Recession in the US seems increasingly remote

EVEN after enduring one of the most aggressive rate-hike campaigns by the Federal Reserve, the US economy continues to show resilience, raising hopes of a soft landing. With just three months left in the year, economic data has held up surprisingly well and the possibility of a US recession this year is starting to seem remote.

Data released by the Bureau of Economic Analysis indicated that real gross domestic product (GDP) increased at an annual rate of 2.1 per cent in the second quarter of 2023, following the first quarter’s expansion of 2 per cent. The gain was largely driven by strong consumer spending and business investment.

In July, consumer spending rose further to 0.8 per cent month on month, ahead of the median consensus forecast of a 0.7 per cent gain. Adjusted for inflation, consumer spending rose 0.6 per cent in July – the largest gain since January. This is not too shabby for an economy that is supposed to enter a recession.

Accounting for more than two-thirds of GDP growth, private consumption has significant bearing on the health of the US economy. If consumer spending were to stay strong, the US should stand a decent chance of avoiding a recession.

Many factors affect consumption, but in general consumers tend to spend more when they feel confident about their finances, job prospects and the economy. At present, the strength of the US consumer is underpinned by a robust labour market, which has been red-hot despite the Fed’s best efforts to cool it down. While the labour market has shown some signs of loosening lately – with a jump in the unemployment rate and slowing wage growth – it remains tight relative to pre-pandemic levels.

Aside from wages which have been rising since the end of Covid, another important component of consumer finances is the amount of debt. As at Q2 2023, total household debt stood at approximately US$17 trillion, of which roughly 72 per cent comprised mortgage loans. The remainder comprises other types of debt, such as credit card, car loans and student loans.

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Even though conventional wisdom suggests that rising interest rates tend to increase debt servicing costs, the reality is not exactly what one would expect. In fact, rate hikes have resulted in a modest impact on households’ ability to pay their mortgage loans, with the ratio of mortgage debt service payments to disposable personal income rising marginally from 3.88 per cent in Q4 2021 to just shy of 4 per cent in Q2 2023, data from the Fed indicated.

This is because the US housing market is very different compared to the rest of the world.

Unlike most countries where mortgages are based on variable rates or an initial fixed rate, homebuyers in the US predominantly obtain fixed-rate mortgages. The most common is the 30-year fixed-rate mortgage, which is estimated to account for more than 70 per cent of all mortgages in the US.

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Many homeowners have also taken advantage of the rock-bottom mortgage rates during the pandemic to lock in their loans. According to data compiled by Redfin, 82 per cent of US homeowners have an interest rate of less than 5 per cent, against the current rate of 7.2 per cent for a 30-year mortgage. It is not hard to see why US consumers are less affected by rate hikes than their counterparts in other countries.

Apart from being better insulated against the negative impact of rate hikes, consumer balance sheets are still in a much better position compared to pre-pandemic levels, largely due to the generous amounts of pandemic stimulus; legislation such as the Inflation Reduction Act; more than a decade of low interest rates; and high savings accumulated during the pandemic. These factors suggest it would require a significantly larger deterioration in consumer finances to result in a marked slowdown in consumption.

Business investment, often the second-largest contributor to GDP growth, is likely to be resilient as well. Just like consumers, many companies also took advantage of the pandemic to refinance their debt at lower rates and for longer durations – resulting in less refinancing needs in the near term.

Most existing corporate debt is slated to mature after 2025, allaying fears that US corporates may get crushed by the growing debt maturity wall. The majority of corporate debt in the US also carries an investment-grade rating, which means that the increase in interest expense should not be significant even as rates rise.

While the recent data does show that the US economy may be doing better than expected, it is not out of the woods yet. Lately, the rally in oil prices has caused US inflation to accelerate for two consecutive months – something the Fed is paying close attention to.

The resumption of student loan payments (which were suspended since March 2020) is also expected to be a drag on consumer spending and, by extension, economic growth. And lastly at 5.5 per cent, interest rates are definitely in restrictive territory, which will continue to put pressure on economic activity.

Still, whether or not a recession is declared, US economic growth is likely to be modest in the months ahead. Investors should bear this in mind as they position their portfolios. In terms of asset class, we continue to favour fixed income over equities, particularly shorter duration bonds. Short-term bond yields have moved significantly higher compared to long-term yields, allowing investors to receive higher returns without having to take on greater duration risk.

As for equities, investors should focus on quality stocks, with attributes such as strong balance sheets, stable earnings and cash flows. Those with a longer-term investment horizon may consider sectors that are supported by long-term megatrends, such as the shift towards renewables and the rise of artificial intelligence.

The writer is a portfolio manager of the research and portfolio management team at FSMOne.com, the B2C division of iFAST Financial Pte Ltd. The latter is the Singapore subsidiary of SGX-listed iFAST Corporation Ltd.