An Economic Update
The release last week by the Commerce Department that GDP grew at an annualized rate of 4.1% in the second quarter was notable for several reasons. First, as widely noted, this was the strongest economic growth seen since 2014. Second, both consumer spending and business investment remained strong, with non-residential fixed investment up 7.3%. Perhaps most symbolically, the U.S. is now at $20 trillion in annualized GDP.
All this is great news and is being widely trumpeted as an indication that we are moving in the right direction economically. Pundits cite tax cuts and reduced regulatory burdens as factors behind this strong growth, and indeed there are many reasons to be optimistic. However, it is also crucial to examine where things are possibly headed. So with that in mind, what are the implications of this strong economic growth?
- Interest rates are going higher. The Fed already has a bias towards higher rates, and this strong economic growth gives the Fed further impetus. The perception of many is that the Fed was asleep during the early 2000s and allowed rates to remain too low for too long, ultimately resulting in the financial crisis later in that decade. Regardless of the accuracy of this perception, the Fed would prefer to avoid a repeat. In addition, the Fed’s basic tool in economic slowdowns is interest rate reductions. If rates are not moved up, the Fed has no room to bring rates down during the next recession. So expect two more rate increases in 2018.
- The yield curve will continue to flatten. In line with rising rates, expect the yield curve to continue to flatten. This is because while the Fed can control short-term rates, its control over long rates is more problematic. The chart shows the spread between 2 year and 10 year Treasuries. Note how we are moving towards an inverted yield curve – the spread between 10 year and 2 year Treasuries is moving to negative ranges. A flat or negatively sloped yield curve is problematic for two reasons. First, it works against the earnings model of most financial institutions, who take advantage of a positively-sloped yield curve (funding longer term loans with shorter term deposits). Second, an inverted yield curve is commonly a precursor to recession – typically by a year or so.
- Cost of funds will be an increasing concern for most financial institutions. As rates continue to move up, funding costs will climb. This could put downward pressure on margins, especially for those institutions that are unwilling to raise loan rates in the face of competitive pressure. In the industry we have not had to worry about deposit acquisition and retention strategies for over a decade. That is changing.
- Expect delinquencies to continue to rise. The good news is that incomes are rising in the U.S. The bad news is that interest rates are likely to increase at a faster pace. The impact of this is that the trend we have seen in regard to rising delinquencies is likely to accelerate. This is a natural phenomenon in an aging business cycle. This will have an impact on the earnings of many financial institutions. Perhaps the portfolio where this is most apparent is the indirect lending portfolio. For our clients in Performance Analytics, we have seen declining margins coupled with increasing delinquency activity within the indirect portfolios.
- Recession in late 2019? All this points to a potential recession in 2019, probably later in the year. While we hate to be the bearers of bad news, all recoveries end, and this has been a particularly long one, now the second longest on record at 110 months. What are the clearest signals of imminent recession? First is a negatively-sloped yield curve, as we have discussed above. Second is a spike in first-time claims for unemployment, which we have yet to see, so keep an eye on that statistic.
The good news is that any recession we experience is likely to be relatively short in duration and magnitude. There are many factors which favor the U.S. economy in the long term – our favorable demography, our increasing energy independence, and our continuous innovation - so we anticipate growth will be strong in the longer term.