Pain delayed, not averted

The following is an extract from our latest CIO outlook.

Over the past year the euro area and the UK have stagnated, while Chinese growth has disappointed. Yet the US economy has been remarkably resilient to the sharp rise in interest rates. Can the positive news from the world’s largest economy continue?

Four surprises have led to stronger-than-expected US growth:

1. Fiscal policy has been far more supportive than anticipated. The underlying budget deficit has blown out by almost four percentage points over the past year, and while the multiplier on some of this is extremely low, it can still account for a significant share of recent growth.
2. The Fed’s new emergency lending facility averted a potential regional banking crisis in the spring.
3. Excess savings accumulated during the pandemic were revised significantly higher, which helps explain continued consumer momentum.
4. Manufacturing construction has boomed as semiconductor production in particular has been re-shored.

These supports have masked the impact of the huge rise in bond yields, which has led to tighter lending standards and a sharp slowing in overall credit growth. It is also possible the lags on monetary policy are longer this cycle, because households and businesses locked in low rates during the pandemic, while interest receipts on elevated cash assets increased more immediately.

Headwinds are building

Fiscal policy is set to turn more restrictive. Democrats will be keen to continue spending in an election year, but House Republicans are proposing cuts. The compromise is likely to be a near freeze in the level of spending. State and local governments will have to curb spending after their recent splurge, as revenue disappointment has begun to place a strain on their finances.

The consumer environment is deteriorating because of reduced transfer payments, rising student loan repayments, slower job and wage growth, restricted credit availability, rising delinquencies, and pressure to raise the extremely low saving rate.

This seems to be reflected in weak consumer confidence, even if actual spending has only slowed gradually so far.

Inflation should ease further

The reversal of supply shocks has driven a significant reduction in goods-price inflation, but for the next few months services inflation is likely to remain sticky and prevent inflation from returning to target.

However, if the recession we expect to begin in the first half of 2024 materialises, this should increase unemployment and squeeze out the wage and services inflation pressure.

Ultimately, this should allow the Fed to cut rates more aggressively than the markets expect.

The alternative scenario is a benign labour market rebalancing so inflation returns to target and yields fall, which avoids tipping the economy into recession. We see this as more likely than the economy failing to land at all in 2024. For the latter to occur we’d look for signs of an aggressive take-up of the open-ended tax credits in the Inflation Reduction Act.

When the US sneezes, the rest of the world catches a cold

Europe is already on the verge of recession. A slowing US, alongside tight credit conditions, could tip the region over the edge. Fiscal policy is constrained, and with core inflation still well above target consistent levels, scope for monetary support is limited. The prospect for rate cuts will increase if the recession intensifies next year.

China is also struggling from structural problems in housing, a reluctance to ease monetary policy given potential pressure on the exchange rate, and a loss of confidence amid a more hostile international environment, leading to pronounced weakness in foreign direct investment.

The engines of global growth in 2024 among the larger economies appear limited to only India and Japan.

This is an extract from our latest CIO outlook.