Turn the channel to Bloomberg or CNBC for even a moment and you’ll likely be reminded that the U.S. economy is indeed slowing. Data provided by the Bureau of Economic Analysis (BEA) shows a demonstrable contraction in quarterly, seasonally-adjusted GDP from an annualized growth rate of 4.2% to 3.5% for 2018Q2 and 2018Q3 respectively. Furthermore, the Atlanta Fed is currently forecasting 2018Q4 GDP at 1.8% as of February 26, 2019 (the official number will be released February 28, 2019). But before you completely reallocate your equities to fixed income, consider this: We knew this was going to happen. The Trump Administration’s combined fiscal stimulus package of tax cuts and additional federal spending was introduced during a period of exceptionally low unemployment and when real, seasonally adjusted GDP was bumping up against real potential GDP. Any first-year economics student will be able to tell you that for fiscal stimulus to have its desired effect, slack in the economy is needed. That is, the current output of an economy must necessarily be well under an economy’s potential output. Otherwise, there simply isn’t anywhere for the stimulus to go. Thus, the elevated levels of output enjoyed in 2018 were unsustainable from the very beginning. A fall in the growth rate of GDP for 2018Q4 and for 2019 shouldn’t come as a surprise. The real question is: Will GDP stabilize following the stimulus induced sugar high or will GDP contract further, and recession ensue?
Although this coming Thursday’s GDP data release will provide insight into answering this question (and we will be following this release closely), we’re still missing one key component to produce a recession: A catalyst. The current headlines of the so-called trade war with China and other geopolitical instabilities are unlikely to produce sufficient disruption and the U.S. consumer is still quite strong. The most popular argument for recession as of late is its simply been a long while since we’ve had one so perhaps we’re due for a recession. While that logic isn’t entirely off-base, I’m not about to make an investment decision with that framework. Now, I’m not trying to make a bullish case for the U.S. economy either. In fact, I’ve been methodically reducing exposure to domestic equities as markets return to near-all-time high levels (more on my asset allocation to follow in a later article). All I’m arguing is that until a strong enough catalyst emerges to disrupt growth, a return to pre-stimulus levels is the more likely scenario. Does that mean we can expect to tip-toe around a recession for the next couple years? That’s anyone’s guess. My models at this point are somewhat indeterminate and personally I’m leaning towards probably not. But, fundamental to catalysts that cause recession is their unpredictability. If they could be predicted, recessions could and would be prevented and avoided. The late economist John Galbraith suggested that, “There are two types of forecasters: Those who don’t know, and those who don’t know they don’t know.” Therefore, my best forecast is “we shall see.” In the meantime, control your left-tail risk.
So what are my catalysts? While I myself, as well as my colleagues at Scriba Waldron Capital, track a multitude of macro variables, there are several related developments I find especially concerning. First, the declining trade balance. The trade deficit of the United States with the rest of the world has worsened considerably over the past twenty years. While the trade deficit alone isn’t necessarily a problem, it’s the causal effect (or lack thereof) that we find concerning. To purchase foreign goods, you must exchange domestic currency for the foreign currency of the producer. That is, sell the domestic currency and buy the foreign currency. This selling places downward pressure on the domestic currency – the U.S. Dollar in this case. So, we should expect to see the Dollar on a sustained trajectory lower relative to the rest of the world. Do we see this? No. In fact, the Dollar, as represented by the Trade Weighted Dollar Index provided by the St. Louis Fed, has shown continued strengthening against the rest of the world. Because, in the mid-to-long-run, we should expect countries with persistent trade deficits to see their currencies depreciate, the fact that the U.S. Dollar has yet to see a depreciation, or even a slow in appreciation, suggests that when the eventual depreciation does occur, it will likely occur suddenly and with great magnitude.
Furthermore, the U.S. fiscal deficit is continuing to worsen. Once again, this isn’t necessarily bad. The United States can likely sustain much higher levels of indebtedness before near-term problems arise. If fact, the idea that the U.S. fiscal deficit doesn’t matter is currently a popular idea among economists at the moment. I would disagree but the point remains. The problem isn’t relating to the deficit itself, instead the problem lies with the probable implications of the Dollar depreciating as foreign investors demand a higher risk premium for holding Dollar assets. When sovereign debt crosses some unknown threshold (its different for every nation and can only be determined ex post facto), a rational foreign investor will begin to suspect that the government will need to implement austerity or monetize the debt as in-place tax revenues become increasingly insufficient to service its debt. Both fiscal austerity and monetization will cause a currency to depreciate. A foreign investor will need to be compensated for this risk of depreciation in the form of a risk premium for holding the currency. In effect, the risk to the foreign investor that the currency will likely depreciate in the future will cause the currency to depreciate now.
Finally, a re-balancing of existing U.S. assets held by foreign investors could bring the Dollar under further pressure. Our deep, liquid, and (relatively) well-functioning financial markets as well as our (relatively) transparent, and well-functioning legal system and respect of property rights (especially intellectual property) has made the United States a very attractive economy to invest in relative to the rest of the world. Because of this, foreign investors have accumulated a large stockpile of U.S. Dollar dominated assets; in excess of 30T. Should these investors decide to reduce their exposure to the U.S. Dollar due to, perhaps unsustainable sovereign debt, the selling of dollars that could potentially occur would be enormous causing considerable Dollar weakening. As new economies emerge through the effects of globalization, and thus attractive alternatives to the U.S. economy emerge for purposes of investment, this scenario becomes increasingly likely.
As you may have noticed, the catalysts I mentioned could be aggregated as one: A large depreciation of the U.S. Dollar may be likely to occur in the not so distant future. Now, those without a finance or economics background may be asking themselves what does the dollar exchange rate with the rest of the world have anything to do with a recession? The domestic economy in the United States is dominated by the consumer. Personal consumption represents around 68% of GDP according to data provided by Federal Reserve Bank of St. Louis. If the U.S. Dollar depreciates then the real value of assets denominated in Dollars will fall. An economic concept known as the Wealth Effect suggests that as individuals perceive their wealth to have decreased through a decline in asset prices, the rational individual will decrease their expenditures accordingly. Thus, if the real value of assets held by U.S. consumers falls due to a depreciation in the U.S. Dollar, a material decline in consumption should be expected to follow. With consumption being in excess of two-thirds of GDP, this decline would be a major drag on GDP and could certainly bring about recession. Lastly, crises of this nature tend to experience feedback loops. As GDP falls from a decline in consumption, layoffs will occur and consumption will further decline as households either loose their incomes or simply become defense in their spending habits. If debt/GDP is already high, which it certainly is, the government’s ability to deploy fiscal stimulus to rescue the economy is severely limited due to a limited ability to borrow further given declining tax receipts and high in-place debt. Because of this, should a recession occur born from a currency shock, expect lasting pain.
To bring it all together. Do I think a recession is likely in the next year or two? As conditions are today, no. All I’m saying is that should a recession occur, this is how I see it unfolding given the risks present at this time. Do I think the probability of a recession is rising with time? Yes. As debt/GDP continues to rise and the trade balance and fiscal deficit continues to worsen, the probability of recession rises. Most importantly, no one knows when or what the tipping point(s) will be. Like I mentioned earlier – control your tail risks.