Stay of Execution: Will the Fed's Rate Pause Breathe More Life into the U.S. Expansion?

As we head deeper into the year, the U.S. economy continues to grind slowly forward despite trade concerns and Brexit worries. Markets have rebounded from their Christmas Eve lows, and the Fed has signaled that rate hikes are on hold for several months. Does this mean the all-clear has been sounded?

No. Our view is that the U.S. remains late in the economic cycle—and that the economy is still likely to roll over into a recession in 2020. While perhaps a little later than originally anticipated, the risk of an economic slump by the end of next year remains high, in our opinion. Why? Let’s start by taking a look back at the events of last December—a December better left un-remembered, in the minds of most.

2018’s wild December: The catalyst for the Fed’s rate pause

There’s a saying in our industry: economic expansions don’t die of old age, rather they are murdered … usually by the U.S Federal Reserve (the Fed). Late last year, it seemed that this old saying would come true again as the Fed continued to increase interest rates, hiking for the ninth time in three years on Dec. 19. The result of this tightening monetary policy was a flattening U.S. Treasury yield curve, with the yield curve threatening to invert in the immediate future. Yet, at the time, it seemed likely that given the ongoing strength of the U.S. economy, the Fed would continue to raise rates regularly, regardless of any possible inversion.

Then, something happened. Late in the fourth quarter, the strong economic data that powered the market for most of 2018 started to show weakness. This was punctuated by a significant drop in CEO confidence levels1, as companies faced the stark reality that the spectacular earnings growth of 2018 would slow dramatically as tailwinds from the late 2017 tax cuts faded. The market also began to realize that the very strong above-trend GDP (gross domestic product) growth rates of 20182 would face similar declines in 2019 as the effects of the fiscal stimulus package passed by Congress in February 2018 dissipated. The result? Underlying surveys of the economic landscape—such as the Institute for Supply Management’s Manufacturing Index and Purchasing Managers' Index (PMI® )—plummeted, and consumer confidence fell in December.3

The good news? This weakness was not lost on the Fed. Early in January, Chairman Jerome Powell assured the market that the Fed was watching the numbers, and that weaker economic data would likely lead to a pause in interest-rate increases by the central bank. Markets celebrated the Fed’s forbearance, with the Russell 1000® Index climbing 8.38% during January. This marked yet another example of how bad economic news can be good news for equities—at least in the short term. In this particular instance, the reason for the market rally is straight-forward: if the Fed is going to pause its tightening regime, then it becomes less likely that the central bank will outright murder the economic expansion.

But, is this really good news? And how long will the stay of execution last?

It’s not just the Fed: Slumping confidence can also spark a recession

From the vantage point of the market, a Fed-induced recession appears to be the most likely way the next U.S. economic downturn will set in—but it’s not the only scenario. Negative sentiment can trigger a recession as well. Why? If everyone thinks a recession is likely to occur, consumers will begin spending less, stowing away more of their earnings for the rainy day to come. This, in turn, chips away at economic growth—especially in the U.S., where consumer spending drives roughly 70% of the economy.4Companies, in turn, begin doing the same—squirreling away more of their income rather than re-investing it in new hires or business growth opportunities. Such a cycle can eventually snowball into a recession.

Will the U.S. escape a recession this year?

At Russell Investments, we believe that the soft spot in economic data we saw around the turn of the year will stabilize to generate a GDP growth rate of 2.25% for the U.S. in 2019. Recently-released economic data also indicates that this is the path the economy is on this year. Does this mean we’re out of the woods when it comes to a U.S. recession in 2019?

Our answer: Not necessarily.

The key issue that continues to loom over the U.S.—and future Fed monetary policy in particular—is the nation’s extraordinary low unemployment rate, which is hovering at levels not seen since the 1960s.5 This means there are very few qualified candidates for the approximately 7 million current job openings.6

Generally, this tight of a labor market leads to companies bidding against each other for labor by raising employee wages. This competition for jobs tends to drive up wage inflation, as illustrated by the approximate 3% rise in year-over-year wage growth in the U.S.7 For point of reference, the Fed has an inflation target of 2%. This growing wage pressure makes it likely, in our minds, that the Fed will be forced off the sidelines in the not-too-distant future to once again raise interest rates to combat this potential source of inflation.

We see this happening later this year, perhaps as soon as the Federal Open Market Committee (FOMC)’s meeting in June or September. Should this occur, we believe a yield curve inversion would likely follow—and the recession countdown clock would begin to tick down.

On average, a recession follows a yield curve inversion by 14 months. Going by this measure, that would place the start of the next recession in the third quarter of 2020. However, as recent research by the San Francisco Fed shows, recessions have followed yield curve inversions by as little as six months.8 While that represents the extreme short-term end, if such a scenario were to repeat, the U.S. could fall into recession by December of this year.

All that said, at this point, we believe the third quarter of 2020 is the most likely start of the next recession—but it goes without saying that the Fed’s actions over the next several months bear close watching.

Because in the end, the story will likely conclude with: The Fed did it.


1 Source: https://www.vistage.com/research-center/wp-content/uploads/2019/01/WSJ-CEO-Survey-1218.pdf

2 Source: https://www.bea.gov/media/3531

3 Source: https://www.wsj.com/articles/u-s-consumer-confidence-fades-a-bit-in-december-11545924288

4 Source: https://fivethirtyeight.blogs.nytimes.com/2010/09/19/consumer-spending-and-the-economy/

5 Source:https://tradingeconomics.com/united-states/unemployment-rate

6 Source: https://www.bls.gov/news.release/jolts.nr0.htm

7 Source: https://www.cnbc.com/2019/02/01/nonfarm-payrolls-january-2019.html

8 Source: https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

This material is not an offer, solicitation or recommendation to purchase any security. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do no not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.

Russell Investments' ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments' management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

Copyright © Russell Investments Group LLC 2018. All rights reserved.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

UNI-11432

Read more commentaries by Russell Investments