What Might Cause the Next Downturn? Guest Post by Paul Fiorilla, Director of Research, Yardi Matrix
Economic downturns in recent decades have generally started with a bang – bubbles bursting in the housing or technology markets or oil price shocks come to mind – but the next one is more likely to arrive as a whimper.
As the U.S. economy approaches a decade without a recession – closing in on the longest such period post-World War II – guessing what will cause the next downturn and when it will commence has turned into a parlor game for business.
Analysts looking for an overheated sector that could bring the entire economy down are searching in vain. Problems that caused previous recessions seem relatively under control. For example, commercial mortgage lending has grown through the cycle, but leverage levels seem under control. Consumer debt is at an all-time high, but consumer debt-to-income ratios and household balance sheets are healthy. The stock market could be overpriced, and subject to a correction, but it’s hard to predict a major bear market when corporate profits are at record levels. Oil price shocks have been a major factor in virtually every recession of the last half-century, and while oil prices have risen lately, but they remain nowhere near all-time highs while oil’s impact on the economy is diminishing.
It’s true that the next bubble is rarely obvious until after it pops. And there are many potential trouble spots – just that none identified to date have the capacity to create major waves by themselves. Consequently, the next downturn might be caused not so much by the pop of a major bubble, but by the cumulative effect of a series of economic events.
As to when economic growth might turn negative, it’s unlikely to happen soon. U.S. and global GDP is likely to hit a multi-year high at about 3 percent this year, and the consensus view is that growth will slow only slightly in 2019. The U.S. employment market continues to be robust. Absent an unforeseen event, 2020 is the earliest a recession could commence, and even that might be a stretch.
Factors that could serve to reduce economic growth include:
- Corporate debt bubble. Corporations have taken advantage of low Treasury rates by issuing huge volumes of debt. Total corporate debt tops $9 trillion, nearly 50% above the peak during the last bubble. However, debt-service levels and corporate debt as a share of GDP are not as high as past cycles.
- Weaker global growth. Economies in most of the world have picked up in recent years, but trouble spots are on the horizon. Examples: Japan’s population continues to shrink, GDP growth in China is slowing as the government attempts to control rising debt levels, and Europe is struggling to deal with the fallout of Brexit and anti-immigration movements. Emerging markets such as Argentina and Turkey are showing signs of stress, which could grow worse.
- Slowing housing market. Housing prices have rebounded well, with home equity growing by $9.2 trillion since the Great Recession. But affordability and rising interest rates are making it difficult for first-time buyers to afford homes, and construction will get more expensive due to tariffs on housing construction materials.
- Rising oil prices. Crude oil prices have risen steadily to the mid-$70 range. The added cost to consumers of gasoline and other products has mitigated the positive impact of tax cuts. Prices could go up further for several reasons, including political tensions and sanctions on Iran that cut into global production.
- Auto production. The U.S. auto industry has rebounded well since 2009. Sales are topping 17 million per year, led by light trucks and SUVs, and auto debt is increasing accordingly. An increase in gasoline prices could eat into sales of popular vehicles, while higher interest rates could reduce credit available for loans to purchase vehicles.
- Economists largely agree on the benefit of skilled immigrant workers to the economy, and policies that make it harder to bring workers to the U.S. are a headwind to growth. Example: commercial real estate development companies report critical shortages of skilled construction workers, in part due to restrictions on immigration.
- Fiscal policy reversal. Corporate and personal income tax cuts have injected a fair amount of stimulus into the economy, although the impact diminishes in 2019 and turns into a negative drag on growth in 2020. Greg Daco, chief U.S. economist at Oxford Economics, said policies signed into law in 2017 and 2018 will boost U.S. GDP by 65 basis points in 2018, 50 basis points in 2019 but will reduce GDP by 30 basis points in 2020.
- Rising interest rates. The federal funds rate is up to 2.0 percent and Federal Reserve is expected to raise policy rates by 0.25 percent per quarter. The 10-year Treasury rate climbed to 3.2 percent in early October, the highest level since May 2011. The Fed is trying to prevent inflation from rising above the 2 percent target level, but there is concern it could wind up choking off growth. Interest rates are a particular concern to commercial real estate because growth in the 10-year Treasury will increase the cost of permanent debt financing and reduce the premium between debt costs and acquisition yields. Cap rates have remained near all-time lows even as the 10-year Treasury has risen over the past 18 months, but something will have to give as the premium narrows even more.
- Yield curve. A related concern is that the short-term interest rate will increase above the 10-year Treasury rate, which is called an inverted yield curve, a phenomenon that frequently has presaged recessions. The yield curve has steadily declined since January 2014 and was about 25 basis points before the latest jump in 10-year rates. If the Federal Reserve continues to raise short-term rates and growth falters, the yield curve could invert.
- Economists almost universally hate a trade war, and the Trump Administration’s use of tariffs as a policy tool is a stress on the economy, increasing the cost of consumer goods, housing, autos and more. So far, the impact has been minor, but that could worsen if other countries such as China and Canada retaliate, and the number of tariffs escalate. Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates, lists tariffs and unpredictable policy responses among the likely causes of the next recession.
Although it’s late in the cycle, there are possibilities with upside as well. One would be that corporate tax and regulatory reform produces a wave of investment and higher productivity. Another is that wage growth could accelerate and produce a wave of consumer spending. Still, the most likely positive economic scenario is for growth to maintain its current level, producing steady job growth and low volatility in the capital markets.
A Series of Unfortunate Events?
For all the worrying, the near-term outlook is positive. The median GDP forecast of economists surveyed by the National Association of Business Economists (NABE) is 2.9 percent in 2018 and 2.7 percent in 2019. The biggest concern expressed by economists is on the issue of trade, as tariffs could lead to an increase in inflation and decrease economic growth by one-quarter to one-half of a percentage point. The other risks cited most often by economists in the NABE survey were higher interest rates and a declining or volatile stock market. The biggest upside risks cited in the survey were growth from corporate tax reform and higher wage growth.
With growth solidly near 3 percent, and the unemployment rate at 3.7 percent, the lowest since 1969, it must be said that none of the potential headwinds on the radar could produce enough of a downside to turn into a recession on their own. That means a likely recession scenario encompasses several areas of the economy softening at once or a combination of variables such as higher interest rates or tariffs or an exogenous global political event snowballing into a loss of consumer/business confidence. Whenever it comes, those recession scenarios are unlikely to occur before 2020 or 2021 and the resulting downturn will probably be shallow.