After seven years of expansion, the US economy appears to be headed for a recession. Earlier this month, a weak jobs report bolstered fears that hiring has been slowing and hundreds of thousands have been dropping out of the labor force. Employment growth is running at half the pace it was in 2015. Meanwhile, the Fed’s broader Labor Market Conditions Index has been dropping, economists have lowered their estimates of job growth over the next 12 months, business capital investment is falling, the manufacturing sector is on the verge of contracting, and the economy grew at a rate of only 0.8% in the first three months of this year.
A number of other indicators that suggest oncoming recessions are blinking. While the yield curve on Treasuries may no longer be the clear guide to future downturns it once was, the difference between 2- and 10-year Treasury note yields is the smallest it’s been since before the last recession. This matters because it telegraphs investor pessimism via strong demand for long-term bonds. It also foretells a possible contraction of bank lending. How’s that? Because banks earn long-term yields and pay depositors short-term rates, a flattening yield curve implies shrinking profits – a pattern that usually results in banks lending less.
Depressing stats about the US economy are everywhere. Corporate profits have declined—a dynamic that has historically been associated with recessions. In the last three months of 2015, corporate profits fell over 10% compared to the previous year, the biggest drop since 2008. Although they ticked up at the start of 2016, a tighter labor market could erode this progress. As Morgan Creek Capital Management chief executive Mark Yusko pointed out at John Mauldin’s Strategic Investment Conference in Dallas last month, the last few times consensus future earnings estimates for S&P 500 turned negative were 1990-1991, 2001, and 2008-2009—the last three recessions. It happened again at the end of 2015. Moreover, growth in household net worth has slowed to zero, a shift that has also coincided with past recessions.
Depressing stats about the US economy are everywhere.
Yet not everyone is fixated on doom and gloom. As the economist Justin Wolfers pointed out, the dire jobs report was not as bad as it seemed, because seasonal factors and the Verizon strike may have made the situation look worse than it really was. Since the report, more than 35,000 Verizon workers are back to work. Demographic factors—baby boomer retirement in particular—also reduce the number of jobs we need to create each month to maintain our low level of unemployment, Wolfers added. On top of that, consumer spending is on the rise, service sector revenue has picked up, and data released last week showed that unemployment benefits claims had fallen.
In the aftermath of the jobs report, Fed chair Janet Yellen emphasized the positive over the negative, pointing to strong auto and housing markets, and signs of worker confidence. Despite her cautious optimism, we shouldn’t be surprised if growth turns negative. The current expansion is already one of the longest in modern US history. As Larry Summers points out, if history is any guide, a recession is more likely than not to happen in the next three years.
Even over the next 12 months, economists think there’s a 21% chance of recession. A Wall Street Journal survey of economists emphasized four factors in particular that could lead to a contraction. First, the economy is already growing at a slow pace, meaning that otherwise minor issues—let alone major ones—could push it into negative territory. Second, many are concerned about a downturn in the Chinese economy, which could spread to the US. Third, declining business investment is making economists nervous; spending on capital goods has declined 12% since September 2014. Finally, they point to the uncertainty surrounding this year’s presidential race as a possible recession catalyst.
Other potential risks include the UK voting to leave the EU, a recession in Japan, an oil price shock, and an asset price collapse. Macro strategist Worth Wray also notes the possibility of European banks failing. Recently, George Soros has grabbed headlines making pessimistic bets on some of these risks, selling stocks and buying gold-related assets. A growing interest in the precious metal among high-profile investors is a sign of how widespread fear has become.
Although few economists in the Wall Street Journal survey mentioned Fed hawkishness as a recession risk, I worry about a major policy error by our regulators. A premature rate hike could send the American economy into a downturn, drive dollar strength, push commodities lower, and bring down global growth. If it does turn hawkish, the Fed risks repeating the mistake of 1937, when it threw the economy back into contraction by tightening too early.
If we do find ourselves in a recession, the Fed will have few tools left to deploy. Interest rates are already extremely low, leaving limited room for lowering the cost of money. It could experiment with negative rates, but that hasn't worked so well in Europe. Or it could try even more exotic maneuvers like helicopter money—in Ben Bernanke’s words, “an expansionary fiscal policy—an increase in public spending or a tax cut—financed by a permanent increase in the money stock.” Doing so would likely require coordination with Congress to allocate the funds. And no disrespect to our legislators, but they’re not exactly cooperative these days. Politics will constrain fiscal spending.
The shortfall of tools is just as worrying at the state-level. According to the Brookings Institution, last year "only eight states had accumulated enough in their rainy-day funds to offset a hypothetical one-year loss of 10 percent or more of their annual expenditures.” The blunt fact is that states are as ill-equipped to handle a downturn as is the federal government.
So while we have a potential recession to fear, our inability to fight it may be even scarier.