Stall speed?

• As global economic growth slows, concern is mounting about the possibility of descending below “stall speed.”
• Historically, the U.S. stall speed was 2.0%: virtually every time the annual real GDP growth rate fell below that threshold, the economy would shortly descend into a recession. There was arguably an exception to this rule in 1956 when growth subsequently rebounded, though a recession did follow in 1958.
• Why might a stall speed exist? There are two ways of thinking about it.
  • First, when economic growth significantly underperforms, it worries businesses and consumers, who then reduce their investment, hiring and spending activities. This, in turn, creates a psychological vicious circle that ultimately resolves in a recession.
  • Second, 2% GDP growth historically represents a significantly below potential rate of growth. When the economy is expanding at less than its potential rate, this means that the unemployment rate is rising and capacity utilization is declining. This then reduces the scope/need for additional spending/investment.
• The existence of a stall speed is less clear in other countries. Historically, Canada has generally abided by the sub-2% rule, but with notable exceptions in 1996 and 2003. The concept applied to the U.K. through the 1970s, 1980s and 1990s, but less obviously before or since. It is clear that Germany and Japan can sustain much lower rates of growth without stalling, though that doesn’t rule out the possibility that they simply have a lower stall speed than the rest.
• While we do not forecast sub-2% growth in the U.S. in 2019, the recent financial market shock paired with the government shutdown shaved our working growth outlook down to around 2.25% for the year. This is too close to sub-2% for comfort, at least if the historical stall speed applies.
• Fortunately, the idea of a 2% stall speed hasn’t found much support since the global financial crisis. In fact, U.S. growth has retreated below that threshold without consequence on four separate occasions since then: in 2011, 2013, 2014 and 2016. Naturally, no period of slow growth is particularly cheery, but no magnetic attraction toward zero was evident.
• What might explain this abrupt shift? We can think of two possible explanations:
  • First, it is clear that the sustainable economic growth rate is notably lower than it was before the crisis, for a mix of reasons having to do with demographics, innovation and a post-crisis malaise. With 2% now approximately the “normal” rate of growth, it is hard to imagine that a slight deviation below that normal would induce the kind of psychological damage necessary to conjure a recession out of thin air. In other words, any stall speed today should be considerably lower than 2%.
  • o Second, the structure of developed-world economies has shifted over time, placing a greater weight on relatively stable services and reducing the influence of the inventory cycle. In addition, a large fraction of spending now occurs automatically via recurring payments. This leaves less room for overreaction on the part of jittery businesses and households.
• What conclusions can be reached, then? Several:
  1. The U.S. economy is nowhere near stall speed at present. Even as conventionally defined, U.S. growth is a good percentage point higher (3.0% versus 2.0%).
  2. To the extent that stall speed continues to exist, it is very likely lower than it once was, potentially at just 1.0% growth, or even less.
  3. Despite the fact that the stall speed does not presently play a central role in our thinking, we believe the recession risk is higher than normal due to a mix of economic headwinds paired with the late point of the business cycle.

Brexit:

• The never-ending-story that is Brexit continues to stumble raggedly along, from one crisis to the next.
• Last week brought the biggest ever government defeat in the history of the British House of Commons, when the Prime Minister’s proposed U.K.-EU Brexit pact lost by a staggering margin of 230 votes. The loss was not a surprise, though the magnitude was.
• Then, on the basis of that defeat, the opposition Labour Party demanded and secured a confidence vote to determine if the existing government could continue to function. The vote went along party lines, resulting in a slight majority supporting the existing government.
• This week, Prime Minister May is proposing a Plan B that would soften the Northern Irish backstop that has proven so contentious. The problem is that the backstop promises that Ireland and Northern Ireland will be effectively borderless forevermore via a customs arrangement that necessitates a permanent alignment of regulations between the two jurisdictions. The problem is that with this restraint the U.K. would then struggle to pursue a harder version of Brexit at a later date without having to effectively sever Northern Ireland off from the rest of the U.K.
• In many ways, Brexit seems barely closer to a resolution than it was a year ago. Virtually all options remain on the table. Then again, the very nature of political negotiations is that little progress is made until the last possible moment, which in the present context is still nine weeks away. That might not sound like much time, but it is an eternity for negotiators. It is often darkest before the dawn.
• A central challenge in all of this is that there are many possible permutations of Brexit, such that it is hard to get more than half of MPs to support any one option.
• The odds of another election have arguably just diminished slightly with the successful confidence vote. But the Conservative Party could yet itself fracture and necessitate an election. The odds of a second referendum continue to rise as other options are crossed off, one by one.
• We continue to stubbornly believe that some form of customs union remains the most likely solution, not so much because it makes anyone particularly happy, but because it fails to cross the red lines associated with controlling immigration and minimizing the Northern Irish border.
• The second most likely scenario is no Brexit at all, given the reality that a large fraction of British MPs do not actually support Brexit themselves, despite what their constituents have said. Of course, that would require working across party lines, a concept that has been foreign so far. For that matter, public support for Brexit is lower than it was at the time of the original referendum.
• The risk of an accidental hard Brexit seems fairly low, in part because no one wants that outcome -- in part because courts have ruled that the U.K. can unilaterally withdraw its Article 50 declaration at any time, and in part because most such threats are transparently a negotiating tactic.
• While many possible outcomes remain, we feel that a softer outcome is more likely than a harder one.

U.S. government shutdown:

• The ongoing U.S. government shutdown continues extend deeper into record territory, now stretching for 31 days.
• In so doing, the shutdown has already exceeded initial expectations. Of course, with Congress split between Republicans and Democrats plus an iconoclastic president in the White House, it was never going to be easy.
• So far, the public are putting most of the blame on President Trump and the Republican Party. However, it is an open question whether that thinking could begin to shift now that the President has proposed a compromise to the Democrats, which was seemingly rejected out of hand.
• The specific proposed compromise – a possibility we discussed in these pages a few weeks ago – involves funding border security as per the White House’s demand, but also extending work permits for illegal immigrant “Dreamers” and similar parties.
• We’d like to think negotiations will progress from here and alight upon a solution in the not-too-distant future, but really there is very little hard evidence with which to make such an assertion. It may require blame to be increasingly shared equally between the two parties to get proper action.
• We continue to assess economic damage at the rate of 0.05% per week, meaning that the damage to-date now sums to between 0.2% and 0.25% in total, split between the tail end of 2018 and the beginning of 2019. Given that we had originally estimated a slight 0.2% boost from fiscal stimulus in the U.S. for 2019, this now suggests that the broader fiscal tailwind is beginning to turn into a headwind.
• In addition to the amusing photos of take-out fast food being served to White House guests, there are other quirky implications. For instance, certain pieces of economic data can no longer be published. Furthermore, should the shutdown continue through the end of this month, January payrolls will likely reveal the first monthly job loss in (an astonishing) 100 months. Of course, those job losses will be largely reversed whenever the shutdown ends.

China update:

• We continue to believe the key issues for China are its slowing growth rate, the offsetting delivery of fiscal stimulus, and the resulting debt risks.
• Chinese Q4 GDP was just released, confirming the expectation of a decelerating trend. The country’s annual rate of growth for 2018 was just 6.6%, the slowest in nearly 30 years, though hardly bad by any other standard. The country’s annualized growth rate in the fourth quarter specifically (as opposed to the Q4/Q4 YoY estimates widely announced) was just 6.2%.
• We continue to forecast just 6.0% growth across 2019, motivated by structural factors (lost competitiveness, slowing globalization, deteriorating demographics), cyclical impulses (the lagged effect of deleveraging efforts, slowing global demand) and idiosyncratic considerations (U.S. protectionism).
• Related to this, not much progress is being made vis a vis U.S.-China trade negotiations. Yes, the now familiar offers of “buy more soybeans” and “lower auto tariffs” continue to be made by China, but a) they are not new promises; b) they will not by themselves come close to eliminating the bilateral trade imbalance; and c) the real trade issues relate to China’s unorthodox economic structure. This is to say that even if there is a superficial trade agreement between the U.S. and China before the March 1st deadline, there is a good chance tensions flare up again not long after.
• China has already responded to its slowing growth trajectory with various forms of stimulus, spanning rate cuts, tax cuts and regulatory loosening. The country has furthermore indicated that more is coming, with rumors of a VAT tax cut, more business tax cuts and permission for local government to issue more bonds.
• For now, we believe the negative growth momentum more than offsets this extra stimulus, particularly given that China is reluctant to reignite its debt excesses. Given the lags involved, that narrative could begin to change into the second half of 2019, but that is not yet a certainty.