Recession and the Fed
We’ve asked the region’s top wealth managers to respond to two questions: 1) If the current economic expansion lasts past July, it will be the longest in U.S. history. When do you expect the U.S. economy to enter into a recession? 2) After raising interest rates steadily for more than a year, the Federal Reserve suddenly made a dramatic U-turn, and equity markets responded favorably. Is the Fed making a mistake by pausing in its tightening efforts? We hope you find their answers interesting and/or helpful.
JOSEPH SCARPO, PWA WEALTH MANAGEMENT
Guessing the starting point of a recession is a fool’s game. The current expansion is driven by global demand, low interest rates, and a positive economic climate, which can change in the blink of an eye. Expansions are generally followed by a period of consolidation and slower growth. Two consecutive quarters of negative GDP growth is the technical definition of a recession. Given the U.S. trade issues with China and slowing global growth, the 10-year Treasury rate has fallen to levels not seen in years. Yet, despite the fears, U.S. economic conditions remain in a 2 percent growth range. PWA believes the best course of action is to be cautiously optimistic that the expansion, although slower, will continue. Until we see a change, we remain bullish on the USA.
We believe that the Federal Reserve has the most current and important information available to make its decisions. Under the last three chairpersons the country has benefitted from a Fed that guided the U.S. through the Great Recession, fueled an economic expansion for nearly 10 years, and has done so in a manner that allowed the employment rate to reach record levels. The Fed decision to pause is warranted given the global trade tensions and economic slowdown that exist today. We applaud the Fed for the work it has done over the past 11 years and believe that these well-informed policy makers remain on the correct path.
LINDA DUESSEL, FEDERATED INVESTORS
I’m reading that over 50 percent of economists think there’ll be a recession in 2020. How dare they? They’re just using a 35-year-old rulebook that says the recovery is old so there should be a recession soon. Things are slowing down but in many cases, just off record highs. Confidence remains strong. More people are working today than ever, there are more job openings than people to fill them and unemployment is at a 50-year low. Historically, a Fed that tightens too much brings us into recession, but the Fed’s on pause and may be done. A fully employed economy with no sign of excesses or inflation and a Fed at bay can continue to surprise. When is the next recession? How do I know?
The Fed is not making a mistake at all. We at Federated expected it. The Fed is keenly aware of weakness around the globe, the slowdown in the U.S. and, notably, the ongoing absence of problematic inflation. Even former Fed Chair Janet Yellen said she doesn’t understand why we don’t have rising inflation. The Fed has two jobs. Full employment, check. Keep inflation under control, check. So there’s no reason not to pause. I do applaud it for taking advantage of the window of a stronger economy the past few years to raise rates from unhealthy record low levels. This gives the Fed a policy tool—interest rates that can be cut—to help fight the next recession, whenever that may be.
ERIK KIMBROUGH, PNC WEALTH MANAGEMENT
The U.S. economy is in solid shape right now. The fundamentals are good: solid job growth, rising wages, good consumer balance sheets, a balanced housing market and strong corporate profitability. Absent a geopolitical shock, or a trade war, the U.S. is unlikely to enter recession this year. And the Trump administration has strong incentives to avoid a recession in 2020, ahead of the presidential election. But a recession becomes likely in 2021, as fiscal stimulus is set to have turned into fiscal drag by then, and imbalances in the economy will have had another two years to develop.
The Federal Open Market Committee has room to keep the fed funds rate at its current level, or even cut rates if warranted, although that will likely not be necessary in 2019. So far there is no evidence that the tight labor market and rising wages are leading to higher inflation. Inflation has been below the Fed’s 2 percent objective throughout the current expansion, and has moved lower in early 2019 thanks to falling energy prices; the central bank would be happy if inflation were a bit stronger. Given this, the FOMC can be patient in raising the Fed Funds rate.
THOMAS L. WENTLING JR., WENTLING TARQUINIO LOUGHNEY WEALTH CONSULTING GROUP, UBS FINANCIAL SERVICES INC.
Recessions have been primarily inflation contingent—not time contingent. They don’t die of old age, but rather because the Fed raises interest rates due to perceived demand imbalances building up, as evidenced by inflation (too many dollars chasing too few goods). The longer an expansion continues, the more time excesses have to build up, but it’s not the clock per se, rather the forces at play. While the ultimate result of the Great Depression was deflation, it was an overheating “Roaring Twenties” economy, coupled with Smoot Hawley trade protectionism, that threw us into the vortex and snuffed out demand, creating too many goods chasing too few dollars (i.e., deflation). We do not see a recession at least through 2020, ex an exogenous shock to the global economy.
Inflation is at the Fed’s target, rates are in the Fed’s estimate of the neutral zone (rates neither stimulating nor restraining the economy) and economic growth is decelerating, so we think Chairman Powell was right to take the pause that refreshes. The Fed has done an admirable job in managing the money supply since the 2008 recession. That said, the elephant in the room is the approximately $3.8 trillion of reserves on its balance sheet, up from $600 billion prior to the meltdown. Selling those securities, or allowing them to mature, shrinks the money supply by an equal amount. Negative interest rates persist in Europe and Japan—a harbinger of deflation. Raising rates without clear evidence of inflation could be catastrophic. So far, so good.
JAMES ARMSTRONG, HENRY H. ARMSTRONG ASSOCIATES
The cycle of recessions and expansions is not governed by a clock. We have yet to see anyone reliably predict its timing over a long period. The cycle is inevitable, but the timing is unknowable. Factors other than the passage of time will create the conditions under which a recession will begin. Thus, we would not base our investment decisions upon a guess as to when the next recession will begin. Rather, we try to invest in companies that can thrive and prosper through a wide range of economic conditions, including recessions.
The Fed’s pause will turn out to be a mistake if it creates harm in two ways: 1) if it causes inflation to rise; and 2) if interest rates stay near zero, the Fed is deprived of its ability to reduce rates to help us climb out of the next recession. At the present time, inflation is relatively low, interest rates are very low, the economy is doing well, yet government deficits have been climbing for many years. We’ve never seen this set of forces before. For example, over $10 trillion of international government debt carries negative interest rates—investors are paying those governments to hold their money. This is a strange state of affairs, and we don’t know how it will turn out over the long run.
JOHN AUGUSTINE, HUNTINGTON BANK
The U.S. economy will reach a milestone in 2019—the longest post-WWII economic expansion, surpassing the current record holder of 1991 to 2001. This is good news. To enter a recession, an economy needs too much of something that needs to be worked off. In 2001, it was a hangover from pre-Y2K technology spending. In 2008, it was too many houses with bad financing. What’s next? It may be government debt stress when economic activity slows noticeably, and interest rates move higher. While we currently do not predict that, it could potentially occur sometime after the 2020 U.S. presidential election.
We believe the Fed has made the right choice in pausing its tightening cycle for three reasons: 1) the U.S. and global economies slowed late in 2018 and into early 2019; 2) the Fed was arguably too far out in front of other global central banks in tightening; and 3) inflation is running below the Fed’s own target. The question now is this: What will the Fed do next? The bond market futures think it will cut the Fed funds rate this year by at least 0.25 percent. We hope that is not the case, as that would point to a weaker U.S. economy later this year, which is something we at Huntington currently don’t see but continue to monitor.
ALISON F. WERTZ, BILL FEW ASSOCIATES
Most professional economists are unsuccessful at predicting recessions; I won’t presume to try to outguess the experts. As a long-term investor, it is important to understand what happens to the market during a recession, what can drive the decline and then ultimately the recovery. Sharing this knowledge with clients is what helps them stay the course in uncertain markets. There isn’t much I can guarantee to my clients, but I feel comfortable guaranteeing that they will experience a recession in their lifetime, probably several. The Great Recession of 2008 absolutely taught me that my clients in retirement who had the appropriate asset allocation and were not distributing more than 4 percent before the recession were able to ride out the recession with little change in lifestyle and income.
The recent inversion in the yield curve supports the Federal Reserve’s position that a pause in rate hikes is warranted. As does the economic data including modest inflation, slowing GDP growth and a slight decline in the rate of hiring. I think the Fed felt comfortable taking a pause from the rate increases when you look at our government bond yields versus other countries and the current strength of the dollar. Had the Fed kept hiking rates both measures would have become more distorted versus our global counterparts. Although we would never want the Fed to feel like they are responsible for the stock market (their mission is inflation and employment), obviously stock market participants were happy with the Fed’s decision to tap the brakes for a while.
JACK KRAUS, ALLEGHENY FINANCIAL
The last recession was deeper and longer than the average recession, so it is no surprise that the economic expansion has lasted for an extended period. The prediction of a recession is a fool’s errand, but it does not look like it will happen in 2019. Recessions, while they do happen, do not frequently occur during a presidential election year. So, at the risk of being a fool, we do not expect a recession until 2021 or later. This could change with a large unexpected macro-economic or geopolitical event. Additionally, the next recession may be much more typical in depth and length and not like the recession during the financial crisis.
The Fed members have painted themselves into a corner, by committing that they will not raise rates in 2019 with one possible rate increase in 2020. By committing to the “pause,” the market expectations may not match the Fed’s desired course of action if the economy shows renewed strength, and they run the risk of disappointing the market. Additionally, the Fed generally does not like to raise or lower rates during a presidential election year, so the one move in 2020 would probably be by March. Additionally, the Fed announced a pause in the reduction of their balance sheet, which may limit their future actions. Yes, it was a mistake because they promised too much and run the risk of violating those expectations.
ELIZABETH GENTER, SCHENLEY CAPITAL
We, at Schenley Capital are not market timers or individuals who can predict the future. However, we pay close attention to economic indicators and their effect on the market. While it is true that the current economic expansion is approaching the longest, it is the slowest expansion over the past 10 years. There are many illustrations of this activity, but one is particularly significant. Unemployment, at 3.8 percent, is now near a 50-year low. In order to spur this economic growth, the Federal Reserve engaged in three rounds of quantitative easing and this has been fueling the stock market. So where do we stand on the future of this economy? While growth cannot continue forever, we remain cautiously optimistic that growth will continue for the foreseeable future, albeit at a slower rate than in the past.
The Federal Reserve did not make a mistake in pausing to reevaluate its strategy of raising rates in 2019. The market had a violent reaction to the rate increase in the 4th quarter of last year. For example, the S&P 500 dropped over 13.5 percent in the quarter with intraday price swings of more than 1 percent. This heightened volatility in the stock market left investors confused and weak at the knees. As noted above, the economy is continuing to grow, albeit at a slower rate, employment is high and businesses continue to invest profits back into their businesses, all of which would suggest that no tightening is presently required, particularly when one considers the market’s reaction last year. However, we should expect tightening to resume, in the near future.
WIN SMATHERS, SHOREBRIDGE WEALTH MANAGEMENT
The majority of economists are predicting the next recession to occur in 2021. It’s well documented that economists are notoriously poor predictors of recession, but in light of the long duration of this expansion, the odds are increasing that recession is near. It is evident the U.S. economy is currently very healthy but growth is moderating. Most leading economic indicators are not yet flashing yellow, let alone red, as is supported by a resilient stock market, low inflation and strong manufacturing activity. The bond market is signaling perhaps caution is in order as the curve formed by short and long-term rates flattens. But rest assured the President will be pulling whatever levers he can over the next 18 months to keep the economy from being a damaging issue during the 2020 election cycle.
The Fed is reacting to the clear evidence of a coordinated slowdown in global growth. The U.S. economy grew at nearly 3 percent last year, largely fueled by the 2017 tax cuts for corporations. Growth is expected to slow in 2019 and the Fed is being prudent to not move rates too far too fast, especially in light of benign inflationary pressures. The Fed has restored ammunition to its policy gun since 2015 through raising rates nine times and allowing bonds bought during the Quantitative Easing programs to roll off its balance sheet. Certainly, the Fed wants to maintain its independence from political pressures coming from Washington, but its decision to pause was the right thing to do given the present circumstances.
KIM CRAIG, F.N.B. WEALTH MANAGEMENT
Many factors lead us to believe that this economic expansion has the potential to continue into 2021. The U.S. economy has never entered a recession with corporate profits up year-over-year, as should be the case in 2019 vs. 2018. Confidence among U.S. consumers and businesses remains high due to healthy household and business balance sheets. Of the eight recessions that have occurred since 1960, none have started with a real Fed Funds rate less than roughly 2 percent. Currently, the real Fed Funds rate is approximately 25 basis points. Additionally, wage growth (average hourly earnings) remains well anchored below 4 percent, a level at which a recession is historically 18–24 months away.
No, the Fed is not making a mistake by “pausing” in its tightening efforts. One of the biggest risks to the financial markets in 2019 is a Fed policy error; for example, tightening into a slowing economy and throwing the nation into a recession. That risk has been reduced, if not eliminated, as the Fed has stated it will be patient in raising rates and become more data dependent. In our opinion, it is prudent for the Fed to wait and see what impact, if any, the four previous rate hikes in 2018 have had on U.S. economic activity. At this point, it appears there will be no more rate increases in 2019. In addition, the Fed recently signaled that the reduction of their balance sheet will end this fall. Both actions have been favorably received by the markets.
DAVID B. ELLWOOD, WESBANCO
Based on recent changes in the Federal Reserve’s expected actions, the recession possibility has been moved further out the time line. With no interest rate increases expected this year, and an end to the balance sheet reduction, the economy should respond positively. Recession fears have increased as recent economic releases including retail sales, job growth, and durable goods orders had begun to weaken. This “soft patch” appears to be moderating as we enter the second quarter, perhaps further delaying an end to the current cycle. When the recession occurs is uncertain, but I would not expect anything of the magnitude that was experienced in 2008–09.
Looking back, the mistake may have been the increase in December, followed by unexpected and unusual actions by Treasury Secretary Mnuchin to reassure the financial markets that all was well. Economic indicators were showing signs of weakness and inflation pressures were mild at best. Wage growth has remained stubbornly slow limiting the impact on profitability of the tight labor market. Rate sensitive sectors such as housing and autos were fading as interest rates continued to move higher, while at the same time the yield curve was reducing the inflation premium available in longer-term securities. The Fed is where it needs to be for the remainder of the year barring unexpected events that would result in a surge in domestic growth.
BRIAN SOMMERS, HBKS WEALTH ADVISORS
Economists have a very poor record when predicting future economic conditions, so at HBKS we don’t try to predict the timing of future recessions or otherwise time the markets. That being said, we believe we are experiencing a short-term period of softness in the economy and growth may strengthen in the second half of the year. While the global Leading Economic Indicators are falling, in many individual countries the Leading Economic Indicators have begun to turn upward. Manufacturing activity, which had been deteriorating, appears to have stabilized. Consumer confidence has rebounded, and global financial conditions have eased significantly since the start of the year. So a recession does not appear to be on the horizon for a while.
The Federal Reserve came to the conclusion that there are too many economic risks around the world to support rate increases in the U.S. for at least the next two quarters, and we believe the Fed is acting prudently. The case for raising rates lies in the belief that rapid inflation would occur if rates are held below “neutral” during periods of solid economic growth. The neutral rate is defined as the interest rate that supports the economy at full employment and maximum output while keeping inflation constant. However, members of the Fed are now backing off on the belief that economic growth will cause inflation to spike higher. Though the unemployment rate has fallen to 3.8 percent, near the lowest levels in five decades, inflation expectations have not gone up. If anything, they’ve been falling. It now appears that global competition has been effective in keeping inflation low. With the U.S. economy increasingly impacted by global economic forces, it makes sense for the Fed to pause until they begin to see some signs of inflation.
ROBERT Y. KOPF JR., SMITHFIELD TRUST COMPANY
It would be the height of arrogance for me to predict with any degree of precision when the U.S. economy will enter into a recession. Given that qualification, I can say with some modest certainty that, at least statistically, we should be entering into an economic contraction by the end of 2020. Moreover, there is a distinct probability that the triggering event for such a contraction will be a circumstance totally unforeseen by most of us at this point in time.
While we have not been shy about criticizing the Federal Reserve about its policies regarding interest rates in the past, we are, based on input from our economist, Michael Drury, and our own empirical analysis, satisfied with the actions of the Fed under the leadership of Chairman Jerome Powell. Powell has, in our view, acted prudently and in a nimble fashion. At some point, however, the Fed will need to “normalize” interest rates, and these higher rates will cause a dangerous increase in the cost of servicing our exploding national debt.
PETER F. MATHIESON, FAIRVIEW CAPITAL INVESTMENT MANAGEMENT
The old joke about economists predicting 17 out of the last three recessions nicely encapsulates the difficulty we all face in making these predictions. Central banks around the world have been stimulating their economies through loose monetary policy over the past 10 years, interest rates are at all-time lows, corporate profit margins are at all-time highs with little room to increase further, balance sheets are excessively leveraged, and the benefits from corporate tax reductions are now subsiding. What we do know is that we are closer to the end of the boom cycle than we are to the start, but we cannot know with any precision. Instead, we can simply prepare our client portfolios for that eventuality by investing in competitively advantaged businesses that exhibit superior balance sheet strength. This is a proven strategy that works through all economic cycles.
Central bank stimulus policies that were prudent in the immediate wake of the financial crisis are now proving to be excessive as evidenced by negative interest rates in many parts of the world. Low rates and loose lending standards have resulted in asset bubbles and excessive corporate borrowings. Given the continued toxic political environment, there will never be a comfortable time for the Fed to raise rates. But how “comfortable” it feels should not be a consideration in making the decision. Rather than following policy that will only exacerbate the excesses, the Fed should continue on its gradual course of raising rates and returning its most effective “tool” back to the proverbial tool box. Doing so will help to correct these market excesses and will quell asset bubbles before they become even larger and more systemically risky.
HENRY S. BEUKEMA III, GUYASUTA INVESTMENT ADVISORS
The U.S. economy has continued to grow modestly, with 2018 fourth quarter annualized GDP growth of 2.2 percent. This, however, represents a deceleration from 3.4 percent in Q3 and 4.2 percent in Q2. Trade frictions and slowing global economic growth are headwinds for the U.S. economy. While U.S. growth may be slowing, the economy is unlikely to enter a recession in 2019. Inflation remains moderate, the unemployment rate is very low, the credit cycle is not yet flashing a red light and most importantly, the Fed has moved away from rate increases in 2019 and beyond. If growth continues to slow, the Fed could cut short-term interest rates and further lengthen the economic cycle. A U.S. recession could develop in 2020-2021 if international economic growth continues to decrease, no trade deal is reached with China, the credit cycle turns negative or purchasing managers index (PMI) data deteriorates.
The Federal Reserve is making a prudent decision not to continue to raise interest rates. With low inflation, decelerating economic growth and a flat yield curve, the Fed needed to pause its rate hike program. In fact, it could be argued that short-term rates need to be reduced, with a potential rate cut occurring in Q4 2019. The Fed became overly concerned that the low unemployment rate combined with tax cuts would overheat the economy and create an inflation cycle. Inflation has slightly increased in the past three years, but this does not pose a risk that requires the Fed to continue to raise short-term rates.
JEFF MUHLENKAMP, MUHLENKAMP & COMPANY
I don’t know. Economic growth in the U.S. is currently slowing, it is not clear if that will result in a recession or not. Of course, the lower economic growth is, the more likely that a recession will occur.
No, the error was continuing to raise rates and reduce the balance sheet in the face of weak inflation—that is what the stock market reacted to in the 4th quarter of 2018. Imagine if the Fed had announced in January 2019 that they would continue raising rates and shrinking the balance sheet—that would have been a world-class error! I think the Fed is pretty happy with both employment and inflation and they’re trying not to mess things up. Sooner or later we’ll get a recession, but the Fed isn’t interested in creating one in order to control inflation—inflation just isn’t a problem right now.
GREGORY CURTIS, GREYCOURT & CO.
The Fed’s recent decision to pause in quantitative tightening will give the U.S. economy more room to run. The Fed will also come under intense pressure from the Trump administration not to raise rates before the next election. Indeed, unless the Fed actually cuts rates it can expect to remain under fire from the Administration. Still, the economic expansion is very long in the tooth, Europe, Japan and China are all slowing, and the U.S. will not be able to avoid a recession, or at least a much-slowed economy, beyond mid-to-late 2020.
If the measure of a sudden Fed policy change is how the equity markets and the U.S. president react, the Fed made the right decision. But if the proper measure is the confidence economic actors have in the steadiness and discipline of the Fed’s decision-making, the U-turn was a serious mistake. It looks very much like the Fed caved in to pressure from the markets and the president, and as a result the Fed’s credibility has taken a serious blow.