Economy

Caution is warranted but US 'should avoid a recession,' economists say

Key Points
  • A choppy week for global markets last week saw a substantial sell-off in equities, while the bond market spooked investors as the U.S. 10-year/2-year Treasury yield curve inverted, an event widely seen as a warning sign of recession.
  • However, underlying factors across major economies indicate that recession fears may be overblown, economists have suggested.

The U.S. and global economy should avoid a recession in 2020, with a combination of strong retail sales, potential monetary policy easing and service sector robustness expected to mitigate slowing growth, according to several leading economists.

A choppy week for global markets last week saw a substantial sell-off in equities, while the bond market spooked investors as the U.S. 10-year/2-year Treasury yield curve inverted, an event widely seen as a warning sign of recession.

Meanwhile, the German economy contracted while eurozone GDP (gross domestic product) growth halved to 0.2% for the second quarter.

However, underlying factors across major economies indicate that recession fears may be overblown, economists have suggested.

Over the weekend, German finance minister Olaf Scholz indicated that Europe's largest economy would be willing to take fiscal measures if a recession loomed, shifting the government's tone.

Meanwhile, the People's Bank of China announced a program of interest rate reform aimed at stimulating an economy reeling from the impact of the trade war.

U.S. consumers to the rescue

Strong retail sales figures for July suggested that U.S. consumers are continuing to prop up the economy, partially offsetting the drag on business confidence from the U.S.-China trade conflict.

Sales climbed 0.7% month-on-month in July, a fifth successive increase, reiterating the American consumer's role in providing lifeblood to the economy.

A note from UBS Global CIO Mark Haefele on Monday said this reinforces belief that the U.S. economy should avoid a recession. Assuming no trade war escalation, UBS has assigned just a 25% chance that the U.S. economy will contract for two consecutive quarters in 2020.

"But despite the strength of the consumer side of the U.S. economy, we do expect falling business activity to pull U.S. growth below trend, forcing the Fed to cut rates more than we had previously expected," Haefele added.

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However, latest data showed that factory output fell by 0.4% in July, while manufacturing output has now contracted in five of the past seven months, mirroring a broader slowdown worldwide led by China and Germany.

What's more, a swift resolution to the trade war remains unlikely, Haefele suggested, meaning business investment will remain subdued globally, delaying an expected pick-up in growth which had been anticipated for the second half of 2018. UBS now expects U.S. economic growth of around 1.8%, below trend, in 2020.

"So, while we don't believe a recession is looming, and we remain cautiously positive on global equities, we now expect a longer period of lower rates," the note said, adding that UBS now expects the U.S. Federal Reserve to cut rates by 25 basis points three more times - in September, December and March.

Robust underlying factors

HSBC Global Asset Management has also played down the risk of recession, both stateside and globally, retaining a pro-risk stance in its multi-asset portfolios. Global co-CIO Joseph Little highlighted on Monday that equity markets have performed well year-to-date, despite this month's sell-off.

He added that the "valuation gap between equities and relatively expensive bonds continues to increase," but advocated a more cautious short-term approach given the downside risks to growth.

"The global economy is in a difficult place, but investor pessimism could be overdone. Looking at the growth outlook, US activity is being buttressed by a solid labor market," Little said.

"Meanwhile, the recent weakness in euro zone data has been driven mainly by a large downturn in the industrial sector."

While there is no clear indication of a turnaround here, the services sector remains robust, offsetting the impact of dwindling industrial performance.

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Furthermore, muted global inflation trends have kept the door ajar for further monetary policy easing, and Little suggested that alongside an expected further Fed rate cut and a stimulus package from the European Central Bank (ECB) this year, fiscal policy could also play an increasingly important role.

For instance, the U.K. government has signaled a large program of spending and tax cuts, while Germany has now indicated that it is prepared to deploy fiscal stimulus should its economy continue to lag.

With regards to bond yields, which touched all-time lows across Europe last week, Little said there is no precedent for an inversion at such low government bond yields, but "yield curves have to invert further before they reach the levels that have preceded previous recessions."

An inverted yield curve is generally considered a recession predictor. When short-term yields climb over longer-dated yields, it shows that borrowing costs in the shorter-term are more than the longer term. In these cases, businesses could find it more expensive to expand their operations. Meanwhile, consumer borrowing could also fall, thus leading to lesser consumer spending in the economy. All of these could lead to a subsequent contraction in the economy and a rise in unemployment.

New all-time highs for equities in 2020

While respecting the historical significance of the U.S. yield curve inversion in preceding recessions, J.P. Morgan equity strategists led by Mislav Matejka highlighted a number of variables which at present are inconsistent with such events.

"Typically, the curve inversion is a sign that real policy rates have become too high; lending conditions are tightening and banks are beginning to restrict access to credit; high yield credit spreads are worsening; and the labor market has started to deteriorate," Matejka said in a note on Monday.

"This time around, high yield spreads are well behaved, real rates are not much above zero, and claims remain resilient."

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Matejka also highlighted that the yield differential between the U.S. and the rest of the world remains at near highs, which may be a factor impacting the U.S. yield curve slope.

"Put together, the curve inversion might be more an indicator of extreme market nervousness at present, of increasing central banks action, skewed bond ownership, and of global search for yield, rather than a sure sign that US is about to enter a recession," he added.

As such, J.P. Morgan anticipates that equities will hit new all-time highs into the first half of 2020, though this development increases of a potential peak of the market for this cycle next summer.