The skies of the U.S. economy are clear and sunny, but many analysts see storm clouds on the horizon.
By many measures, the economy is in its best shape since the Great Recession of 2007 to 2009. Unemployment hit an 18-year low of 3.8% in May. Average wage growth is widely expected to reach 3% by the end of the year. And the economy is projected to grow nearly 3% in 2018 for just the second time since the downturn.
Yet the economic expansion is the second-longest in U.S. history, leading many economists to forecast a recession as early as next year. Half the economists surveyed last month by the National Association of Business Economics foresee a recession starting in late 2019 or in early 2020, and two-thirds are predicting a slump by the end of 2020.
Precisely because things seem to be going so well.
The late stage of an economic expansion is most vulnerable to a popping of the bubble. It's typically when unemployment falls, inflation heats up, the Federal Reserve raises interest rates to cool the economy down - often going too far - and investors and consumers pull back.
"It's just the time when it feels like all is going fabulously that we make mistakes, we overreact, we overborrow,' says Mark Zandi, chief economist of Moody's Analytics.
But some other ingredient typically is needed to tip an economy into recession, Zandi says. In 1990-91, it was an oil price shock. In 2001, it was the bursting of the dotcom bubble and resulting stock market decline. In 2007, it was the housing crash.
"A recession fundamentally is an outbreak of pessimism' that causes consumers and businesses to rein in spending, economist Jesse Edgerton of JPMorgan Chase says.
Here is the baseline scenario that could push the nation into a recession in the next couple of years:
This is the most likely road to recession. Falling unemployment and rising wages are a good thing, but eventually higher pay forces companies to raise prices more sharply. The Fed's preferred measure of annual core inflation, now at 1.8%, could drift past its 2% target for a sustained period.
That could prompt the Fed to raise rates faster - perhaps four hikes in both 2018 and 2019 instead of the three now forecast. Higher rates and inflation fears push up other borrowing costs for consumers and businesses, including mortgage rates, curtailing home sales as well as household spending and business investment broadly.
Federal tax cuts and spending increases may further swell the national deficit and push up rates.
Low- to middle-income Americans could feel the pain even more acutely. Credit-card delinquencies made up 2.54% of outstanding debt the first quarter, up from a low of 1.96% in 2015, according to UBS. Higher borrowing costs would increase the burden.
The added ingredient that could spark recession in this scenario is high asset prices, Zandi says. Prices of Standard & Poor's 500 stocks are 19.6 times profits during the past four quarters. That's above the 50-year average of 15.7 but well below the bubble peak of 28.9 in 1999, according to Thomson Reuters.
Yet rising labor costs could eat into company profits and hurt earnings, making stocks seem even more overvalued. As confidence ebbs, investors could flee stocks and other assets, such as commercial real estate, for risk-free bonds that would provide higher-than-current rates. A steep market decline would reduce consumer wealth and further dent household and business confidence and spending.
Other triggers that could spark a recession:
President Trump has slapped 25% tariffs on steel and 10% on aluminum to combat what the administration has called the dumping of low-priced metals from other countries in the U.S. below market prices. That's expected to raise prices for consumers and businesses and draw retaliation from other nations against U.S. exports. Even so, the impact on the economy likely will be negligible, economist Kathy Bostjancic of Oxford Economics says.
The bigger risk is the $150 billion in tariffs Trump has threatened on Chinese imports and the potential retaliation from China. Trump also has hinted at tariffs on auto imports and threatened not to renew the NAFTA trade pact with Canada and Mexico. Those steps could raise consumer prices and crimp U.S. exports, curbing growth by more than a percentage point next year, Bostjancic says. .Of course, it's highly unlikely all of these threats would be carried through, she says. Administration officials have suggested they're merely negotiating ploys. Yet even an escalation in the standoffs that raises investor fears could help set off a downturn, Edgerton says.
Oil price spikes have contributed to every recession since World War II by sapping consumer purchasing power, according to Moody's. U.S. benchmark crude oil prices of about $65 a barrel are up from a low of about $26 in early 2016 and $59 early this year but well below the $112 reached in 2014. And average gasoline prices are just under $3 a gallon compared with more than $4 four years ago.
Yet if conflicts intensify between Iran and Saudi Arabia, threatening the latter's 10 million barrels a day in output, that could drive oil and gas prices higher, Zandi says.
Perhaps an even more likely cause is a new regulation from the International Maritime Organization that will cap the sulfur content of fuel oil used by ships starting in 2020, says Tom Kloza, global energy analyst for the Oil Price Information Service. Some analysts believe the mandate will increase costs and bring back $4 gasoline.
Early this year, Congress raised budget spending caps by about $300 billion, with most of that devoted to higher defense spending, but that deal expires in late 2019. And the nation's debt limit must be raised in early 2019. Both issues set up dramatic showdowns in Congress, especially if the midterm elections this year result in a more even split between Democrats and Republicans.
Economist Diane Swonk of DS Economics believes the standoffs could help nudge the U.S. into recession. Remember - Congress' failure to raise the debt limit early enough in 2011 prompted Standard & Poor's to lower the nation's credit rating, hammering stocks and consumer and business confidence.
The new populist government in Italy has vowed to reverse the country's austerity measures and give citizens a minimum income. Such measures could revive the country's debt crisis, Zandi says. They also could pose threats to European banks that hold the debt and spell new risks to the European economy, hurting global stocks and U.S. exports.
Joe LaVorgna, chief economist of Natixis, believes the chances of all these scenarios are low. And with a more global economy and e-commerce holding down inflation long-term, he thinks the Fed will raise rates more slowly than many anticipate. He's not expecting a recession over the next few years.
"It's not ordained that it has to happen,' he says.
Contributing: Adam Shell
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