Practically everyone is gushing over the second-quarter burst of U.S. economic growth, but why should anyone be surprised? After all, the peak impact of the tax stimulus took hold this last quarter – how could the economy not take off? That’s not the issue.
The issue is what little impact there has been when you benchmark this tax cut to prior attempts at fiscal stimulus in Washington. There have been four of these going back to the Kennedy-Johnson tax cuts in the mid-1960s, and on average, the immediate effect was to boost real GDP growth by 5.5 per cent at an annual rate. This, I hope, puts the second-quarter showing of 4.1 per cent into perspective. There’s actually less than meets the eye.
From my lens, the pro-growth thrust we have seen, from the Trump deregulation measures to the deficit-financed tax relief, are in the past. What lies ahead are the lagged effects on the economy from the U.S. Federal Reserve’s tightening moves (both the Fed funds rate and the unwinding of its massive balance sheet), as well as the future impact of what Fed chairman Jerome Powell et al. plan to do – which is even more monetary restraint. The impact of central bank actions, and this is true in Canada as well, hits the economy and the markets with lags that often are long, variable and insidious.
With all that in mind, the best leading indicator for the U.S. economy is the shape of the yield curve – the gap between long-term and short-term interest rates. Too much of the current debate is whether the curve inverts and if it does, whether it will signal a recession as it has done so often in the past. But we don’t have to waste our time with hypotheticals. The fact is the Fed has managed to flatten the yield curve dramatically, with the spread between 10-year and two-year rates narrowing to just 27 basis points from 100 basis points last year (a basis point is a hundredth of a percentage point). This is the flattest yield curve in a decade and is foreshadowing a return to an economy at a stall speed of sub-2-per-cent growth next year. Whether or not it turns into a recession, no market or asset class is priced right now for a return to the kind of growth we saw during the Obama administration.
The inflation risks from easing fiscal policy at a time of full employment, and into the 10th year of an economic expansion, are hardly non-trivial. This reckless move to juice up the U.S. economy with a deficit-induced tax cut for everyone only makes the Fed’s job tougher. Not to mention the downside to the macro outlook from the early stages of this global trade war we have found ourselves in this year.
The Fed holds the key to the longevity of this economic expansion, now into its 109th month – the second-longest on record. There have been 13 Fed rate-hiking cycles in the post-Second World War era, and 10 landed the economy in a recession. But even with the three that did not, growth slowed substantially in the aftermath of the tightening measures. We can learn a lot from history. The Fed has had its thumbprints on every expansion and recession, and every bull and bear market, ever since its inception more than a century ago.
In other words, the refrain “Don’t fight the Fed” works in both directions. If it worked one way in 2009, why wouldn’t it work the other way heading into 2019?
One last item. This entire cycle was built on a mountain of debt that likely never does get paid down, but still has to be serviced nonetheless. Consider that at the peak of the previous credit bubble, the level of outstanding debt at all levels of U.S. society – household, business and government – totalled US$27-trillion or about 225 per cent relative to GDP. Fast-forward to today and that number has soared to nearly US$50-trillion, or 250 per cent of GDP. So look at what happened – the United States merely added more debt to an existing debt bubble. For all the bravado about this long cycle the United States have enjoyed, it was accomplished on a credit bubble that makes what happened in the 2002-07 mortgage mania look like a walk in the park. The main message being that the economy is more susceptible today to even moderately higher interest rates – which is what we are now experiencing – than at any other time in modern history.
Just remember, interest rates exert their peak impact with lags. My advice, therefore, is to not extrapolate what we just saw in the second-quarter GDP report but to instead treat it as a fond memory.
David Rosenberg