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The economic expansion is poised to be the longest ever. Will it die or get a second wind?

Paul Davidson

The decade-long economic expansion, poised to become the longest in U.S. history next month, is facing an existential question: Will it sputter to a halt by next year or keep on chugging at the same modest pace that got it this far?

Nothing about this halting recovery from the Great Recession of 2007-09 has been normal, and that makes forecasting its demise especially tricky.

On the one hand, the expansion is displaying some telltale signs of old age, such as the 3.6% unemployment rate, a 50-year low; the beginnings of a slowdown in business profit growth; and a mounting debt problem – this time inside corporations. There’s also the wild card of an escalating trade war with China.

At the same time, inflation is muted, interest rates are still relatively low and household balance sheets are healthy – hardly conditions that traditionally have triggered a spiral downward.

Put simply, this economy’s mantra has been slow and steady. It never really took off like prior rebounds until recently – to the frustration of many economists and American workers. But that means it didn’t develop the kind of excesses that have doomed past recoveries, possibly giving it a longer lifespan.

“We’ve been jogging,” not sprinting, says Mark Zandi, chief economist of Moody’s Analytics.

Economists, in turn, are divided about whether a recession is looming, generally viewing the question as a tossup.

Those surveyed this month by Wolters Kluwer's Blue Chip Economic Indicators put the odds of a downturn in 2020 at 38%, according to their average forecast. Economists polled by the National Association of Business Economics in May foresee a 60% chance of recession by the end of next year.

“I think the economy is on a razor’s edge,” Zandi says. “It can go either way.”

Jacob Oubina, senior economist at RBC Capital Markets, is more sanguine. “There’s a very, very, very low recession risk,” he says.

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Here’s a breakdown on where the economy could head next:

More room to run:

Low inflation and interest rates: The seeds for most recessions are planted as economic growth strengthens, causing inflation to heat up. That, in turn, prompts the Federal Reserve to raise short-term interest rates to temper consumer price increases. Typically, the Fed lifts its key rate too aggressively, curtailing borrowing and economic activity, hurting the stock market and spurring the next recession.

Last year, the economy grew a relatively brisk 2.9%, picking up from its tepid 2.2% average pace through most of the expansion, largely because of federal tax cuts and spending increases spearheaded by President Donald Trump. Responding to the acceleration and an unemployment rate that has steadily fallen since 2009, the Fed has raised rates nine times since late 2015, including four times last year.

But the Fed’s preferred measure of inflation, which excludes volatile food and energy costs, is at 1.6%, well below its 2% target. Many economists cite long-term factors such as discounted online shopping and globalization.

With inflation subdued and global risks rising, the Fed did an about-face late last year and forecast no rate increases this year. Now, markets are pricing in as many as two rate cuts in 2019, even though the Fed’s benchmark rate remains historically low at a range of 2.25% to 2.5%.

“Overall, the inflation environment remains benign,” Wells Fargo senior economist Sarah House said in a note to clients. 

Modest household debt, high savings: The 2007-09 recession was fueled by a massive buildup in household debt, particularly mortgages but also credit card and auto loans. Yet the downturn prompted Americans to cut back sharply and pay down those obligations. Although debt has rebounded in recent years, household liabilities as a share of net worth are at the lowest level since 1985, according to RBC.

Similarly, Americans have saved a relatively large share of their disposable income since the recession, socking away 6.2% in April, compared with a range of 2.7% to about 4% in the mid-2000s.

“People are more careful,” Oubina says. That leaves workers better positioned to keep spending and withstand temporary layoffs or other economic shocks.

No major bubbles: The last two recessions largely grew out of bubbles. Stocks of Internet companies skyrocketed in the 1990s before tumbling in 2000 and curbing technology investment. And the run-up in home prices in the mid-2000’s triggered a crash when subprime mortgage borrowers could no longer make their payments, leaving banks with hundreds of billions of dollars of bad loans on their books.

There are no similar examples of sharply overvalued assets in the economy today, though a build-up in corporate debt (see below) is raising some concerns.

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Productivity growth: Productivity, or output per worker, has finally picked up from an anemic pace through most of the recovery, rising an annualized 3.4% the first quarter. Strong productivity growth allows companies to raise wages without passing along the higher labor costs through higher prices, or enduring a big drop in profits. Oubina credits company investments in labor-saving technology.

But Zandi believes the gains represent just a temporary boost from the tax and spending stimulus, which lifted economic output without a similarly large increase in workers.

Jobs: Job growth has slowed from an average monthly pace of 223,000 in 2018 to 164,000 so far this year. That’s a notable downdraft, but it was largely expected as the effects of the federal stimulus fade and low unemployment makes it harder for businesses to find workers. And the pace of payroll gains remains well above the 85,000 or so needed to keep lowering the unemployment rate, Oubina says.

A rise in layoffs and unemployment is invariably a forerunner to every recession, Zandi says.

There are also indications of a potential downturn on the horizon:

Recession worries:

Very low unemployment: Historically low joblessness typically forces businesses to bid up to attract workers. The stronger wage growth is passed to shoppers through prices, spurring faster Fed rate hikes.

While average wage growth has topped 3% since mid-2018, the gains haven’t yet translated into higher retail prices for reasons already cited. Zandi, however, believes that’s likely coming as pay increases gather steam.

The dreaded yield curve inversion: For several weeks, the yield on Treasurys maturing in three months – about 2.2% – has topped the 2.1% rate on Treasurys maturing in 10 years. That’s highly unusual – typically an investor gets a higher rate for locking up cash for a decade. Inversions mean investors don’t have much confidence the economy and inflation will pick up over the longer term.

Such episodes invariably are followed by recessions within an average of two years, according to Oxford Economics. The belief the economy is slowing “can be a self-fulfilling prophecy,” says Joseph LaVorgna, chief economist of the Americas at Natixis, a research firm.

Also, he says, banks make money by borrowing from depositors at lower short-term rates and lending that cash at higher long-term rates to consumers and businesses. A reversal of that equation could squeeze banks’ margins and lead them to pull back on loans, hurting economic activity.

Trade war: Trump has slapped a 25% tariff on $250 billion imports from China, and China has retaliated with tariffs on U.S. exports to that country. Zandi estimates the fight will cut economic growth by about two-tenths of a percentage point both in 2019 and 2020 to 2.4% at 1.7%, respectively.

In other words, it will ding growth, but it’s no expansion-killer.

But if Trump follows through with threats to impose tariffs on the remaining $300 billion in Chinese imports, that will squash business confidence, roil the stock market, cut employment by 3.1 million by 2021 and likely set off a recession, Zandi says.

Corporate debt bubble? It’s no housing bubble, but the financial system has been creating froth of a different kind. Banks and private equity funds have been making loans to companies with less than stellar ratings, bundling them into securities and selling them to hedge funds, insurance companies and other players. Such “speculative grade” corporate debt now totals a record $4.8 trillion, according to UBS.

If corporate earnings slow as the economy wobbles, the companies that borrowed the money could default, causing funding for the firms to dry up. LaVorgna says that likely wouldn’t cause a recession but could make one worse.

But Matthew Mish, head of global credit strategy for UBS, says, “This could snowball and feed on itself” as banks scale back lending.

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Narrowing corporate profit margins: Another way stronger wage growth can hurt the economy is by narrowing business profit margins. That can cause companies to reduce hiring and investment and even lay off workers, Morgan Stanley says.

In the first quarter, margins for Standard & Poor’s 500 companies dropped to 11% from 11.2% late last year, according to FactSet. That’s still high but it’s the lowest level since late 2017. LaVorgna wonders if it's the start of a further margin squeeze.

This article originally appeared on USA TODAY: The economic expansion is poised to be the longest ever. Will it die or get a second wind?