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Party Like It’s 1998

International | Sep 26 2019

A US recession is not looming in 2020, argues Longview Economics. Rather, 2019 looks a lot like 1998.

-US recession fears heightened
-Trade war likely trigger
-Impact contained to manufacturing
-Economy otherwise well supported

By Greg Peel

There is currently a consensus among economists, notes Longview Economics, that the US will enter recession in 2020. This fear is based on a variety of reasons, but the predominant reason is the trade war.

While talks between senior trade delegates from the US and China are set to resume next month, tensions have only escalated in the lead-up. Last month President Trump introduced tariffs on a new tranche of Chinese imports, and the Chinese duly retaliated.

There have been some concessions – Trump pushed around half of his initially planned tranche out to December and the Chinese have removed some import items from their list – but both parties have threatened tariff increases across the board if no progress can be made.

If Trump follows through on his plans, Longview calculates the average tariff on Chinese goods will rise sharply to 26.6% by year end (up from 12.0% in early June). Retaliatory tariffs on US goods will also rise to high levels (from 16.5% June to 25.1% by December).

Bears on the US economy have many concerns, but the trade war disturbs them most. In particular, they expect weakness in trade and manufacturing to increase and spread through the value chain into services, Longview notes, and the US economy more broadly. A recent survey by Bank of America-Merrill Lynch found US investors considered the trade war the biggest risk, and the likely trigger of recession.

And US yield curve inversion only confirms a looming recession, many (but not all) believe.

The key question for Longview therefore is whether that collective judgment is correct? Or, instead, the US is merely in the midst of a late cycle slowdown akin to 1998?

Of note, 1998 shares many parallels with today, Longview suggests. It was a year of slower economic growth, heightened recession fears, a yield curve inversion and a series of Fed rate cuts. The recession, though, didn't begin until 2001, three years later.

Those were the days

In the mid-nineties, the great economic success story was that of the "Asian Tigers" – South East Asian nations that fuelled export-led economic growth via a number of government-driven subsidies, easy finance and pegged currencies. In 1997, the Thai government decide to abandon its US dollar peg and let the baht float.

It didn't float, it sank, along with the currencies of the other Tigers, by as much as -38%.

The crisis reverberated across the globe, leading ultimately in 1998 to Russia defaulting on its sovereign debt and heavy investor in Russian debt – hedge fund Long Term Capital Management – going under to the tune of US$6bn. In the context of the 2008 GFC, it's hard to believe that only ten years earlier it was feared that US$6bn would be enough to bring down the entire global financial system, as the dominos fell.

As was the case in 2008, the crisis was averted by central banks. The "Great Recession" was ended in 2009 by central banks printing money. In 1998, central banks moved to end the crisis by selling gold.

On balance, believes Longview, and while trade war risks bear watching closely, the evidence suggests that 1998 is the correct template for today and that economic reflation, not recession, is the most likely outcome for the US in 2020.

Key pieces of evidence support that view, including the resilience of the service sector, the recent (and notable) easing of credit conditions, the pick-up in housing activity and house prices (which should underpin an ongoing household wealth effect) and the (cyclically) strong health of the corporate sector.

Impact Contained

Generally, bouts of weakness in the US economy can be classed in one of two ways, notes Longview. Either as "economy-wide" recessions, or "manufacturing-only" recessions. In the latter, service sector activity is typically supported by a central bank policy response and, as such, it keeps expanding while manufacturing activity contracts.

The Fed has this year provided two rate cuts, supporting a sharp easing of credit conditions and offsetting weakness in manufacturing: While US manufacturing PMI readings have moved sharply lower, service sector readings have held up well. Measures of CEO expectations have a similar message: In manufacturing, they have fallen sharply, but in the service sector they have remained stable/mid-range.

On balance, therefore, and while tariffs are due to rise later this year, weakness in the US economy does not appear to be spreading more broadly, Longview points out. Generally, US recessions begin after a sharp tightening of credit conditions. In recent months, though, the opposite is true. For small businesses, for example, the "availability" of loans has risen to a 17-year high. Expected credit conditions for small businesses have improved to their "best" level since 2001.

On that basis, recession risk is therefore low and growth in credit and money should remain underpinned, says Longview.

US housing activity is re-accelerating. That should result in stronger US house price growth and a positive wealth effect on the consumer. Of note, the sharp fall in bond yields and mortgage rates has had its usual effect on housing activity, Longview points out: Mortgage refinancing has accelerated; measured demand for mortgages has picked up sharply; and housing transaction volumes, which were shrinking year on year, have begun to grow.

The trend in house price growth typically follows the trend in housing transactions (with a lag time of around six months.

A re-acceleration in house prices in 2020 is therefore likely and should help support (already strong) growth in household consumption, Longview believes. Evidence of a turn in housing activity (and stronger house prices) also suggests recession risk is low.

The US corporate sector remains healthy, in a cyclical sense, and therefore, Longview suggests, faces little pressure to retrench. Ahead of recessions, companies become over-stretched by relying heavily on externally generated sources of cash. A shock then forces them to retrench, and retrenching is the recession dynamic.

Note that "retrench" in this context does not specifically refer to laying off employees, rather "business retrenchment" implies reducing one or more business operations with the view to cut expenses and reach to a more stable financial position. Which of course may then lead to employee retrenchment.

All of the past ten US recessions began when companies were running a cash flow deficit, Longview notes. Currently the cash flow position of companies is neutral and, on that measure, recession risk is therefore low.

In addition, the usual "shocks" that cause companies to retrench are not in place and, if anything, are having a positive impact on companies and the broader economy: Monetary policy is relatively loose (not tight); oil prices are not up, but down -18% year on year; and, while wage inflation is rising, growth in unit labour costs remains relatively low and range-bound.

So if 2019 really is mimicking 1998, we have nothing to fear, at least for three years.

The New Brave New World

Yet it should be noted the US recession of 2001 did not represent a lagged reaction to the events of 1997-98. It was in the late nineties that wider world became very excited about something called a "dotcom". The bail-out of Long Term Capital Management may have averted a financial crisis, but it was the dotcom bubble that drove the US stock market into the heavens.

The bubble burst in 2000. 2001 brought 9/11. The US stock market did not bottom out until 2003.

The dotcom bubble featured a series of IPOs of companies with little more than a promise of great things to come in this Brave New World, with "infinite" price/earnings ratios given they were yet to make a profit, and price/revenue ratios through the roof.

Just like Tesla, Uber, Beyond Meat, WeWork…

Indeed, it does look a lot like 1998.

The good news, however, is Wall Street appears to be showing signs of "once bitten, twice shy".

Yes, Beyond Meat did rally about 500% from its May listing price but it has since stabilised, and analysts do genuinely see growth potential in veganism. The more familiar Tesla is down -35% from its 2018 high as it continues to walk a financial tightrope, the much vaunted Uber remains around -30% below its May listing price, and the planned WeWork IPO has been pulled due to perceptions of serious overvaluation.

These are but four examples, and the list of recent US IPOs is extensive, particularly in the cloud-based SaaS space (the new "dotcom"), but Wall Street has not turned "parabolic", as it did in 1998.

Technical limitations

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