A report this week from the National League of Cities caught my attention. In it, 63% of finance officers from major U.S. cities predicted a recession as soon as 2020.1 A perfect storm of falling city revenues, rising expenditures, softening business investment, and a housing market that feels like it’s plateauing. The question is – could this be a basis for a recession on the horizon?
The report, known as City Fiscal Conditions Report,1 looks at responses from finance officers in 554 cities with populations over 10,000, so I’d characterize it as offering a comprehensive view into economic conditions throughout America. For the data wonks out there, the Fed’s Beige Book is another example of a report that offers a glimpse into how cities and regions are performing, and I’d consider it equally insightful in helping us understand economic conditions ‘on the ground.’
The findings in the City Fiscal Conditions Report for 20191 undoubtedly show softening across the board. A summary of the findings includes:
- In fiscal year 2018, total constant-dollar general fund revenue growth slowed to 0.6%.
- Property tax revenues increased by +1.8%, compared to +2.6% growth in 2017.
- Sales tax revenues grew by +1.9%, compared to +1.8% in 2017.
- Income tax revenues rose +0.6%, compared to +1.3% in 2017.
- Expenditures are rising: +1.8% in 2018, which is slower growth than previous years but less than what’s expected in 2019.
Cities do fiscal reporting on a yearly basis, meaning that there’s about an 18 to 24-month lag for economic shifts to show up on city ledgers. In other words, the softening trend could be a signal of a slowdown that is already well underway, which is what I think has finance officers worried.
A report on U.S. cities’ fiscal conditions can help us take the pulse of the U.S. economy, but it does not help us forecast corporate earnings looking out over the next six to twelve months. In terms of portfolio management, it is not enough to determine what is happening from an economic standpoint – we need to determine what the market expects to happen and whether those expectations are being met.
The City Fiscal Conditions Report gives an indication the economy is slowing, but this simply confirms something we already know. I would argue that it’s already being reflected in the market, too, with downward revisions to earnings estimates of cyclical companies over the past few months. Given the negative expectations around corporate earnings coming into the third quarter, what we’re seeing today are earnings surprising to the upside – which is helping push the market to new highs.
But there’s another side to the story that few people are telling: year-over-year growth is slowing, but it is not yet contracting. Looking at the figures above from the City Fiscal Conditions Report, it is clear to see that revenues are still growing, even if they’re growing at a slower rate than previous years. In the previous recession, revenues were declining for almost two years before the recession took hold. I think we need more data before making any recession declarations.
As I’ve mentioned in previous columns, I also believe some of the softer economic data we’re seeing across the board – but particularly in business spending – is tied to policy uncertainty (particularly in the realm of trade). If some of the pressure gets released over time with movement towards a deal, or perhaps even the eventual signing of a deal, I could see most of these trends reversing.
Bottom Line for Investors
Amid stories and data points of weakening economic growth, I believe it’s important to remember that the market is a discounting mechanism of future earnings expectations. Only two factors drive stock prices, in my view: expectations for future earnings and interest rates. Expectations for future interest rates are essentially determined by the yield curve, so the key issue is how earnings expectations change in response to changing economic expectations. In my view, it’s times when the economic outlook is completely positive – and stocks are discounting strong earnings growth – that the market is more likely to come under pressure. When the economic outlook turns more negative and stocks discount weak earnings growth (like we’re seeing today), surprises to the upside can drive prices higher. This is why I’d argue the market is hitting new highs at the same time economic signals, like the fiscal condition of U.S. cities, are showing weakness.