Untangling the US growth debate

The US economy continues to defy the odds, as a recession predicted for over 18 months remains elusive. Why is growth not falling in the wake of aggressive interest rate hikes – is the slowdown delayed, or not coming at all? Could ongoing monetary policy tightening now cause a severe downturn? We still see a mild recession as the most likely outcome.

The case for a soft landing for the US economy – where inflation falls without an accompanying recession – has risen in recent months. The Citigroup economic surprises index, which tracks the difference between official data releases and forecasts, shows data are beating forecasts by the biggest margin in two years. This is being driven by consumption, long the principal source of US economic growth. Spending is very strong on services such as travel and eating out, helped by pent-up pandemic demand and savings, low unemployment, and rising incomes. Despite steep monetary tightening, the labour market is only rebalancing gradually. The jobless rate fell to 3.6% in June, while hourly wages rose 4.4%. Meanwhile, durable goods orders, new home sales and construction all rose unexpectedly in May. House prices in some US markets have hit new highs. Competition with China is driving new investment in computer chips and microprocessors. Minutes from the Federal Reserve’s June rate-setting meeting showed the bank’s economists still expect a mild recession later this year, but they concede a scenario where recession is avoided is “almost as likely.”

Chronicle of a recession foretold

Many indicators do point to a recession ahead, even if it keeps getting delayed. The most famous of these is a deeply inverted US yield curve, where interest rates on three-month Treasury bills have been above those for 10-year bonds since October 2022. When this has happened in the past, a recession has followed within two years: five times in the last 40 years, with no false positive readings. High short-term rates are the result of the most aggressive Fed rate-hiking cycle in decades. The slowdown may be late, but the lagged effects of this tightening could see weakness in Q3 and Q4. Trade data and surveys of US company managers already show an economy growing below trend. Such surveys have shown manufacturing contracting since September 2022, and services now slowing too. A new metric published by the Fed shows financial conditions at their tightest since the global financial crisis, which it estimates will shave 0.75% off growth over a year.

Why have rate hikes not had a big impact on growth yet? One reason is the ongoing recovery from pandemic shocks: labour shortages, particularly in services sectors that laid off staff during Covid, are keeping wages and employment high. In any case, service-heavy economies with less need to borrow money for expensive machinery feel less impact from rate hikes. Pandemic-era savings are providing a temporary buffer from higher interest rates. The share of US floating rate mortgages is very low, meaning rate hikes are taking longer to feed through to households.

Renowned economists Larry Summers and Olivier Blanchard have also questioned whether the Fed’s estimated ‘neutral’ rate of interest, that neither drives nor restricts growth, may be higher post-pandemic, after massive stimulus and government debt issuance. This would mean monetary policy is still not that tight. Real interest rates, after inflation, are in any case several percentage points below the Fed’s benchmark 5.00-5.25% rate.

Immaculate disinflation?

While a debate rages on recession and growth prospects, greater clarity has emerged on the inflation front. This is slowing convincingly, despite the absence of a major dip in growth. Consumer price inflation (CPI) fell to 3.0% in June, and the measure excluding food and energy to 4.8%, both slightly below analyst expectations. We expect a further fall in coming months, led by lower housing costs. The labour market is also slowly coming into better balance. Job creation is slowing, the ‘quit’ rate is normalising, average weekly hours worked are falling – a first response to weakening economic conditions – and the number of people forced from full-time into part-time work is creeping up. We still expect a further 25 basis point (bps) Fed rate hike in July. There is also the risk of another 25 bps in September, although this is not our base case. The conditions are then in place for an extended Fed pause on rates, lest investor exuberance undo some of its tightening to date. We expect more tough talk on inflation from Fed officials – perhaps at the annual central bankers’ symposium at Jackson Hole, Wyoming in August – and rates on hold until early 2024.

Ultimately, it is the persistence of restrictive financial conditions that will matter most for the economy. At its heart, the debate on US growth is one over the relative strength of opposing forces, which also helps explain the divergence between manufacturing and services. Excess consumer savings, tight labour markets, and – at the margin – new public investment in a race with China are all acting to support growth. In contrast, tightening credit conditions, which have never been at their current level without inducing recession, are slowly squeezing economic expansion. Our view is that at some point in the coming months, credit tightening will gain the upper hand, progressively eroding consumer spending and corporate profits, and leading to a mild recession in late 2023 and early 2024.

A neutral stance on risk

How does this tug of war between inflation and growth translate into the way we invest client portfolios? The main headwind to risk assets earlier in the year – high inflation – has eased, supporting risk sentiment, and giving us less reason to be underinvested. Yet the price to pay has been more uncertainty on growth, which prevents us from adding too much risk at this stage. A growth overshoot could reignite interest rate volatility, and on the downside, recession concerns. It is still unclear how this economic slowdown will evolve. We remain nimble in our tactical asset allocation, and while compensation in safer assets remains attractive, we retain a neutral approach to both risk and equities.

As inflation falls and interest rates approach their peak, we lean towards high grade fixed income, including US Treasuries and European investment grade credit, both for capital preservation purposes and the attractive yields they offer. Within equity allocations, we prefer non-US markets with better growth prospects and a margin of safety offered by lower valuations. We also seek companies that are better able to pass on higher costs and weather weaker demand, including those in the consumer staples and healthcare sectors.

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