Even as U.S. economic growth slows--as fiscal stimulus filters out of the economy and the trade dispute with China weighs on business investment decisions--continued spending by American consumers looks set to prolong the historic expansion in the world's biggest economy.

Expected spending under the recently enacted Bipartisan Budget Act of 2019, favorable financial conditions (thanks to interest-rate cuts by the Federal Reserve), and an apparent calming of the trade seas, at least for now, support slightly above-trend GDP growth next year. S&P Global Economics now sees 2020 real GDP growth at 1.9%, up from 1.7% in our September forecast--and near our 1.8% estimate of the potential growth rate. We've also lowered our estimate of the risk of recession in the next 12 months to 25%-30%, from 30%-35% (although it remains near the top of the new range).

Of the 10 leading indicators of near-term U.S. economic growth we look at, three are positive, while five are neutral, and just two negative. This is a slight improvement from our assessment in August, as the term spread and single-family building permits turned neutral from negative, though Institute for Supply Management (ISM) manufacturing new orders index turned negative from neutral (see "U.S. Business Cycle Barometer: Walk The Line," Nov. 25, 2019).

Table 1

For this year, GDP growth will likely slow to 2.3%, from 2.9% in 2018, as protectionist policies and weaker private investment this year slow growth. Recent softness in business fixed investment is expected to be replaced with a modest upturn next year. But consumer spending has remained robust despite trade-related worries and headwinds to goods-producing sectors (18% of the economy). A tight jobs market, with rising real wages, and strong household balance sheets look set to bolster spending this holiday season. Solid household wealth and continued strong income growth could also add to the upside potential in our household spending forecast of a 2.4% increase in 2020.

In A Tight Labor Market, Even Bob Cratchit Gets A Raise

While American businesses are turning more cautious, with investment having slowed dramatically, they are still hiring. The U.S. even added 128,000 jobs in October despite the 42,000 drag from the General Motors strike. While headline unemployment rose 0.1 percentage point to 3.6%, it remains near a 50-year low, and labor-force participation rose to 63.3%--its highest since 2013. Wage growth was flat for the month at 3% year over year.

Payroll gains are likely to slow to a monthly average of 100,000-125,000 per month by fourth quarter next year as the unemployment rate bottoms out at 3.4% (by midyear) with the economy at full employment. We expect year-over-year wage growth to average 3.1% in 2020. The pass-through of some tariffs on Chinese goods amid a tight labor market will likely push up the core personal consumption expenditure (PCE) to just over 2% by midyear 2020. Strength in the dollar, which is helping to keep pre-tariff import prices down, and declines in energy prices will likely keep a cap on how high inflation rises.

Chart 1

Consumers aren't quite in the holiday spirit just yet. Amid elevated policy uncertainty and recession talk, slower spending should be no surprise. October retail sales saw a modest 0.3% rebound, with half of the subcategories reporting lower sales, including traditional holiday sectors such as clothing, electronics, and recreational goods. Shoppers may have also bought early to get ahead of the first round of new tariffs announced in July, the majority of which were on consumer items, particularly electronics. At the same time, the unusually short holiday sales season (with six fewer days between Thanksgiving and Christmas than there were last year) also suggests a more modest holiday outlook. Still, a rosy jobs market with fatter paychecks will likely put a little holiday spirit in last-minute shoppers to eek out fourth-quarter real consumer spending of 1.7% (annualized), down from a 2.9% gain in the third quarter.

Homes For The Holidays

Moreover, executives at services companies say the economy is still running strong, with the nonmanufacturing index from the ISM posting a still-strong 54.7 in October after slowing to 52.6 in September. Driven by domestic demand, services are less exposed to trade uncertainties and overall global weakness. Together with lower borrowing costs, stable home prices, higher wages, and stock market gains, the housing sector--which is part of the service sector--has also stabilized. Residential investment grew 5.1% in the third quarter, ending six consecutive quarters of declines. We believe the housing slump has bottomed out, and we expect low-single-digit price gains through 2022.

To be sure, international disputes are taking a toll. But the U.S. economy is so big and domestically driven that the direct costs of tariffs on Chinese goods have been relatively modest. Assuming the scheduled tariffs for Dec. 15 now won't go through as part of "Phase 1" ongoing discussions, we expect tariffs that have already been put in place to date to trim around 35 basis points (bps) from growth if they stay in place through 12 months. However, second order effects (hard to measure) from the trade war are likely more significant as deteriorating business confidence curbs spending.

Chart 2

Chart 3

Nonresidential investment slowed dramatically this year as trade uncertainty, political dysfunction, and company-specific factors weighed on business investment. Overall fixed investment has declined for two consecutive quarters through the third quarter. And while residential investment has improved--and looks set to continue to do so next year--both equipment and nonresidential construction spending posted declines in the third quarter, and we expect further weakness in the final three months of the year as businesses batten down the hatches. We see GDP rising just 1.6% in the fourth quarter after a stronger-than-expected third-quarter bounce of 2.2%, which kept our forecast for the full year at 2.3%. The recent durable orders bounce also suggests some upside to our equipment investment figure of negative 1.2% in the fourth quarter, which will give overall GDP growth an extra lift.

Related to ongoing industrial sector weakness, the six-week United Auto Workers' strike against General Motors, as well as continued problems with the 737 MAX airliners at Boeing, will also weigh on fourth-quarter activity. Indeed, factory shipments for nondefense capital goods excluding aircraft declined by 0.7% month over month in September, the fourth consecutive monthly decline. However, investment spending may be bottoming out in the fourth quarter, with U.S. durable orders up a much stronger-than-expected 0.6% in October. Nondefense capital goods orders excluding aircraft jumped by 1.2%; it's the first increase since June. We expect fourth-quarter equipment spending to decline by just 1.3% after falling by 3.8% in the third quarter. 2020 equipment spending is expected by be up just 0.8%, half the 1.5% we expect for 2019. However, if recent signs that the trade dispute is thawing come to fruition, we may see a New Year upward surprise.

For Trade, Will "Ho Ho Ho" Bump "Bah, Humbug"?

In light of the tentative trade agreement between the U.S. and China, we have removed some tariffs from our baseline forecast. Our assumption for now is that a Phase 1 deal gets done, with China buying additional American agricultural products, instituting a new foreign investment law, and adding a currency side agreement. While very difficult to predict, we now expect that the planned Dec. 15 tariffs are off for now, even if sign-off on the deal is delayed until early next year. The détente could be particularly reassuring to last-minute holiday shoppers, as this round of tariffs targeted consumer products, particularly electronics.

Still, any deal is likely to be fragile. And even with Phase 1 in place, tariffs on two-thirds of all U.S. imports from China remain. Moreover, nontariff barriers on both sides of the fence are still in play, and the next steps in negotiations could prove more difficult, adding to the list of worries as businesses plan their investment strategies over next few years. The disputes in the agreement (see chart) cover a lot of ground, but the technology sector--broadly defined--is central to the three main issues, and any agreement still seems a long way away.

All of this has weighed on manufacturing conditions. The ISM manufacturing sentiment and its jobs subcomponent are below 50, indicating contraction. This suggests a dismal outlook for the sector, foreshadowing job losses. On the bright side, tight inventories and improving trade conditions suggest the U.S. manufacturing recession may soon be bottoming out.

Despite the tariffs, inflation has remained subdued. Early this year, falling oil prices and a slowing in import price inflation because of a strong dollar helped keep the core PCE, excluding food and fuel, at just 1.1% in the first quarter.

Slowing global growth and trade tensions have strengthened the value of the dollar, restraining import prices and core inflation. On the flipside, higher tariffs and a hotter domestic economy have started to warm prices. The core Consumer Price Index (CPI) rose 2.3% in October from a year earlier, near the 13-month high of 2.4% in August and September. While September core PCE, at 1.7%, is still below the Fed's inflation target of 2.0%, it's much hotter than readings near 1% in the first quarter. We expect the dollar will remain near its two-year high through next year, continuing to restrain import prices and core inflation.

Under cover of subdued inflation, in October the Fed cut the benchmark federal funds rate by a quarter-point for a third time this year as insurance against downside risks from tariffs and slower foreign growth. We believe the Fed will keep the benchmark rate at 1.50%-1.75% through 2020, with the next move being a hike the following year. In this light, the yield on 10-year Treasuries--used as a reference for such things as mortgages--is expected to slowly trend higher and remain range bound between 2%-2.5% in our forecast horizon of 2019-2022.

Fed Bless Us, Everyone

With the business sector cooling its heels, GDP growth is especially reliant on consumer spending, which generally accounts for 70% of the world's biggest economy. And so any signs that consumers are keeping their wallets closed is troubling.

By contrast, positive corporate earnings surprises, the cooling trade dispute, and the Fed's insurance cuts have given investors a reason to see the glass half-full. Benchmark stock indices are at or near all-time highs and the 10-year Treasury yield has risen 45 bps from its September low, steepening the yield curve after a brief inversion early in the year (often a reliable recession indicator).

While the seas have calmed, downside risks to our outlook haven't disappeared. A Phase 1 trade deal would still leave significant tariffs in place, not to mention the more troublesome nontariff barriers. Additional trade tensions could arise, and American manufacturing may see the worst to come. Moreover, tension between the U.S. and Iran has not ended, and higher oil prices for the New Year is a possibility. Global growth remains lackluster, with no signs of an upturn, and Brexit concerns may return next year.

While we expect the Fed to remain on hold through 2020, with the next policy action a hike in 2021, this could change if our downside risks come to fruition. The central bank may be forced to cut rates again in March if economic growth slows to below potential and inflation recedes further.

The minutes from the Oct. 29 meeting of the Federal Open Market Committee underscore that risk. Policymakers have shifted to a wait-and-see stance after three rate cuts this year. They still see downside risks to inflation and the broader economy despite some easing in trade tensions and the lower chance of a so-called "hard" Brexit between the U.K. and EU. But while conditions have improved, the Fed remains on full alert, saying a "material reassessment" of its economic outlook could prompt further rate cuts.

Table 2

Upside And Downside Scenarios

Each quarter, S&P Global economists project two scenarios in addition to their base case, one with faster growth than the baseline and one with slower. Scenarios are based on ordinary risks to baseline growth, not extraordinary risks.

Upside: The Grinch's heart grew three sizes that day!

In the upside scenario, an accommodative Fed, de-escalation of trade tensions, and a slower fade of overall fiscal stimulus (compared with the baseline) spell two more years of solid above-trend growth for the U.S. economy.

After a slow 2019, private fixed business investment would pick up next year, reaching about 2.4% on average in 2020 and 2021--slightly higher than average in our baseline case--as calming trade seas lead to a lasting agreement between the U.S. and China. After stumbling in 2018 and 2019, housing would see a rebound, with real residential investment climbing 2.4% in 2020 as opposed to a more modest 1.6% increase in the baseline. As U.S. economic activity picks up, the Fed would have the room to raise rates gradually by an additional 25 bps each year from 2020 to 2022. The easing of trade tensions would help rebound business sentiments across both the industrial and service sectors, with the S&P 500 reaching 3,283.7 average in 2020, much higher than 3,101.9 in our baseline.

Higher-than-potential growth would require businesses to continue looking to hire more folks in tandem, thus keeping the pace of net jobs added per month in 2020 above the demographically driven long-term steady pace of about 100,000. The unemployment rate, in this scenario, would decline to 3.2% by beginning of 2021--lower than 3.5% in the baseline scenario.

Continuous strength in the labor market would let workers enjoy steady wage gains of 3% plus throughout next year. Together with the income effect, wealth from another above-historical-average stock market gain in 2019--following a cooling in trade tensions--would lead to higher consumer sentiment. All of this would be sufficient to keep consumer-spending growth robust at 2.2% in 2020 compared with 1.9% in the baseline scenario. Strength in the labor market would help push up household formation rates, providing more tailwind to the housing market (compared with the baseline).

In this optimistic scenario, after a solid 2.9% rate in 2018 and 2.3% this year, real GDP growth would slow to 2.2% next year and 2.0% in 2021, above 1.9% and 1.8%, respectively, for the baseline, with both years still comfortably above our potential growth estimate of 1.8%.

Downside: Reindeer games canceled

In our downside scenario, the boost from the December 2017 tax cuts enjoyed by the consumers and businesses fades faster. Business confidence would sour as trade-related rancor continues, keeping corporate pocketbooks shut. The stock market would decline 1.4% in 2020 on an annual average basis (decline of 11% fourth quarter over fourth quarter), in contrast to a 6.9% gain in our baseline. Business fixed investment would decline by 0.7% in 2020 (versus +1.7% in baseline) and recover only slightly by 0.5% in 2021.

The drop in business confidence would mean hiring is less robust than in our base case, and the unemployment rate would start ticking up in the second half of 2020. The unemployment rate would climb to 4.3% in 2021 (versus 3.6%, in our baseline), and this rate would be higher if not for the labor force participation rate declining at a faster pace than in our baseline case. Business investment would remain lackluster in 2020 as trade tensions and signs of a global economic slowdown give managers reason to keep their pocketbooks shut. Because of weaker customer demand, company shelves would remain full, with no need to restock inventories. The household sector would be cautious, spending just 1.8% for 2020, in contrast with 2.4% for the baseline. The housing sector would remain stuck in a soft patch. After falling by 1.5% and 2.0%, respectively, in 2018 and 2019, residential investment would witness barely a bounce of just 0.6% in 2020.

At 1.1%, U.S. real GDP growth in 2020 would fall well below the longer-run potential growth of the economy following 2.2% estimated growth in 2019 (versus 2.3% in the baseline) and 2.9% in 2018. With fiscal impulse turning negative in this scenario, private-sector activity would not be enough to avoid two consecutive quarters of near-0% quarterly growth rates in 2020.

In an environment of sharply weakening growth in domestic demand and the output gap falling into negative territory, the Fed would cut its policy rate another 25 bps at the end of 2019, 100 bps in 2020, and another 50 bps in 2021. That would help, albeit slowly, to start a recovery process in closing the output gap.

Table 3

Table 4

Writer: Joe Maguire