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The economy of 2018 was both wacky and predictable

Given the wackiness od 2018, making a 2019 prediction would seem like a fool’s game, but despite this year’s volatility, the economy performed largely as expected. It’s just that it did it in a very odd way.

With declining savings rates, consumer spending won't be able to be sustained in 2019 at the same level as this year.
With declining savings rates, consumer spending won't be able to be sustained in 2019 at the same level as this year.Read moreJohn Minchillo / AP

The end of a tumultuous year is in sight. We had markets surging and crashing, the strongest growth since 2014, and the start of a trade war. Have I missed anything? Yes, political chaos that overlaid the economy.

In light of all that, is it possible to provide an economic outlook for the next year? Of course it is, but with great trepidation.

First, let’s review the 2018 economy. It started out moderately but soared in the spring. Growth hit 4.2 percent, the highest pace since it averaged 5 percent in mid-2014. The unemployment rate dropped to its lowest level in nearly 50 years.

But the economy could not sustain this excessively high level of growth, and activity moderated in the summer and fall.

The driving forces behind the pullback are readily identifiable.

Despite strong job growth and historically high levels of job openings, wage gains remain disappointing. Spending power is not growing rapidly enough to support the level of consumption needed to sustain strong growth.

In addition, the hoped-for surge in business investment never materialized. While corporate taxes were cut sharply, management didn’t plow the money back into their companies. Instead, stock buybacks exploded to the tune of nearly $1 trillion and dividends were increased.

And then there was the battle of the titans. The president declared economic war on China and tariffs were implemented by both nations. The trade deficit, which had been narrowing, started widening again.

As for the equity markets, they went on some of the wildest rides ever seen. The major indexes soared in January, tanked in February, bounced around like crazy in the spring, went on an extended rally during the summer, and gave it all back in the fall. Amazing.

Given this wackiness, making a prediction would seem like a fool’s game — which some think is an apt term for any economic forecast. But it isn’t. Despite this year’s volatility, the economy performed largely as expected. It’s just that it did it in a very odd way.

The 2019 outlook requires one major assumption: The trade battles don’t become a full-blown trade war. If that happens, all bets are off. Both China and the U.S. would be harmed significantly and world growth would falter. A recession would become likely in either 2019 or 2020.

Instead, assume some face-saving agreement will be made. It may be more puff than pastry, but it will get us through the year.

Put simply, growth is likely to continue softening all through 2019.

Expect consumption to fade as we move through the year. Consumer spending has been driven by rising incomes. But inflation is accelerating and the average household will not likely experience a significant increase in spending power.

A declining savings rate adds to the concern about consumption. The typical family is saving little and may not be able to sustain the current spending increases much longer.

Expect investment to fade next year even though capital spending didn’t surge this year. If after receiving massive tax cuts in 2018, management failed to employ the capital to improve productivity, why should anyone believe they would up investing heavily in 2019?

It is hard to see how government expenditures will expand as rapidly as they did this year. The spending binge is unsustainable. The budget deficit could hit $1 trillion, a level that would, and should, raise alarm bells.

Expect the trade deficit to widen, which would also slow growth. Trade relations have been changed permanently. Undoubtedly, both the U.S. and China will start altering supply chains and markets where they sell their goods. Some sectors could be hurt greatly, either immediately or in the long term.

Though the economy will soften, growth should still be decent. But there is a warning: As we move through the year, economic momentum could be lost. While no recession is expected in 2019, it cannot be ruled out for 2020.

Given the economic forecast, what should happen to interest rates?

The Federal Reserve has been slowly but steadily moving rates up toward normal levels. This is needed to give it the capacity to lower rates to fight a future slowdown.

Even if we get another three increases next year, short-term rates would still be near normal levels. The Fed would not be jamming on the brakes.

In summary, expect moderate growth in 2019 with the economy slowing steadily through the year. Interest rates should rise but not become so high they short-circuit growth. That economy may not make everyone happy, but it may be the best we can get.