The Year Ahead

Last year, the United States experienced breakout economic growth. After a disappointing start, the economy achieved cruising altitude in the second and third quarters, and while Q4 data have not yet been released, the final growth rate for the year is likely to be 2.9% — tied with 2015 for the best year since the recession. Other than the housing market, the economy was firing on all cylinders for much of the year, and the combination of lower tax rates, strong consumer demand and a global upswing triggered a surge in business investment and soaring confidence that benefited the equipment finance industry.

Looking ahead to 2019, one might expect the combination of heightened business and consumer confidence, a historically strong labor market, steadily rising wages and lower tax rates to produce another year of strong growth. However, while the economy remains in reasonably good shape, several warning signs and red flags have emerged that deserve attention. We are increasingly concerned about the possibility of a slowdown this year, and depending on how some of the factors described below evolve, a growth pause at the end of the year is quite possible.

In the recently-published 2019 Equipment Leasing & Finance U.S. Economic Outlook (produced by the Equipment Leasing & Finance Foundation in partnership with Keybridge Research), we forecast a 2.3% growth rate for the economy and 4.1% growth for equipment and software investment.

A year ago, we were notably more optimistic about the economy than the consensus view, as we summarized in this space:

“While not everything is rosy—a strengthening dollar may dampen exports, construction investment has been very weak, and interest rates will almost certainly rise substantially—the U.S. economy is witnessing a broad-based cyclical upturn that should make 2018 one of the strongest since the recession (though we expect growth will fall just short of the elusive 3% rate last achieved in 2005).”
(Jensen & Rust, December 2017)

We hope the analysis below will be just as prescient. Here are nine key industry, policy and macroeconomic factors to watch in 2019.

The U.S. economy will cool in 2019.

After respectable 2.2% annualized growth in the first quarter, the U.S. economy finally began to find its groove last year, surging 4.2% in Q2 (the fastest pace since mid-2014) and 3.5% in Q3. Consumers led the charge, which is no surprise given strong job growth, sub-4% unemployment, steadily rising wages and manageable household debt levels. Business investment was also healthy for much of the year, boosted by a lighter-touch regulatory approach and lower corporate tax rates that helped take the sting out of trade restrictions (more on that later).

Looking ahead, however, it is likely that last year’s surge was also a peak, and the economy is beginning to lose steam. Business investment appears to be slowing, housing remains very weak (residential investment has contracted in five of the last six quarters) and global demand is softening. The stimulative effects of tax cuts that helped jolt the economy last year are waning, leaving in their wake trillion-dollar deficits that will need to be dealt with sooner or later.

To be sure, the U.S. economy is in better shape than most; after all, three of the G-7 economies (Japan, Germany and Italy) contracted in the third quarter, and the United Kingdom is trying to avoid becoming a fourth as it navigates a post-Brexit future. On the positive side, consumers are still spending at a healthy rate and do not appear to be overleveraged. Moreover, even as job gains remain robust, the prime-age labor force participation rate is still nearly a percentage point below its pre-recession level, suggesting that the labor market still has a bit more room to run. All things considered, we expect the U.S. economy to expand at a moderate 2.3% annual rate this year (on the low end of the consensus estimate of 2.3–2.5%), with growth stronger in the first half of the year.

Equipment and software investment will soften, but should remain positive.

Investment in equipment and software (E&S) is a key component of GDP and the lifeblood of the equipment finance industry. For example, in 2015-16 the annualized growth rate of E&S investment averaged around 2% and exceeded 5% only once in eight quarters. During this period, the equipment finance industry contracted according to the Foundation’s Industry Horizon Report. Since then, however, E&S investment has improved markedly: in 2017 and the first half of 2018, annualized E&S investment growth exceeded 5% in every quarter and reached double-digits more often than not. Growth slipped a bit in the third quarter (+4.7% annualized) but remains solid.

Looking ahead, the outlook for E&S investment is mixed. Various business confidence metrics—including the NFIB Small Business Optimism Index and the Business Roundtable CEO Economic Outlook Index—remain elevated but have also fallen in recent months. The Foundation’s Monthly Confidence Index likewise fell markedly in November and December (it is now roughly equivalent to where it was just before the 2016 Presidential election), and several other indicators have weakened in the last 2-3 months (e.g., ISM Manufacturing and Non-Manufacturing Purchasing Managers Indices, shipments and orders of durable goods). On balance, E&S investment should grow at a moderate pace in this year: our forecast as published in the Foundation’s 2019 Equipment Leasing & Finance U.S. Economic Outlook is 4.1% annualized growth. However, a more significant deceleration next year is possible if business confidence continues to erode due to trade tensions, tightening credit conditions or other factors.

Technology verticals look promising in the first half of 2019.

Regular readers of the Foundation-Keybridge U.S. Equipment & Software Investment Momentum Monitor know that most equipment verticals were in the “Recovering/Emerging” or “Expanding/Thriving” range for much of 2018. Based on recent data, the technology sector, where both computers investment and software investment posted solid gains in 2018, is well-positioned for continued growth. Industrial sector verticals are also positioned for growth, including materials handling equipment and, to a lesser extent, other industrial equipment.

However, there are other sectors that may not fare as well this year. One area of concern is medical equipment, for which momentum fell for most of 2018. A substantial decline in the investment growth rate for medical equipment—and potentially a contraction—is something to watch for in the next 3–6 months. Another weakening vertical is agricultural equipment, which posted solid growth in 2018 but faces an uncertain future due to the ongoing trade war and a less optimistic global economic outlook.

Finally, there are some wildcard industries for which equipment investment growth is difficult to predict, including mining and oilfield equipment, which will depend largely on oil prices. Railroad equipment investment will also depend heavily on oil price movements, and the sharp downturn in oil prices that began in October caused a substantial drop in the latest release of the Railroad Equipment Momentum Monitor. Finally, construction equipment investment has been surprisingly robust in recent months given weakness in the housing market, but recent movement in the Construction Equipment Momentum Monitor suggests that the next two quarters may bring weaker investment growth.

Under divided government, if the parties can navigate a shutdown over immigration, it may open the door to compromise on other issues.

With Democrats now in power in the House, President Trump and Senate Republicans will need to work across the aisle to pass legislation. Some results are predictable: House Democrats will focus on government oversight, with hearings, subpoenas and investigations into a broad set of issues spanning across the Trump Administration’s first two years. Senate Republicans will concentrate on approving President Trump’s conservative judicial nominations, while other priorities, such as repealing the Affordable Care Act, implementing additional tax cuts or reforming entitlement programs, are likely off the table. A return to policy gridlock appears likely, and a split Congress will make it significantly more difficult to approve a government spending bill. As we have seen, a shutdown can undermine market confidence and, potentially, delay planned investment, particularly if neither side feels political pressure to compromise. This, in turn, could exacerbate the natural slowing we expect will occur in the economy this year.

However, there are also viable areas for the two parties to collaborate. One issue on which a compromise appears possible is prescription drug pricing, and such legislation could also address the opioid crisis—a politically motivating issue for both parties given its outsized impact in key swing states (e.g., OH, WI, PA, MI and NH). Equipment finance professionals, however, are likely more interested in an idea that is often discussed but never seems to go anywhere: investment in infrastructure. Leaders in both parties (including President Trump) have expressed support for a bill to improve America’s deteriorating roadways, bridges and other infrastructure. Efforts thus far, however, have borne little fruit due to fundamental disagreements over the size of an infrastructure package and how it should be paid for. We are somewhat pessimistic about the chances that a divided Congress can reach a compromise on infrastructure in 2019— and even if a successful bill does materialize, it is unlikely to boost equipment investment until at least 2020. That said, both sides have an incentive to try, and we expect they will.

The Fed is likely to slow its rate hike path, but 2019 will be a year of heightened uncertainty for monetary policy.

The Fed raised its benchmark policy rate four times for a total of 100 basis points in 2018, the fastest pace of rate increases since 2006 and a reflection of strong economic growth and rising inflation. However, given this year’s outlook for the economy (slowing) and inflationary pressures (weakening), the Fed is likely to adopt a more cautious approach. Recently the Fed has signaled that it may raise rates more slowly this year, particularly if inflation pressures remain low due to a drop in oil prices and weakening global demand. For this reason, we expect only two rate increases this year—though it would not surprise us if the Fed raises rates just once.

However, this year is also among the most uncertain for Fed policy in recent memory. Of late, Fed communications have shifted away from the need to “normalize” rates while remaining “accommodative” of economic activity, and toward the importance of making “data-dependent” decisions that respond to immediate economic conditions. In other words, the Fed appears to be deemphasizing plans for gradual and regular rate hikes in favor of a more improvised approach. The unknown effects on credit conditions of the Fed’s ongoing sales of long-term Treasuries and the numerous downside risks to global growth only add to the uncertainty, making Fed policy a major factor to watch in 2019.

While unlikely to sway actual policy, attacks on Fed independence undermine its legitimacy and capacity to support economic stability.

The Fed’s rapid rate hike path in 2018 invited criticism from President Trump, who, over the course of the second half of 2018, has called the Fed “wild,” “loco” and “out of control”; deemed the Fed’s “ridiculous” rate-hike policy “the biggest threat to my presidency”; and argued that interest rate increases are “not necessary in my opinion and I think I know about it better than they do.” Previous presidents have criticized Fed policy privately, and some have tried to influence rate-setting decisions behind the scenes (e.g., Richard Nixon’s phone calls to Fed Chair Arthur Burns). However, the public nature of Trump’s attacks is unprecedented and goes against decades-old norms regarding Fed independence.

Although Fed Chair Jerome Powell has shown no signs of bending to Trump’s will, the President’s attacks are concerning and may presage a premature change in Fed leadership. If this occurs, it could degrade market confidence in the Fed’s institutional ability to control inflation, interest rates and other macroeconomic variables even if the political consequences are unappealing. Instead of operating in an environment of relative obscurity and insularity from popular pressure, as it has in the past, the Fed could become politicized in the same manner as the Supreme Court or the FBI. This would represent a shift that could move the U.S. economy into uncharted territory.

The global economy faces a challenging year.

A year ago, global economic growth was in full swing, and our 2018 forecast predicted that the global economy would expand at the fastest pace since the Great Recession. Although that forecast has proven correct, storm clouds began appearing on the horizon in the second half of 2018. Whereas no major economies were in a recession one year ago, Argentina and South Africa are now heading into a recession, driven largely by an emerging market currency rout spurred by rising interest rates in the United States. Germany and Japan posted worrying GDP contractions in the third quarter, apparently triggered by a slowdown in exports stemming in part from global trade tensions. A combination of tightening global credit conditions and a populist upswing in Europe have brought Italy’s debt situation to a head, and its economy also contracted in Q3.

Most worrying of all: China’s economy also appears to be slowing. The latest manufacturing purchasing managers’ index fell into contractionary territory in December, new export orders have fallen in four of the last five months and are at their lowest level in more than three years, and China’s auto sales in 2018 are on track to post their first yearly decline in nearly three decades. As the primary engine of global growth, a slowing Chinese economy may shave several tenths off global economic growth in 2019. Even worse, Chinese economic weakness could ignite a debt crisis, as China’s 300% debt-to-GDP ratio becomes increasingly unsustainable. While this scenario is by no means certain, there are several worrying signs that warrant close monitoring. This year, U.S. economic performance will depend on global developments much more than usual.

Trade policy will play an outsized role in determining global growth.

If the U.S. economy hinges on global economic performance, the fate of the global economy in 2019 rests on trade policy. U.S. actions to impose a host of tariffs on major trading partners have dampened global growth, as evidenced by the fact that big, export-dependent economies like China, Germany and Japan are among those whose recent performance has disappointed the most. If a substantive truce (emphasis on substantive) emerges between the United States and China on trade issues—and if no additional trade skirmishes occur between the United States and other key trading partners—then the global economy should register another solid year of growth.

However, if trade tensions continue or worsen, many businesses will need to reexamine and rearrange their global supply chains, resulting in increased costs and, presumably, falling confidence.

• Despite an apparent rapprochement between the U.S. and China at the G20 summit in early December, a serious agreement will require both countries to concede far more than they have been willing to thus far. Indeed, many of the sticking points (e.g., Chinese overcapacity in key industrial sectors, high barriers to market entry and intellectual property theft) are central to the Chinese economic model.
• Meanwhile, steel and aluminum tariffs show no signs of disappearing, and the new, recently-signed NAFTA renegotiation (i.e., the U.S.-Mexico-Canada agreement, or USMCA) faces hurdles to passage in each member’s legislature.
• Perhaps the greatest threat of all is a proposed tariff on automobiles coming from several U.S. trading partners—apparently dropped several months ago, but recently revived in comments by President Trump. If auto tariffs were to be implemented on a major trading partner like Germany, Japan or China, the result would be crippling for the global economy, given the size of the automobile sector globally and the centrality of that sector to many countries’ economies.

While not a base case scenario, the potential for a dramatic escalation in trade tensions between the U.S. and other major economies is significant enough to make trade policy the number one issue to watch this year.

A recession on the horizon?

Recent stock market turbulence and some other worrying signs in the economic data have renewed concerns that the U.S. may soon be headed for another contraction, nearly a decade after the Great Recession. Indeed, many economists and market analysts sense that the next recession may be nearing.

Although recession forecasting is a notoriously tricky art, a handful of indicators have proven to be reasonably reliable. Foremost among them is the “yield curve,” or the spread between short- and long-term Treasury yields. When the yield curve falls below zero (that is, when shorter-term yields are higher than the longer-term yields), a recession tends to follow 1–2 years later. The spread between two-year and five-year Treasuries inverted in December, and the two-year / ten-year spread continues to hover just above the zero threshold.

To be clear: we are not forecasting a recession in 2019. However, we do anticipate a significant slowdown by the end of the year that, in retrospect, may turn out to be the leading edge of a recession in early/mid 2020—particularly if some of the downside risks discussed above materialize. As such, businesses should ensure they have a plan in place for adjusting their strategies and tactics to a slow growth or recessionary environment. It may not happen this year, but as we’ve said in this space before, winter will come eventually.