The US economy remains healthy—for how long?

The US equity and bond markets are telling completely different stories about the outlook for the country’s economy. In the first seven months of 2019, the S&P 500 index rose by 10.2 per cent, suggesting firms could continue producing strong corporate earnings off the back of decent economic growth. Over the same time period, borrowing costs on 10-year Treasuries fell from 2.68 per cent to 1.89 per cent, sign-posting lower rates and inflation, and the likelihood of recession ahead. This economic recovery in the United States is the longest on record, and analysts are on the lookout for signs it is ending. Who has it right—equity or bond investors?

For the next year, I think equity investors have a more accurate read on the US economy. To be clear, US growth is slowing down. It is unreasonable for anyone to expect the US to continue growing above potential—around 1.75 per cent—in the absence of significant stimulus measures, a jump in productivity or an increase in the labour supply.

The main factor propping up US growth is consumption, which accounts for nearly 70 percent of gross domestic product. In the second quarter of 2019, consumer spending grew at an annual rate of 4.3 per cent—a stellar result this late in the business cycle. Consumer confidence remains close to post-crisis highs, according to the University of Michigan’s consumer sentiment index.

Consumption has been underpinned by a strong labour market, with unemployment falling to 3.7 per cent—close to the lowest in nearly 50 years—while the US has added an average of 165,000 jobs per month this year so far. Annual wage growth was 3.2 per cent in July compared with a year earlier. That is robust for this cycle (though admittedly still weak by historical standards). There are few signs in the employment data that point to an imminent recession.

What has analysts concerned is a collapse in business spending. Investment was a drag on growth in the second quarter of 2019, as firms faced a double whammy of slower demand from abroad and heightened uncertainty about trade.

Industrial and manufacturing production fell in the first two quarters of 2019, indicating that the manufacturing sector is in recession and raising concerns that a general recession will soon follow. This need not be the case. Manufacturing only accounts for about 11 per cent of GDP and 8 per cent of employment. The US is primarily a services-based economy and the service industry data have remained buoyant.

A recession was avoided during the last manufacturing downturn in 2015-16, but this was largely due to a dovish tilt by the Federal Reserve that served to weaken the dollar and ease financial conditions. That is unlikely to work this time, as financial conditions are already easy. The Fed’s rapid shift in tone from rate rises to rate cuts since the end of last year has done surprisingly little to weaken the currency.

The key to whether a manufacturing recession bleeds into an economic one is President Trump’s trade policy. Not only have trade tensions contributed to weaker demand from China for US goods, they have disrupted supply chains and inventory management for US manufacturers. It is unlikely that the US and China will find resolution on the trade war any time soon—at stake is which economy will be the world’s largest based on excellence in artificial intelligence and machine learning.

Piling currency worries on top of the trade issues only heightens the uncertainty, encouraging corporate leaders to rethink spending plans they can’t be certain will pay off. China allowed the RMB to fall below the psychologically important threshold of 7 on 5^th August and the White House retaliated by declaring China a currency manipulator. Broad-based currency wars are generally ineffective since countries can't all devalue their currencies against each other, but competitive devaluations can boost inflation, damp growth and create roller coasters in the foreign exchange markets.

Another risk for the US economy lies in the markets. Volatility has changed in the past few years such that spikes tend to be short and sharp; volatility incidents are less like long storms and more like hurricanes. If the equity markets suffer one such event and decide that the economy is going into recession, they can create a self-fulfilling prophecy. We had a small taste of this in December 2018.

Pockets of corporate debt look frothy, particularly leveraged loans and BBB-rated credit. As the Fed cuts rates, it is inflating these asset class bubbles further. When corporate profits wane and firms begin to have difficulty servicing their debt, the resultant defaults could serve to deepen the next downturn.

The US economy continues to grow above potential, driven largely by the consumer. But business investment and manufacturing are flagging and trade tensions, currency wars and market disruptions threaten to knock the recovery off track. Equity investors might be more accurately reflecting the US outlook over the next year, but bond investors will eventually be proven right as well—so ignore them at your peril.

Megan Greene is a global economist, Senior Fellow at the Harvard Kennedy School and regular contributor to the Financial Times