- The US economy showed surprising resilience in the first half of the year, mostly due to continued strength in the job market. Inflationary forces will continue to drive interest rates higher this year.
- Recessionary forces continue to tug at the US economy and will strengthen as a number of tailwinds ease in the second half of this year.
- Much of the strength in US equities can be attributed to relief that inflation seems to be cooling and the advent of artificial intelligence but is largely limited to a handful of mega cap technology stocks.
- Any recession is likely to be shallow but will contribute to equity market volatility going forward.
The US economy showed remarkable resilience in the first half of the year in the face of rising interest rates, sticky inflation, a regional banking crisis, an ominous yield curve and persistent geopolitical tension in Europe and with China. Many of the surprises in the economic data have their roots in a robust labor market, which is driving solid wage growth and persistently strong consumer demand. The strong job market remains a bugbear in the Fed’s quest to get a lid on inflation and will continue to drive interest rates higher this year. The exuberance in equity markets has largely been driven by “less bad” inflation readings and the advent of artificial intelligence (and the efficiency gains it promises) but has largely impacted a very narrow set of mega-cap technology stocks. On a more somber note, economic growth is faltering and the temporary drivers that helped stave off the effects of tightening credit conditions are beginning to fade. So, while recession has been deferred, it remains a very real risk in the foreseeable future.
A number of factors will weigh on growth going forward that continue to make recession a likely outcome at this point in the economic cycle. First, while real disposable income jumped in the first quarter, the increase was driven by an upward inflation-driven adjustment to social security payments, a one-time and fleeting boost to consumer spending. Second, global manufacturing growth rebounded in Q1 along with European and Chinese growth, while the US dollar fell. These dynamics acted as a tailwind for large multinational companies, whose earnings benefit from a weaker dollar. That rebound in global manufacturing reversed in Q2 and the dollar appears to be strengthening again. Third, global central banks provided a whopping $1.3 trillion of additional liquidity over the past two quarters to deal with an array of issues, from a banking crisis in the US to a weaker than expected post-lockdown recovery in China. While this injection of liquidity likely fueled a rally in more speculative investments like AI-related names, it is not likely to be the beginning of a longer-term easing cycle. In fact, to the contrary, global central banks’ balance sheets are set to shrink by roughly $1 – 1.5 trillion by the end of the year (central banks with accommodative policies like China and Japan only partially offset those who are still in tightening mode like the US, Europe and other developed market central banks). That shrinking liquidity will be an additional headwind to growth. Fourth, consumer spending is likely to become more conservative going forward as student loan payments resume and the depletion of savings contributes to greater caution among consumers (the personal savings rates has fallen to 4.2% this year, well below its long-term average of 8.9%). Finally, despite large spending programs like the Inflation Reduction Act, US fiscal stimulus will be more modest this year than last. Globally, this is also true as the net growth effect of fiscal spending will be negative in 12 of the 14 major economies.
The upshot of this is that as the tailwinds that supported the overall economy continue to fade, the effect of tighter monetary policy will intensify. As a result, US growth is likely to decelerate again and resume the recessionary track it was on. Some of this evidence is emerging already. In the first half of the year, gross domestic income (a less volatile equivalent of GDP) shrank as did real GDP (GDP adjusted for inflation). Real retail sales have also declined in eight of the past 12 months. Furthermore, as the real economy shows signs of struggling, the full effect of the Fed’s aggressive monetary tightening – which is known to lag economic activity by as much as 18-24 months – may still be yet to come.
While this may seem like a pessimistic outlook, recession is not a certainty. An economic slowdown or a shallow recession (the more likely scenario at this point) simply increases the economy’s sensitivity to shocks. Risks on the horizon, most notably weakness in commercial real estate markets, have greater potential to do damage than they might in a faster growing and vibrant expansion. The good news is that there aren’t any signs of deep imbalances in the US economy that have preceded deeper recessions, like the froth in credit markets leading up to 2008 or the high market valuations that led up to the dot com crash. Except for a very narrow set of 7 mega cap stocks, market valuations are only slightly above long-term averages (whereas the average price to earnings ratio of those top 7 names is 32, more than double the long-term average of the market). We would expect that risks to earnings remain to the downside and that, with the heightened risk of a recession, profit estimates are likely to come under further pressure. This will very likely contribute to greater equity market volatility in the second half of this year.