Rewriting the U.S. Recession Narrative
Lord Abbett: The Investment Conversation
Rewriting the U.S. Recession Narrative
VO: Welcome to The Investment Conversation, Lord Abbett’s ongoing podcast series.
Will Andrews: This broadcast was originally recorded on November 13, 2019.
Andrews: For those of you who like a good story, here’s something one Lord Abbett expert calls “The Recession Narrative.” This currently popular tale goes something like this. Chapter 1: The U.S.-China trade conflict leads to heightened uncertainty among business managers. Chapter 2: This mood engenders falling business confidence, which leads executives to trim capital spending. Chapter 3: This lower spending causes lower employment, which in turn dents consumer confidence. In the shattering conclusion, the resultant drop in consumer spending causes—wait for it—a U.S. economic downturn.
But is this really the way things are likely to play out? Today’s guest says there’s one factor in particular that could change the story. What is that factor, and how might the U.S. economy actually fare amid all the challenges we’ve seen? We’ll tackle those questions and more in this edition of The Investment Conversation.
Hi, I'm Will Andrews and joining me today is Lord Abbett's director of strategic asset allocation, Giulio Martini. Welcome, Giulio.
Giulio Martini: Thanks, Will, it's a pleasure to be here.
Andrews: Giulio, I gave a Cliff’s Notes version of the recession narrative in the introduction. Could you give us a bit more detail, and tell us why this view might be prevalent today?
Martini: Sure, Will. Well, let me start with what I think is really the backstory here. And that is that we are in the longest U.S. economic expansion ever, 124 months and counting. And I think the length of this expansion naturally causes people to start thinking about what's going to bring it to an end.
Good times don't last forever. Some of these surveys I've seen recently show that a majority of investors expect a U.S. recession to begin in either 2020 or 2021. And the dynamic that might lead to that is very much what you describe. We've got a trade conflict that's really caused global exports to contract. That's leading businesses to question the value of their global supply chains and to cut capital spending, or at least to reduce it and slow it down.
That, in turn, could lead to slowdowns in employment, declines in consumer confidence, and cuts in consumer spending that have been really the driving force-- behind the U.S. economy over the past year. Now, that dynamic—trade, capital spending, consumer spending, all contracting—sounds logical. The problem with it is that it's exaggerated at every step of the way. What's likely to result from that is more an economic slowdown than an outright recession. And there's a big difference between those two, particularly at the stage of a cycle that we've reached.
Andrews: So we'll get back to that prospect of a slowdown in a little bit. But first, I just wanted to take a step back. It seems like the stakes are pretty high in all this for other participants in the global economy as well, not just the United States and China.
Martini: Indeed they are. And there are some ways in which the U.S. declared trade war on China, and the first shot it fired hit Europe. The European economy, especially Germany, is highly exposed to global trade and machinery exports. So it's one of the first to suffer when global trade slows down.
Now, in addition, with Brexit already generating uncertainty on the trade front, adding China-related worries and direct tariff-related threats from the U.S. that target one of Europe's key industries, motor vehicles, is adding insult to injury. Now, there are losers, clearly, in this situation. I think Europe is the single biggest one right now.
But it's also interesting to think about who may be gaining from a change in the global trade regime. For instance, with a new trade agreement in hand, very low labor costs, and a very large workforce, Mexico's position and potential are really improving. And that's something investors can take advantage of.
Andrews: Well, in looking at the scenario for the United States, one problem with the recession narrative might actually be a number of counter-narratives that have been emerging--especially when you look at recent economic data. And I know you've been keeping a close eye on some of these reports. Tell us a bit about what's going on.
Martini: Indeed. The U.S. economy never goes from boom to bust. It always transitions from above-trend growth to below-trend growth before a recession begins. And what that means is that the labor market weakens before an actual downturn sets in. And if we look at the data, what we see is that jobless claims are basically the lowest that they've been in-- in decades.
That the unemployment rate hasn't even started moving up yet from its low for the cycle. So while the economy has slowed down a little, year over year, GDP growth has slowed to 2% from 2.3% on average for the entire expansion. The dynamic that would eventually lead to a recession hasn't even really started as far as the most important and reliable data we have, coming from the labor market, implies. What that means in my mind is that it's unlikely that a U.S.-- that the U.S. economy enters recession in 2020. And that, for investors, means that it's a little too early to look for shelter from the storm that will eventually come.
Andrews: So what are some of the other positive factors you've been tracking besides the labor market?
Martini: Well, the biggest and most important one is consumer spending. Just by size, it's 70% of final demand in the U.S. economy. And it's underpinned by extremely strong fundamentals in the household sector right now. First of all, we have robust employment and income growth.
We have high confidence and record job security. And we have unprecedented household real net worth. So households are generating a lot of income, they're secure about the future of that income, and they're as rich as they've ever been. Now, in addition, the Fed's actions have triggered a recovery in home sales and residential construction at a stage of the cycle when that sector of the economy is normally exerting a significant drag.
And the public sector, government, both federal and state and local, that's about 20% of total final demand in the economy, is finally consistently supportive of economic growth, whereas for most of this expansion, they've acted as a drag. Now, that's enough to offset some weakness in capital spending and exports.
In addition, I think there are signs that activity in China is starting to improve after weakening a bit earlier in the year. And there's a safety valve in China because if things weaken too much, the government has the flexibility and the resources to stimulate GDP growth by doing things like cutting taxes or maybe loosening regulation to allow people to move to parts of the country that are highly desirable and trigger the real estate development and the general infrastructure development that that brings along with it. So I think the U.S. is still very sound. And if there's a positive surprise coming, it's going to come from China really delivering a little bit more than people are expecting rather than something worse than that.
Andrews: Giulio, given all you’ve said here, it seems like there might be a less painful conclusion to the recession narrative than an outright downturn. And that, in fact, just a moderation in the growth rate might be a more likely outcome. Is that correct to say?
Martini: Will, I actually think a slowdown in the U.S. economy at this stage of the cycle, as opposed to an outright recession--a slowdown really isn't a negative development here. The U.S. economy has been growing for a long time. And the labor market has really tightened considerably. That's starting to generate stress.
And if those imbalances become more severe because of overly rapid economic growth, that will eventually create a more threatening and realistic end of cycle dynamic than the one we have in place right now. Paradoxically, too much economic growth is a negative now because we're already very close to the economy's potential to really supply goods and services.
Andrews: Could one of the benefits of slowing U.S. growth be that it actually prolongs the length of the expansion?
Martini: Yes, most definitely. I think that if the U.S. economy slows to something around 1 1/2% to 2% growth, so a little bit weaker than the average for the current expansion, and inflation stays close to the Fed's 2% target, it would really preserve the value of the famous “Fed put” that's really been such a positive for the markets for the past 10 years, really.
What the put has allowed the Fed to do is to cut interest rates in order to support the economy, whenever investors started to fear that a significant threat had materialized. Below 2% inflation was why the Fed was able to respond so quickly to increasing anxiety about trade and capital spending in 2019. It first took planned interest rate increases off the table and then actually cut interest rates three times.
And in this environment, if the Fed turns out to be wrong-- in other words, if it didn't have to be so aggressive about cutting interest rates, the mistake is going to be that the economy grows more quickly, and inflation moves up to the 2% target that the Fed has sooner than it otherwise would have.
So a mistake in this case actually takes the Fed closer to fulfilling its dual mandate. And what that means is that--cutting interest rates was really, really cheap insurance in the current setting. But accelerating inflation would make that insurance more expensive and would eventually make it unaffordable. And that creates problems for equity and fixed income investors because it would change the financial landscape profoundly. But that's really a story for another podcast. So let's not dive into that more deeply than we have to at the moment.
Andrews: Okay, we'll put that one on the calendar, Giulio. As we always do, let's wrap things up with some thoughts for investors. How should they be thinking about markets in the current environment?
Martini: Well, I think there are definitely opportunities. It's very rare that the dividend yield on the S&P 500 is above the 10-year [U.S.] Treasury bond yield, but that's the situation we're in right now. So with investors maybe starting to think about dipping their toes back in the water after being in a position of having cash balances that were higher than they would normally hold, I think dividend-paying stocks are a very good opportunity right now.
High dividend-paying stocks are very attractive. I think high-yield bonds are quite attractive, and international equities look like they're selling at very good value, in part because of the concerns that we talked about before. I think the thing to avoid here is exposure to long-duration [U.S.] Treasuries that really currently embed a negative risk premium at the moment. That's the most vulnerable part of the market in my mind. And it's a little too early yet to seek explicit inflation protection, although I do believe that that's the biggest threat that nobody's talking about right now.
Andrews: And that's the subject of that future podcast that we talked about. Giulio, I learned a lot from today's session, and I'm sure our listeners did too. Thanks, as always, for your insights, and thank you for joining us today.
Martini: Well, thanks for having me, Will. It's been a pleasure.
Andrews: To summarize today's broadcast, the popular narrative that has the U.S. economy slipping into recession because of uncertainty arising from U.S.-China trade tensions may have some story problems, as they say in Hollywood. For one thing, the U.S. labor market remains strong, and consumer spending, which accounts for the majority of U.S. economic activity, remains robust.
More likely is a scenario in which U.S. economic growth moderates for a while, a development that may actually help prolong the record length of the U.S. economic expansion. In the current environment, our expert suggests a focus on dividend-paying stocks, high yield, and international equities.
VO: That’s it for this edition of the Investment Conversation. Please drop us a line on social media or visit our website at LordAbbett.com. Our audio podcasts are available on iTunes, Spotify, TuneIn, and other major streaming media services. Thanks for listening.
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