Slower Economic Growth Is In the Cards, but We Are Not Ready To Utter the “R” Word
By: Sasha Kostadinov, CFA
Nobel Prize winning economist Paul Samuelson once famously quipped that the stock market had predicted nine out of the last five recessions. At the moment we are in the midst of a market correction, and whether or not the correction develops into something more serious depends on whether or not a recession is imminent. Stock market corrections of 10% regularly occur once or twice a year even when the economy is growing. Steeper corrections and associated “bear markets” occur during recessions.
Our current view is that a recession is not imminent, though we do expect economic growth to slow in 2019. Accordingly, we view this as a “valuation correction.” Stocks had gotten relatively expensive given optimism about the improvement in economic growth and corporate results this year. Real (i.e., adjusted for inflation) gross domestic product (GDP) increased 3% in 3Q18. Not long ago, in 2Q16, real GDP growth was just 1.3%. In 3Q18, corporate sales increased 8% while in 4Q15 they declined 4%.
However, the stock market is a discounting mechanism, which means that investors price stocks according to their expectations for future growth.
There are many variables that inform our view that growth will slow, but here we focus on one: a decline in the monetary base. The monetary base is one of several ways of measuring the money supply. Specifically, it is the amount of currency held by the public and commercial banks as reserve deposits. (By law, banks must keep 10% of certain deposits as reserves that cannot be loaned.) This matters because a declining monetary base means that there is less currency for the public to spend and banks to lend. A declining monetary base also puts upward pressure on short term interest rates as banks offer higher rates to attract deposits to meet reserve requirements.
The chart below shows a clear relationship between growth of the monetary base and real GDP growth. As you can see, faster monetary base growth is associated with faster real GDP growth and vice versa.
The next chart below shows these two data series since 2010. As you can see, the monetary base began contracting this year. Since moves in the monetary base are associated with moves in real GDP growth, it is reasonable to expect that growth will slow in 2019, just as it did in 2011, 2013 and 2015.
The difference this time is that the Federal Reserve is contributing to the contraction of the monetary base by raising its benchmark Federal Funds rate and by unwinding its policy of Quantitative Easing. After the financial crisis in 2008-2009, the central bank lowered the Federal Funds rate to zero and purchased Treasury and mortgage-backed bonds, increasing the monetary base fourfold (see chart below). This was an unprecedented policy action. Prior to the financial crisis, monetary base growth typically varied between 3% and 10%, and growth below 5% put the economy at risk of recession.
Why would the Federal Reserve take actions to contract the monetary base given that in the past just slowing its growth rate preceded every modern recession?
The Federal Reserve adopted the policy of Quantitative Easing to stabilize the economy during the financial crisis. At the time, the velocity of money, which is a term that means how many times the money supply turns over in a period, had fallen precipitously. People and companies held more cash than before to buffer themselves during the period of heightened uncertainty. Had the Federal Reserve not acted to expand the monetary base, the recession likely would have been worse.
Now that the economy is on firmer footing, partly due to fiscal stimulus in the form of tax cuts and federal deficit spending, the Federal Reserve is increasing the Federal Funds rate and reducing its holdings of bonds that it acquired during its policy of Quantitative Easing. Doing so means selling those bonds, which shrinks the monetary base. The important thing to notice is that since the financial crisis, the monetary base has contracted four times without a recession occurring, the fourth time being the current instance. Notice that each of these periods were associated with volatility in the stock market. In each case, however, the market rebounded. You can see this in the chart below.
Will this time be different? Will the market rebound or will this correction develop into something worse? To a large degree, the answer depends on the Federal Reserve, which must balance a desire to “normalize” its balance sheet eventually with the needs of our economy today. Tightening Federal Reserve actions, such as the current one, have preceded past recessions. That is why although there are many other factors that influence our view of prospective economic growth, this one is a key factor on which we are keenly focused. At present, we do not see signs that a recession is imminent, but the Federal Reserve’s tightening actions increases the risk of recession.