US recession nowhere in sight, but inflation may prove more stubborn
A more pronounced decline in inflation is needed to coincide with the full rate-cutting cycle priced in markets
AS FEBRUARY draws to a close, we now see that the US economy not only skirted the much anticipated (including by this author) recession in 2023, but also saw second-half GDP growth accelerating relative to a moderately growing first half.
With the US economy on an apparently firmer trajectory, this begs the question – what happened to the most widely anticipated recession in history?
Even astute observers of the US economy are rightly confused, as many recessionary signs emerged in 2023. The industrial sector saw output drop by nearly 1 per cent year on year in autumn 2023, in response to contracting industrial sales earlier in the year. Historically, contraction in both measures has coincided with US recessions.
Similarly, US residential housing construction contracted throughout 2023. Housing starts troughed at minus 25 per cent year on year in the second quarter, as new mortgage applications from would-be homebuyers collapsed nearly 60 per cent below their year-ago levels during the year.
Atypical behaviour
In typical recessions, retrenchment in the industrial and residential housing construction sectors leads to layoffs, as companies move to preserve profitability. In past cycles, this ultimately resulted in consumers cutting back on their own spending, pushing households into a recessionary cycle as well.
However, in 2023, instead of contracting, construction employment grew 3 per cent year on year, a pace robust enough to mimic the levels seen following the 2008 global financial crisis, and just below the 4 to 5 per cent seen following the 1994 US economic soft landing.
Here, US fiscal support in the form of the US Infrastructure Act and the Inflation Reduction Act helped preserve jobs. These programmes, which formed new US industrial policy, helped to more than double non-housing, industrial and manufacturing sector construction from its US$80 billion annual pace from 2015 to 2021, to nearly US$200 billion in 2023.
As a result, aggregate construction activity – housing and industrial – showed year-on-year growth in each month of 2023, and avoided the job losses that have characterised every US recession since 1970.
Despite this fiscal support that encouraged corporates to spend on upgrading and building new facilities, the manufacturing sector still faced a difficult choice. With profits declining in early 2023, corporate America historically has turned to layoffs to shore up corporate profitability in response.
However, employment in the manufacturing sector nevertheless held steady since late 2022, despite declining profit growth in early 2023 and the struggle to hire qualified workers in 2021 and 2022.
Effectively, manufacturers chose to maintain their workforce at the expense of profitability, perhaps reflecting their hope for medium-term recovery prospects. Indeed, the industrial construction activity outlined earlier suggests optimism about future demand, just over the horizon.
Thus, while many took the early signs of slowdown in the American housing market and the turn in profit growth among US corporates as precursors to an expected employment contraction, multi-year stimulus from the US government – combined with the reticence of companies to lay off workers – put a firewall around US households and consumers, resulting in the oft-cited resilience of the American consumer.
On the horizon
Looking ahead, Patrice Gautry, UBP’s global chief economist, expects the US economy to slow further in 2024, like in 2023. But he also expects the US to once again avoid a recession.
Indeed, as corporate profits among S&P 500 companies reflect nearly 9 per cent growth, and nine of 11 sectors beat expectations based on fourth-quarter results, pressure to retrench may in fact ease this year.
Profitability of the American industrial sector is firming up. The Institute of Supply Management suggests that new orders are expanding once again in 2024 for the first time since the onset of the Russia-Ukraine war in 2022. This relieves some of the conflict corporates experienced in 2023 – they no longer have to choose between profitability and retaining staff.
Similarly, US mortgage rates peaked at 8 per cent in late 2023, and fell to below 7 per cent earlier this year. US residential mortgage loan growth has accelerated to a 4 per cent quarter-on-quarter annualised pace, suggesting slow but stable activity in the sector. This should once again be complemented by the multi-year spending programmes – the US Infrastructure, Chips, and Inflation Reduction Acts would continue to underpin the construction segment.
Undoubtedly, the American consumer may step back from the resilience of the previous year. However, unlike in 2023, we expect the firming industrial and construction sectors, combined with election-year government spending, to support growth for the overall economy in 2024.
With employment expected to remain firm and household debt service burden sitting near its lowest level since 1980, a meaningful retrenchment of consumer activity should be avoidable. Admittedly, credit card and student loan debt burdens are rising among American households. However, even here, we expect the debt burden to return to its 40-year average, limiting the prospect of imminent stress.
Indeed, recent strong economic data has rightly repriced the prospect of Fed rate cuts, pushing consensus expectations into the summer months when we expect the central bank to begin a rate-cutting cycle for the first time post-pandemic.
However, with inflation tracking at 3 per cent annually, similar to the average levels in the 1990s, the Fed funds rate of the period of 5 to 6 per cent suggests that a more pronounced decline in inflation is needed to coincide with the full rate-cutting cycle priced in markets.
For bond investors, this suggests a shift from a focus on the prospect of a further decline in yields towards enhanced income from moderate-duration corporate bonds, which offer the most attractive risk-reward trade-off.
For equity investors, while volatility may emerge as markets price in stickier bond yields looking ahead, the broadening of earnings growth, as reflected in the recent reporting season, suggests that earnings growth beyond the recent market leaders may offer the next leg in the equity market performance, moving into the spring and summer months.
