Economists see the Trump economy slowing drastically next year before a possible recession in 2020

  • Economic growth pops in 2018, boosted by tax cuts, but those benefits should fade in 2019 and growth will get back to its longer-term pace of near 2 percent.
  • A group of 10 economists, including the Fed, have an average forecast of 2.4 percent for 2019, according to a CNBC survey.
  • Three big factors are behind the slower growth — fading impact of tax cuts, trade wars and tariffs and the Federal Reserve's rate-hiking policy.
  • Economists do not see a recession until 2020, at the earliest.

Juiced by tax cuts this year, the economy's performance peaked in the second quarter and is expected to increasingly lose steam in 2019, with growth slowing to a crawl and a recession looming.

That is one big reason the stock market has spiraled lower, as buyers rushed into Treasurys and yields on corporate debt snapped higher. Investors' views, in fact, may be even gloomier than those of economists.

Major firms this week have been releasing forecasts for next year, and both Goldman Sachs and J.P. Morgan see growth slowing to below 2 percent in the second half of 2019. But at the same time, the two firms expect the Federal Reserve to raise interest rates four times, while other economists believe the Fed may have to move at a slower pace.

Economists point to a number of factors for the slower growth, but topping the list of scare factors for markets are those Fed interest rate hikes as well as the impact of tariffs and trade wars, should they continue. Economists do not foresee a recession next year, but by 2020, one seems more likely, some economists said.

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"It depends on the Fed. If they continue along the current [interest rate hiking] trajectory they are following ... I think [there's a recession in] the first half of 2020," said Joseph LaVorgna, chief economist Americas at Natixis. LaVorgna expects 2.5 percent growth next year, though slower in the second half.

Stock prices are now flat for the year, after a near 9 percent decline in the S&P 500 since September. More than 40 percent of the stocks in the S&P 500 have seen at least a 20 percent decline, reaching bear market levels. At the same time, credit spreads have widened in both the high yield and investment grade corporate to 2016 levels.

"Look at how much things have tightened," said James Paulsen, chief investment strategist at Leuthold Group. "If you look around the globe, there's been a slowdown in money growth and a rise in yields all around the globe, and typically when you tighten like that, this is what happens. ... You're starting to see more evidence of it in the home builders' survey, the housing numbers, the auto sales, the durable goods numbers."

Watch: How the Fed could cause the next recession, according to Gary Shilling

'Fears escalating'

The fear is also feeding on itself with concerns that worsening financial conditions could add to slower growth but possibly hold back the Fed's rate hikes.

"This market to me now is telling you that investor recession fears are escalating. Whether that's right or not, I still lean toward the view we're going to avoid it, but we're going to be really scared of it. I think we're going to break the previous lows, and be scared to death that either the bull market is over or a recession is here, and that might be a good opportunity to buy," said Paulsen.

Economists, however, are not convinced a recession is in the cards until at least 2020, and the sluggish growth basically returns to the normal pace of slow but steady growth for the years prior to 2018. Growth was just around 2 percent in seven of the last 11 quarters, with the exceptions including the peak of 4.2 percent in the second quarter of 2018.

"Everything points to a slowdown next year. Rising mortgage rates hurting housing construction. Business orders on equipment stalled out. Consumers don't have as much tax cut money to spend. Everything points to a slowdown, but the economy was pretty strong, so it's going to be slowing from what? I think it's going to be about 3.2 percent this year if we get 3 percent in the fourth quarter," said Chris Rupkey, chief financial economist at MUFG Union Bank.

Rupkey sees 2.7 percent growth in 2019. But the average forecast for a group of 10 economists, including the Fed, was 2.4 percent for 2019, according to a CNBC survey.

"We're looking at growth a little above 2 percent, 2.25 percent," said Diane Swonk, chief economist at Grant Thornton. "It's not super strong, but it should still whittle away at the unemployment rate. The most difficult thing for financial markets is what's happening to margins. The cushion provided by tax cuts on year over year has disappeared."

Swonk said she expects a recession in the second half of 2020, in part because of the collateral damage from trade wars.

Tax bump fades

Economists say one of the big factors bringing growth back to its pre-tax-cut pace is simply the fading of the positive boost from tax cuts, and that should be clear in corporate profit growth, expected at about 8.5 percent for the S&P 500, down from about 24 percent in 2018.

Rupkey said there are signs that business spending, boosted by tax cuts, is also topping out.

For instance, durable goods orders for October fell an unexpected 4.4 percent, due in part to a reversal in transportation equipment which had strong gains in August and September. Inside the number, the proxy for business spending, the nondefense capital goods orders ex-aircraft, was flat.

"It gets up to about $70 billion per month and then kind of stalls out there. I think it stalled out. It certainly stopped for now," Rupkey said. "There's just no further driver for the economy coming from investment in equipment. They've ordered all their equipment for now. Trade is partly [a factor] in there."

Rupkey said he is keeping his forecast of 3 percent for the fourth quarter but risks are on the downside. His forecast for next year does not anticipate an escalation of trade wars or tariffs, as anticipated in the forecasts of some of the other economists. "If the President is thinking of cutting a deal with China at G20 in Buenos Aires, now would be the time," Rupkey noted.

U.S President Donald Trump pauses while speaking to members of the media before boarding Marine One for Florida on the South Lawn of the White House in Washington, D.C., U.S., on Wednesday, Oct. 31, 2018. 
Al Drago | Bloomberg | Getty Images
U.S President Donald Trump pauses while speaking to members of the media before boarding Marine One for Florida on the South Lawn of the White House in Washington, D.C., U.S., on Wednesday, Oct. 31, 2018. 

President Donald Trump meets with Chinese President Xi Jinping at the end of next week. That meeting could set the tone for markets but also for how the economy performs if he is to proceed with higher or additional tariffs.

"There is some worry about what's going on with China and what the world growth picture is like now," said Rupkey. Economists note that the slowdown in China has ripples across the emerging world and into Europe.

"I see Europe weakening," said Swonk. "I don't think Europe is prepared for a slowdown in China. There's a lot of risks we don't fully understand in the system."

Tariffs become a new tax

The U.S. economy had been the standout in the past year, with the economy diverging from others, but the loss of the tax cut benefit combined with tariff impacts could now be a double whammy.

As of Jan. 1, the tariffs on Chinese goods could rise to 25 percent from 10 percent, and Trump has threatened another $250 billion or so in Chinese goods could be subject to tariffs.

"We had these competitive policies where tax cuts were widening margins, and at the same time we were losing margins to tariffs and rising wages, and now they all go in the same direction," said Swonk. "Financial markets are uncertain about what will show up in price increases."

Economists expect companies to try to pass on the impact of rising tariffs through higher prices, but they may not be able to do so.

"Next year, if 25 percent tariffs go through on Chinese imports, that would amount to a tax increase of over $100 billion, much of which would fall on the consumer," J.P. Morgan economists noted. They expect the impact to be either absorbed through currency adjustments or in the margins of both Chinese and U.S. producers.

LaVorgna said the tax cuts could bite for another reason, in that some taxpayers may find they have not withheld enough to cover their taxes with the new tax bill and could have to pay more in April.

LaVorgna said that could add to weakness in the second half of 2019. "It's weaker for a few reasons, some of which is the delayed affect of higher interest rates which is certainly slowing housing and perhaps a tightening of fiscal policy, and not because of what you think," said LaVorgna. He said individuals in high-tax states could be the most impacted. "You could wind up having a pretty significant tax increase for people where they owe more than expected."

Canary in the coal mine

Housing is one place investors have been watching, for fear it is signaling a consumer slowdown. As interest rates have risen, homebuyers have increasingly stepped back, and mortgage applications, including refinancings, were 22 percent below last year's level in the last week. Homebuilder sentiment in November fell to its lowest level in two years, in its steepest one-month drop in 4 1/2 years.

"It's a canary in the coal mine. It can respond to interest rates a year-and-a-half before the rest of the economy," said Diane Swonk. She said the current housing market is not the bubble it was before the financial crisis. "Much more of the debt is safer than it was. The problem is what's being issued now to keep the market going. It's not a systemic problem. It's a signal you want to watch. We hope it's a yellow flag, not a red flag."

Existing home sales for October were up an unexpected 1.4 percent. "We look for only a modest decline in residential investment," the J.P. Morgan economists noted. For the first three quarters of 2018, they note that real residential investment declined 2.9 percent on an annualized basis and should continue to decline into 2019. They expect the drag from higher rates to fade, and housing activity should improve again.