A Slowdown Is Inevitable. But a Recession?

Concerns that a recession is coming are rising, with a quarter of all economists saying that a slump is possible in the next 12 months. The current U.S. expansion clearly is slowing as the 10-year anniversary of the last recession approaches. But expansions don’t just end: Something has to serve as a trigger. Bloomberg Opinion columnists Nir Kaissar and Noah Smith recently met online to debate.

Nir Kaissar: The R-word seems to be on everyone’s mind these days. In a few months, the current U.S. economic expansion will be the longest on record. It’s already three times longer than the average expansion since 1854, and twice the average since 1945, according to numbers compiled by the National Bureau of Economic Research. No, booms don’t die of old age, but that doesn’t appear to soothe anxiety that the U.S. is due for a recession.

Recent economic trends don’t help. Yes, the economy is growing, unemployment is low and consumer sentiment is high, but some important numbers are pointing down. The Federal Reserve Bank of Atlanta estimates that real gross domestic product grew at an annual rate of 2.1% in the first quarter, marking the second consecutive quarter of subdued growth and down from 4.2% in the second quarter of last year. That echoes the Institute for Supply Management’s manufacturing index, which fell to 55.3 in March from a post-financial-crisis high of 60.8 in August.

Markets don’t offer much reassurance, either. The 10-year Treasury yield has dropped to roughly 2.5% from 3.2% in November, a sign that the bond market fears a slowdown. And parts of the yield curve recently inverted — that is, some long-term bond yields dipped below short-term yields. Inversions have historically preceded recessions by a year or two.

Meanwhile, the stock market can’t seem to make up its mind. There have been six corrections since the financial crisis, defined as a decline of 10% or more in the Standard & Poor’s 500 Index. Two of them came in the past 15 months, and both were followed by sharp moves higher.

All of which raises the question: Is a recession looming or not?

Noah Smith: Signs of recession are certainly starting to mount. In addition to the ones you mentioned, I’d point to housing and trade. Housing starts, which usually fall before a recession, have plateaued for the past two years. Residential investment, which macroeconomist Ed Leamer calls “by far the best early warning sign of an oncoming recession,” is slightly down from its peak in the second quarter of 2018. So this is another sign of U.S. economic weakness. Meanwhile, if not for increased military spending, those GDP growth numbers might look even worse.

Global trade recently posted its biggest three-month drop since 2009. Chinese exports fell quite a bit in February. A global recession driven by a slowdown in China could easily spill over to the U.S.

Fortunately, governments in the U.S. and China probably are ready and willing to do whatever it takes to prevent a recession. China can and will fall back on its tried-and-true playbook of real estate and infrastructure lending, while Trump will use tax cuts and military spending in his bid for re-election in 2020.

NK: I agree that recession fears are overblown. It’s not that the U.S. has somehow become recession-proof, of course. It’s that, despite recent signs of slower growth, there are few indications of impending negative growth.

The one notable exception is the partially inverted yield curve. But so far the inversions are barely perceptible. In fact, the much-ballyhooed inversion between three-month and 10-year Treasuries has already reversed. There’s still some slight inversion between the short end (less than one year) and middle (three to seven years) of the curve, but it’s much too small and much too soon to declare it a harbinger of recession.

At the same time, the bravado about outsized economic growth coming from the White House and stock-market bulls is overdone. Consider that real GDP grew by an average of 3.6% a year from April 1947 to 1999. Since 2000, however, the economy has grown by an average of just 2% a year, but with half as much volatility as the previous period.

There are many variables that account for that slower growth, but a major one is the size of the economy. The U.S.’s GDP was roughly $10 trillion in 2000. Today it’s close to double that. As the economy swells, growth is likely to be more muted. Similarly, with China poised to overtake the U.S. as the world’s biggest economy in a few years, the law of big numbers will apply to it, too.

So it’s not entirely surprising that the U.S. economy has struggled to sustain its brief growth spurt in 2018. And with the Fed seemingly ready at the rescue if growth falls dangerously close to zero, the likeliest outcome is a snoozer: slow and steady ahead.

NS: I definitely agree that as the growth trend slows, it’ll be harder to tell recession from expansion. A good year will be 2% growth and a bad year will be 0.5%. But because of statistical noise and frequent data revisions, it might be very hard to tell those situations apart, even with the benefit of hindsight. Note that China is probably going to have similar issues, since its trend growth appears to be steadily slowing.

Ultimately, whether you think we’re headed for a recession right now depends on what you think recessions really are. If you think there’s a natural cycle to the economy — that good times lead to overborrowing followed by retrenchment — then you’ll probably conclude that right now we’re at the uneasy plateau before the cycle inevitably swings downward.

But if, like most academic macroeconomists, you believe that the economy does fine until some negative shock comes along to disturb it, then you’ll probably be less worried.

NK: I tend to subscribe to the negative-shock theory. Australia has famously gone 27 years without a recession. Other countries have enjoyed similar or longer stretches, including Japan from 1961 to 1993, and the Netherlands from 1981 to 2008.

Of course, overborrowing and reckless risk-taking could itself cause negative shocks! We saw that during the dot-com bust in 2000 and the subsequent housing-related financial crisis in 2008. I don’t see anything today that rises to that level of speculation, including investors’ fondness for corporate debt, granting that those dangers can be difficult to spot in advance.

But even if the economy manages to sidestep a recession for an extended period, investors may not be as fortunate. Slow and steady growth is likely to mean muted inflation and low interest rates. That would also mean bond returns that are well below their historical average.

U.S. stocks are likely to disappoint, too. Much of the return from stocks since the financial crisis has come from expanding valuations — or investors’ willingness to pay ever more for them. With valuations on the high side, that boost is unlikely to continue. Instead, inflation, real GDP growth and dividends might each contribute 2%, or a total of 6% a year. That’s well below the S&P 500’s historical return of 10.1% since 1926.

And in the medium term, that may be too optimistic. If inflation or growth is lower, or a negative shock appears, or investors simply decide that U.S. stocks are too expensive, returns could be even lower. (It’s worth noting that foreign stocks are much cheaper than those in the U.S., so expanding valuations are a real possibility overseas — but that’s for another day.)

NS: Plus stocks are historically still expensive, at least if you go by Shiller PE ratios. I’m not too enthusiastic about expected returns over the next decade no matter what happens to the economy in the next couple of years.

The real question, I think, is political. If a recession arrives before late 2020, it’ll hurt Trump’s re-election prospects. And since Trump’s trade war and Mexico border shenanigans may contribute to any recession that happens, people might be right to blame him if it does. But that’s also why I expect Trump to pull out all the stops — more tax cuts, military spending, and appointing apparatchiks like Stephen Moore to the Federal Reserve — in order to make sure any recession doesn’t happen until 2021.

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