Moving beyond the inflation shock

Key takeaways

• As tighter financial conditions start to bite in the second half, consumer resilience should falter
• We see recession risks in late 2023 and early 2024, with rate cuts a story for 2024
• Markets have largely brushed off still-high inflation, slowing growth, banking sector and geopolitical risks, focusing instead on a potential monetary policy pivot and a technology sector seemingly unaffected by credit tightening
• We see attractive risk-reward in high grade fixed income, and prefer equity markets outside the US as earnings downgrades unfold.

A mild, short-lived US recession?

With price pressures gradually easing across the developed world, macroeconomic risks have shifted from inflation to growth. The latter looks very uneven. In the US, rate-sensitive areas: housing, investment, manufacturing, and trade are slowing or contracting, while services have been more robust. Fiscal policy will be tight this year or next – considering the modest adjustments factored in the bi-partisan deal to raise the debt ceiling.

Credit conditions are at levels consistent with prior recessions, amid banking sector woes and the most aggressive interest rate hiking cycle in 40 years. Yet so far, the US consumer has proved surprisingly resilient, delaying expectations of when a recession will start, if at all. Unlike their eurozone and Japanese peers, Americans have been spending some of the excess savings they accumulated during the pandemic, which has acted as a shock absorber. Labour income remains solid amid low unemployment and months of strong wage growth. Key factors to watch in the second half include labour market developments, and how tighter lending standards at small banks affect small businesses and their employees, challenging consumer resilience. Historically, such effects have been felt around two quarters later, indicating the impact should fall largely in Q4. Recession risks for late 2023/early 2024 remain high. However, we would expect any recession to be mild and short-lived, and for the US economy to register 0.9% growth for the full year.

Banking problems looks contained

We do not think the US is in the early stages of a significant financial crisis. Bank credit has not been a major source of financing for either consumer or business spending since the 2007-2009 crisis, another factor behind the current resilience of demand. Americans today have borrowed remarkably little relative to their income, and only some of that from banks. Loan growth is slower than in the 2000s and much slower than the 14% annualised growth seen as recently as mid-2022. Relatively low reliance on debt makes current US banking turmoil fundamentally different from previous credit cycles, including the late 1980s/early 1990s and 2000s, when bank failures were harbingers and amplifiers of severe economic downturns and slow recoveries.

Rate cuts a story for Q1 2024

Slowing developed market growth is helping inflation to fall. Demand for goods and supply chain disruptions have eased. Energy prices have fallen. Services inflation is starting to decline. In the US, we expect housing costs to follow suit in the coming months, leading consumer price inflation down to around 3.0% by year-end. Wage growth has been declining slowly but steadily, yet the disinflationary trend is still too slow for the Federal Reserve (Fed) to pivot towards cutting rates before early 2024.

In Europe, the banking sector looks generally more insulated from stresses, and wages have risen less sharply. Trends here have been following those in the US with a lag. Core inflation – stripping out food and energy costs – has only recently started to decline. We believe the European Central Bank (ECB) is very close to the peak of its hiking cycle, with rate cuts also likely in the first quarter (Q1) of 2024, following full-year 2023 growth of 0.7%. We do not see rate cuts in either the US or eurozone giving the global economy any significant support before the second half of 2024.

Consumption to underpin Chinese growth

The Chinese economy is on a different trajectory to most in the West, largely because of its later post-pandemic reopening. Fragilities remain in real estate – with a knock-on effect on consumer confidence – and in manufacturing, as global demand slows. Yet while the sustainability of its Q1 recovery has been questioned, we see consumption remaining a key growth anchor in Q2 and beyond. Inflation remains contained, and authorities may also choose to support the economy further in the second half, e.g. via more regulatory easing or cuts to banks’ reserve requirement ratios. For now, we retain our full-year growth forecast of 5.5%.

Asset allocation – false positive, or fresh dawn?

Could central banks cut rates and support markets as the economic outlook darkens? We think this is unlikely without a rapid fall in inflation. We expect the Fed and ECB to pause yet keep policy rates tight in 2023. Rapid cuts could follow under a more severe recession scenario than we expect, or one that sees further banking stress; neither of which would be obviously positive for risk assets. In other words, disinflationary efforts will succeed, but at the cost of inflicting pain on the economy. How much remains to be seen.