas would lose value, and overall profits may shrink. Weakening profits would weigh on investment spending and hiring.
This scenario is not too far-fetched. Chinese growth is slowing. Both the government and Caixin Purchasing manager indexes (PMIs) are below 50.0, signaling contraction. Vehicles sales declined for the first time in 28 years in 2018. But, the government is doing all it can to stimulate growth. In addition, China is under pressure to get a trade deal done with the United States and wants to have a reserve currency. So, yuan devaluation is unlikely. We don’t expect China’s current growth slump to trigger a US recession anytime soon, but risks are elevated.
Narrower trade deficit, but temporary: The trade deficit fell to the lowest level in five months. Imports and exports both shrank, but imports declined by more. The smaller-than-expected trade deficit may be positive for fourth-quarter GDP. Trade was a significant drag on GDP in the third quarter.
But the fall was likely a one-off. According to Bloomberg, cell phone imports declined because of a lack of consumer enthusiasm, and oil slumped because of refinery maintenance. There was also likely some give back after imports surged in the prior months as businesses tried to build inventories ahead of tariffs.
German slump continues: German industrial production and factory orders dropped yet again in December. On a year-over-year basis, factory orders declined by the largest amount since 2012. The European Commission cut its 2019 growth forecast for Germany from 1.8% to 1.1%. Germany’s manufacturing sector is likely getting hit by China’s slowdown. With downside risks to growth, the chance of a European Central Bank rate hike this year is less and less likely.
While unlikely anytime soon, when a US recession did happen, we’d move into long-dated US government bonds. We’d underweight ex-US stocks. Typically, US stocks outperform the rest of the world’s stocks in a recession. And, if the recession came from outside the US, we’d expect that outperformance to be more extreme. We’d overweight US stocks with a larger domestic exposure, they’d likely be less affected by a surge in the dollar. We’d underweight high yield, with its significant exposure to the energy sector.