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The U.S. economy enters 2020 with a head of steam.
OK, if not an all-powerful thrust, then enough to keep it humming at a 2% real rate of growth, which is estimated to be the economy’s potential.
Recession fears, triggered by the Federal Reserve’s campaign to raise interest rates in 2018 and resultant yield-curve inversion last spring, seem to have abated. The Fed got the message that it had overstepped and lowered its benchmark rate three times in the latter half of 2019, which was enough to return the spread between the policy rate and the long-term Treasury yield to a normal, positive slope.
That doesn’t mean it’s all blue skies and smooth sailing. Consider just some of the possibilities of what could go wrong in 2020 to upend the 10-year-plus expansion, the longest since the beginning of records in 1854.
1. Consumer pullback
The consumer has been carrying the economy through the trade war and manufacturing recession. Even housing, which is usually one of the leaders in the early stages of a recovery because of its sensitivity to interest rates, is getting a second wind.
Both new home sales and single-family housing starts have picked up in recent months. Residential fixed-investment, as it is known in the gross domestic product (GDP) accounts, had declined for six consecutive quarters before turning positive in the third quarter of 2019.
With the job market strong and wages rising, it’s hard to see what would cause a major retrenchment in American consumers’ appetites. And because consumer spending accounts for 68% of GDP, as the consumer goes, so goes the nation.
Which doesn’t mean an economy can prosper from consumer spending alone. Business investment, which has been weak and even declined in the second and third quarters of last year, is the key to productivity growth, which in turn benefits everyone because producing more with less enables prices to fall.
The consumer seems unlikely to retrench on his own. However, the motivation for a change could come from any of the items below.
2. Stock market reversal
Stocks finished their best year since 2013, with the S&P 500 Index
SPX, +0.29%
up 28.9%. But they aren’t exactly cheap.
As measured by economist Robert Shiller’s cyclically adjusted price earnings ratio (CAPE), the benchmark index is at a level seen only a few times in history. At 30.9, the CAPE matches the high set before the 1929 crash.
This year’s solid gains were accompanied by tepid earnings. On a 12-month forward basis, the price-to-earnings (P/E) ratio for the S&P 500 is at 18.3, according to FactSet. That compares with a historic average of 17.7 since 1947.
The Federal Reserve has no plans to raise interest rates anytime soon to spoil the party. The economy is still adding jobs at a rate faster than that required to sustain the unemployment rate at its half-century low of 3.5%.
Probably the most nerve-wracking aspect of the stock market euphoria is that daily increases have become the norm. With economic prospects good, the Fed on hold and the earnings outlook brighter for 2020, few appear to be concerned. Which is probably the best reason we should be.
3. Debt crisis
History repeats itself, but usually with an adequate interval and a slight twist.
The Savings & Loan crisis of the late 1980s was centered on commercial real estate. Fast-forward almost two decades, and it was subprime mortgage loans for residential real estate that fueled the financial crisis and Great Recession.
It may be too soon to repeat the pattern of a debt-fueled binge precipitating another downturn. But if that turns out not to be the case, U.S. corporate debt, which has risen to more than $10 trillion, or 46% of GDP, will be the culprit this time around.
The proliferation of low-credit-quality bonds has garnered the attention of policy makers and the International Monetary Fund.
“High corporate debt-at-risk,” defined as debt owed by companies whose earnings are insufficient to cover interest payments, “may translate into higher credit losses for financial institutions with significant exposures to corporate loans and bonds,” according to the IMF’s October Global Financial Stability Report.
Some of the most highly leveraged firms are taking on an increasing amount of debt for “financial risk-taking … fueling a further buildup of vulnerabilities in some sectors and countries,” the IMF said.
Corporate leverage can amplify shocks, the IMF explained. The burgeoning supply of at-risk debt might not be enough to bring the house down, but once it starts falling, watch out below.
4. Trade wars
The expected signing of a phase-one trade deal between the U.S. and China is not the end of trade tensions; it’s merely a pause.
President Donald Trump would be the first to tell you that he loves tariffs. They are his weapon of choice against any real or perceived adversaries.
The phase-one U.S.-China trade agreement offers tit-for-tat relief from tit-for-tat tariffs: a halt to new U.S. tariffs and a halving of the rate on some existing ones in exchange for China’s promise to boost agricultural purchases from the U.S. It does little to address major structural issues, such as China’s subsidies to state-owned enterprises and strategic businesses.
Trump has threatened new tariffs on European auto exports and 100% duties on some French consumer products, such as Champagne and cheese.
The trade war, which started in 2018, put a damper on business investment, forced firms to reroute supply chains and sent manufacturing into a tail spin.
It’s not clear that a temporary pause in the trade war would eliminate uncertainty and encourage new investment in plants and equipment. Any escalation in international commerce would further dampen manufacturing activity, eventually depressing hiring and crimping consumer spending.
When it comes to Trump and trade, there is never a final resolution. His embedded belief that trade deficits are a sign that the U.S. has been taken advantage of all these years means that misguided trade policy remains a viable threat to the economy.
Even if missteps won’t cause a recession, they would no doubt act as an accelerator.
5. Unforeseen events
The world is a scary place. The rise of populist and nationalist movements across the globe, the breakdown of the post-World War II global order, the strained relationships with long-term allies, protest movements in countries from Hong Kong to Chile to Iran and Lebanon: this is the backdrop against which any flare-up would play itself out.
Then there are the “unknown unknowns,” as former Defense Secretary Donald Rumsfeld called them: the ones we don’t know we don’t know.
Rising economic and political tensions could ignite a global conflagration, especially with an impulsive president in the White House.
On Tuesday, protestors broke into the U.S. Embassy compound in Baghdad, shouting “Death to America,” in response to U.S. airstrikes on an Iranian-backed militia. It was an eerie reminder of events 40 years ago in Tehran.
This is all happening at a time when central banks lack the ammunition to stimulate aggregate demand sufficiently to offset any shock that sends consumers and businesses reeling.
At a time when the institutions designed to ensure global peace and prosperity have been threatened by the rising tide of nationalism, the geopolitical arena seems to be where the greatest risk lies.
Caroline Baum is a MarketWatch columnist.
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