Wells Fargo Securities Economics Group 2020 Annual Economic Outlook
The current economic upswing in the United States, which has been in place since July 2009, is the longest continuous expansion since at least the mid-1850s. Although there is a popular perception that the U.S. economy is “due” for a recession, the passage of time does not necessarily make an economy more vulnerable to a downturn. Indeed, our base-case scenario calls for the U.S. economic expansion to continue through the end of our forecast period in Q4-2021, and we forecast that economic growth will remain positive over that period in most major foreign economies as well. But as the title of this report indicates, there are a number of notable uncertainties that cloud our vision at present. In our view, an economic downturn is not likely in the foreseeable future, but one is more than just a remote possibility.
Recessions happen in one of two ways. First, an “exogenous” shock can lead to an economic contraction. For example, the moonshot in oil prices that occurred in the aftermath of the OPEC oil embargo in late 1973 was the proximate cause of the deep downturn in the U.S. economy in 1974 and 1975. A near trebling of oil prices in the months following the Iraqi invasion of Kuwait in July 1990 contributed to the 1990-1991 contraction in U.S. real GDP. But many exogenous shocks are difficult if not impossible to foresee, and most forecasters generally refrain from incorporating them explicitly in their outlooks.
Second, economies can also slip into recession when imbalances build up in an important sector, such as housing in the previous decade or the tech sector in the 1990s. A sudden unwinding of these imbalances can then lead to an economy-wide downturn. A hallmark of the current expansion in the U.S. economy is its relative lack of large and noticeable imbalances. Consequently, our base-case scenario calls for the U.S. economy to continue to expand. That said, the 2 percent or so GDP growth rates that we forecast for next year and 2021 are hardly robust. Similarly, we look for the global economy to continue to expand through at least the end of 2021, but the 3 percent growth rates that we look for over the next two years are slower than the 3.5 percent per annum growth rate that the global economy has averaged since 1980.
Uncertainties related to the U.S.-China trade war have held back investment spending in the United States in recent quarters, and sluggish growth in capex spending has acted as a governor on overall GDP growth in the U.S. economy. However, strong fundamentals in the household sector have continued to support solid growth in consumer spending. In our view, trade policy uncertainties, which have weighed on investment spending, are not likely to dissipate anytime soon. Although the United States and China may very well agree to a Phase I trade deal, we are skeptical that the two sides will come to agreement on a comprehensive deal that returns tariffs to their pre-trade war levels, at least not in the foreseeable future. Consequently, we forecast that growth in investment spending in the United States will remain lackluster.
If our base-case scenario of modest U.S. economic growth in the next two years is reasonably accurate, then the Federal Reserve likely will refrain from tightening monetary policy over our forecast period. Our base-case scenario looks for the Federal Open Market Committee (FOMC) to cut rates one more time (by 25 bps) in early 2020. We then look for the FOMC to maintain the resulting target range for the fed funds rate of 1.25 percent to 1.5 percent through the end of 2021.
Growth in investment spending in many foreign economies likely will also remain sluggish as long as trade tensions between the United States and China, the two largest economies in the world, continue to linger. And with monetary accommodation in many major foreign economies at its limits and with policymakers in those economies unable or unwilling to undertake expansionary fiscal policies, meaningful acceleration in foreign economic activity does not seem very likely. Although monetary policy in major foreign economies probably will not become significantly more accommodative, central banks in those economies likely will not be tightening policy anytime soon either.
The trade-weighted value of the U.S. dollar is more or less unchanged on balance relative to a year ago. Although the Federal Reserve has cut rates by 75 bps since July, most major central banks have continued to maintain extraordinarily accommodative policy stances. With interest rates expected to remain historically low for the foreseeable future, foreign exchange market participants may well look toward economic growth differentials for insight into currency market moves. With U.S. economic growth expected to slow further, at least in the near term, and with foreign economic growth showing some signs of bottoming out, we look for the U.S. dollar to depreciate modestly over the course of the coming year.
But a Number of Uncertainties Remain
As noted earlier, there are a number of uncertainties that cloud our outlook. For starters, trade negotiations between the United States and China could conceivably turn acrimonious again, which could lead to even higher tariffs. Not only would another increase in tariffs weigh further on investment spending, but higher prices for consumer goods would erode growth in real income that could exert headwinds on growth in consumer spending. On the other hand, negotiators from the two countries could conceivably reach a comprehensive trade deal that leads to the complete removal of tariffs. In that event, the economic outlook would improve markedly. Unfortunately, trade policy outcomes are ultimately political decisions into which we have few insights. In other words, our vision regarding the political decisions that will determine trade policy is clouded.
There are also uncertainties related to the November 2020 U.S. election to consider. There currently are a record number of individuals seeking the Democratic nomination for president, and their policy proposals span a wide range from center-left candidates such as former Vice President Biden and Mayor Buttigieg to more progressive candidates such as Senators Warren and Sanders. President Trump likely would pursue a whole different set of policies than his Democratic rivals if he is re-elected for a second term. Although we do not opine on the candidates in this report, we offer a description of some of the major policy proposals of the frontrunners. There is also the make-up of the next Congress to consider, which is impossible to predict at this point.
How will individuals and businesses react to the inherent uncertainty that the election imparts? Although we found that prior elections have not had a discernably negative effect on the U.S. economy, could the polarized nature of American politics today and the wide range of potential policy outcomes cause consumers and businesses to take a cautious approach to spending in 2020?
The foreign economic outlook is not immune to uncertainties either. Much like the U.S. economy, the outlook in most foreign economies could be meaningfully affected by the different trade policy outcomes. That is, the outlook in these economies would brighten if trade tensions between the United States and China subside and, conversely, the outlook would darken if tensions ratchet up further. In addition, the U.K. parliamentary election results will have major implications for the Brexit process that has cast a cloud of uncertainty over the U.K. economy for more than three years. A Chinese crackdown in Hong Kong, should one occur, could impart a negative shock to global growth prospects.
In sum, we believe that the economic expansion that has been under way in the United States for more than 10 years will continue for the foreseeable future, albeit at a subdued pace. Likewise, we forecast that economic growth in most foreign economies will remain modest over the next two years. But all economic forecasts, even in the best of times, are subject to at least a bit of uncertainty. In our view, the unsettled political and geopolitical environment at present imparts more uncertainty than usual into the economic outlook.
The Economic Outlook in an Environment of Uncertainty
2019 was the year in which the U.S. economy broke the record for the longest economic expansion, and our forecast anticipates that this upswing can be sustained through 2021 provided a reasonable détente could be reached in the trade war. U.S. economic growth remained positive this year despite a global slowdown and a pervasive sense of uncertainty for business leaders and financial markets. Recent rate cuts from the Federal Reserve have returned at least a modest upward slope to the yield curve, alleviating one of the recession warning signs that was flashing yellow just a few months ago. A “settled rulebook for global trade,” as Chairman Powell referred to it, would go a long way in reducing the largest source of this uncertainty, though remarkably the trade war has not been the millstone some analysts feared it might be. The slump still under way in the manufacturing sector has not yet bled into the service economy in a major way or caused serious restraints in consumer spending.
All this is occurring alongside a relentless torrent of trade-related developments, including ongoing talks with China, the ratification of the USMCA and potential (though unlikely in our view) auto tariffs. Interestingly, this is frustratingly reminiscent of how the year began, with a 35-day shutdown that did not end until January 25, 2019. Of course, 2020 is also an election year, which could impart even more uncertainty as November 3 approaches.
Our baseline expectation is that a trade war alone will not bring the U.S. economy to its knees. Our forecast has the slow-growth expansion getting even weaker, at least in the near term, but – critically – we avoid recession. The nuances of the forecast come down to the outlook for trade – frustratingly, an unknowable factor as it is largely a political decision. If the trade war escalates much more than we presently expect and we do get a recession, then sending in the cavalry will be trickier than in prior cycles. The fiscal policy response could be limited by large and growing budget deficits. The monetary policy response would be bounded by the fact that the fed funds rate would be starting at a much lower point than in prior cycles. So as we make our case for where we see the U.S. economy heading, we also consider the upside and downside risks to our forecast from different trade policy assumptions.
No Recession, Expansion Continues, Proceed with Caution
We suspect that a comprehensive trade agreement will remain out of reach. But unlike 2019, when the cost of the trade war was progressively rising, we do not expect trade prospects to get meaningfully worse in 2020.
Even without any deterioration with respect to the trade situation, we are looking for modest growth in the final quarter of 2019, with real GDP rising at an annualized rate of just 1.5 percent. Much of the weakness in the rate of GDP growth in Q4-2019 is due to sluggishness in business fixed investment spending and a continued drag from less inventory building. Residential construction activity, which is picking up slightly, is a silver lining in an otherwise cautious forecast. Given the tendency of homebuilding to have a multiplier effect, improvement in that sector may produce some additional follow-through into other areas of the economy. Even with our forecast for a weak fourth quarter, real GDP remains on track for a 2.3 percent calendar-year gain for 2019, right in line with the average annual growth rate for this expansion.
Mark Twain once famously quipped that rumors of his death had been exaggerated. For now, Twain’s joke appears to be applicable to all the hand-wringing over imminent recession that gripped financial markets at various points earlier this year, culminating in a yield curve that remained inverted for weeks during the summer. Yet other than the pullback in manufacturing and some diminished confidence on the part of both businesses and consumers, the U.S. economy continues to expand. The FOMC has been proactive, cutting the federal funds rate 25 bps three times this year and providing needed liquidity to short-term funding markets by starting to expand its balance sheet again with purchases of short-term Treasury bills.
None of this is to suggest that slowdown fears were entirely misplaced. Job growth had indeed slowed throughout the first part of the year, but not declined outright even in the face of capital spending cuts, disruption in supply chains, Boeing problems with its 737 MAX, and the recently settled strike at General Motors. Given those challenges, the 128,000 new jobs originally reported in October was surprisingly resilient. Employers added an average of 193,000 jobs per month in the third quarter. But the most recent jobs report revealed renewed strength in the labor market. Employers added 266,000 jobs in November and October’s gain was revised higher by 28,000 jobs. We expect that the pace of hiring will slow going forward, but it defies the rumors of death for the longest expansion on record.
Speaking of rumors, it takes little more than just a glimmer of hope to move the needle in financial markets these days in the context of a potential resolution to the trade war. The manufacturing sector is ready for an armistice. The ISM manufacturing index remained in contraction territory for the fourth straight month at 48.1 in November. Just the mere indication of a thawing in trade tensions in October lifted the export orders index 9.4 points to 50.4 in October – its largest one-month rise ever. But, the index gave back some of that gain in November, when the prospects of a Phase I trade deal subsided, falling back into contraction at 47.9. That October surge, however, indicates that capital spending could snap back quickly if the headwinds from the trade war truly subside.
Beyond the capex outlook, households are in a relatively strong position today. The Conference Board’s index of consumer confidence peaked in October 2018, but it remains historically high and the household saving rate is currently around 8 percent. Wages and salaries may have decelerated somewhat, but they are still up at a 4.3 percent annualized rate over the past three months, enough to sustain solid growth in consumer spending. Interestingly, wages are rising fastest at the lower end of the income spectrum, where workers tend to spend a larger portion of their take-home pay.
Until consumer fundamentals return to where they were prior to the escalation of the trade war, we have only modest growth in our outlook, looking for real personal consumption expenditures (PCE) to rise at a rate of just 2.1 percent in Q4 and to remain near this growth rate throughout most of the forecast period. Due to low base effects after a particularly soft ending to retail sales in 2018, our 2019 holiday retail sales forecast looks for a 5 percent jump from the same period last year. The recent pick-up in home sales, should it be maintained, could be a factor that boosts consumer spending. Most of the improvement has been in new home sales, where builders have found ways to deliver homes priced for first-time buyers. We look for new home sales to rise 9.4 percent this year and to grow nearly 4 percent in 2020.
Given the recent improvement in the economic outlook, doubts are surfacing as to whether the FOMC will cut rates any further. At least some members of the FOMC have not been on board with the three rate cuts that the Committee has already implemented. The presidents of the Boston and Kansas City Federal Reserve banks dissented at all three policy meetings, preferring to leave rates unchanged. Furthermore, Fed Chair Powell has observed that although “monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade.”
Although the statement at the conclusion of the October 30 FOMC meeting acknowledged a “strong” labor market and an economy “rising at a moderate rate,” it also noted that both headline and core inflation are stuck below the Fed’s 2 percent target. The Committee pledged to monitor incoming information. In our view, the FOMC is signaling that it likely is nearing the end of its “mid-cycle” period of easing, but it also does not have a preconceived notion of how policy will necessarily evolve. Therefore, we are not convinced the FOMC is done cutting rates just yet. With real GDP appearing to grow at a sub 2 percent rate in Q4-2019 and an inflation rate that is having difficulty edging above 2 percent on a sustained basis, we think the Committee will decide to cut rates another 25 bps in Q1-2020. (This forecast was predicated, at least in part, on our assumption that additional tariffs were to be levied on December 15.). Financial markets are not priced at present for additional tariffs, and market volatility could return, which would tighten financial conditions. If, as we forecast, real GDP growth edges a bit higher later next year, then we think the Committee will decide that no further easing is needed. But we also forecast that the FOMC will refrain from raising rates for the foreseeable future. In other words, interest rates likely will remain low for quite some time.
Downside Risk: What If the Trade War is Not Resolved?
The trade war has already taken a toll on various measures of U.S. manufacturing activity. The ISM manufacturing survey has included references to the tariffs or trade war in every month of 2019. We have also seen weakness in hard data such as orders and shipments. Core capital goods shipments rose 0.8 percent in October, but that came after declining the prior three months, leaving the three-month annualized rate of growth for this category at -3.3 percent. It is difficult to get excited about a near-term turnaround in business investment given the fact that despite a 1.1 percent gain in October, core capital goods orders declined the prior two months and are down 1.8 percent on a three-month annualized basis. The most recent data mean equipment spending is poised for a slight rebound in Q4, but nevertheless the trend in orders growth remains generally uninspiring. When we look at forward-looking measures of equipment spending like surveys and capital expenditure plans, there is a similar lack of conviction on the part of purchasing managers.
There have been instances – for example in May – when prospects of a major trade deal between the United States and China appeared to be at hand only for the budding agreement to be scuppered. In prior instances of failed talks, the United States has upped the ante by either raising tariff rates or exposing a new category of goods to tariffs. If a new round of tariffs goes into effect in the future, then 97 percent of U.S. imports of Chinese goods will be subject to tariffs. Without much in the way of new categories to subject to tariffs, further increases in the tariff rates would appear to be the most likely next step. So if the gloves come off completely, it stands to reason that businesses will hunker down and put off any major spending plans until the dust has settled on trade policy. Supply chain disruption, not just in the United States but all over the globalized manufacturing system, would become more difficult to avoid.
Amid the backdrop of apprehension over the past year, solid growth in consumer spending has been a needed and sometimes vital counterweight to those fears. Dissenting voters in the FOMC have even pointed to the robust pace of consumer spending to raise doubts about the need for more accommodative monetary policy. Initial concerns that the tariffs would immediately lead to higher inflation and hit consumers’ wallets have proven to be ill-founded. Because the initial rounds of tariffs largely targeted intermediate goods, they have so far – and by design – avoided directly impacting the typical U.S. consumer. More recent rounds impact finished goods such as toys, clothing, and consumer electronics. This more direct consumer exposure gives this last round of tariffs the capacity to impact U.S. inflation and consumer spending more meaningfully than earlier rounds did.
Still, consumer spending will not necessarily crater just because tariffs may push up prices of consumer goods. A typical household devotes only a third of its overall spending to goods. The other two-thirds is devoted to services, which have not been subject to tariffs. But higher good prices will lead to lower sales of those items, or squeeze wallet share for other spending, including services. The saving rate could also recede as consumers would only be able to stretch a paycheck so far.
Although further increases in tariffs likely would push up inflation, the FOMC probably would respond to any intensification in the trade war by cutting rates further. Tariff hikes probably would cause just a one-off rise in the price level. That is, inflation would not continue to climb steadily higher on an ongoing basis. But any slowing in consumer spending growth due to deceleration in real income would cause further slowing in overall real GDP growth. In our view, the FOMC would look through the one-off increase in the price level and would ease monetary policy further in an effort to cushion the economy from the tariff-induced weakening in real PCE growth.
Upside Risk: What If the Trade War is Resolved Amicably?
If the United States and China actually agree to a comprehensive (i.e., more than just $40 billion or so of American exports of agricultural goods) trade deal, then there is scope for the economy to find a higher gear in the year ahead. Without political editorializing, it stands to reason that with the election approaching, the current administration could reap some benefit from an amicably resolved trade situation and the faster growth backdrop that would likely accompany it.
The most vulnerable part of the economy in 2019 has been the retrenchment in capital spending and the production cuts and softening in manufacturing employment that have come with it. Based on the fact that the export orders component of the ISM posted a record monthly increase in October on the mere indication of a trade deal suggests to us that the manufacturing sector is like a coiled spring that is being held back, at least in part, by the difficulty of complying with an ever-changing list of imported goods subjected to tariffs. The survey data from the ISM corroborate a similar sentiment that we hear in client meetings and trade shows with businesses in the manufacturing sector.
As noted previously, the consumer impact from the trade war is evident in two ways. The first is that confidence, while still elevated, has been knocked down from the highs of autumn 2018 before the trade war with China picked up in earnest. The second is the fact that the latest rounds of tariffs has the potential to meaningfully impact prices for consumer goods that were not previously subject to tariffs. Both of these factors would reverse if the United States and China were to agree to a trade deal. In such an environment, consumer spending could return to the healthier pace of growth that existed prior to the escalation of the trade war, perhaps on the order of 3-to-4 percent on an annualized basis.
As the economic outlook improves, the case for further Fed easing would not be very compelling. In fact, the FOMC could even start to reverse its recent rate cuts. Such a complete trajectory reversal would be unlikely in 2020, particularly as the FOMC might wish to avoid any perception of monetary policy interference as the election approaches, but rate hikes could become more likely in 2021 in such a scenario.
The full 2020 Annual Economic Outlook is available at wellsfargo.com/economicoutlook
This feature appeared in the February 2020 issues of the ACP Magazines:
California Builder & Engineer, Construction, Construction Digest, Construction News, Constructioneer, Dixie Contractor, Michigan Contractor & Builder, Midwest Contractor, New England Construction, Pacific Builder & Engineer, Rocky Mountain Construction, Texas Contractor, Western Builder