Pervasive gloom: just how bad is the US outlook?

Markets have embraced a stagflationary outlook so far this year. Inflation has surprised to the upside, central banks have continued their hawkish pivots and the chatter around recession risks has grown louder.

Our views on US recession risks have only marginally shifted up from early April partly because we expected terminal rates to re-price higher and for inflation to prove more persistent.

Kicking the tyres of the US economy

So, what happens next? There is some evidence that US growth is beginning to slow beyond the statistical volatility in GDP, which will likely make the first half of this year appear much weaker than the underlying momentum.

The consumer savings rate has been run down, which has allowed real consumption growth to outstrip real disposable income growth. The excess savings buffer accrued during the pandemic and still exceptional levels of wealth, despite the drop in stock markets this year, should allow the savings rate to remain low, but from now on consumption will need to grow in line with incomes.

The tightening in financial conditions is also playing a role. While painful for investors, it is probably positive in the longer run. The sooner the US economy slows to trend, the less depth required in the next recession to squeeze out the overheating caused by excess demand today.

The sharp rise in mortgage rates is cooling the housing boom, but still-low levels of inventories suggest house prices should eventually stop rising rather than fall. For the next few months, rents still have a long way to go to catch up with prices amid low vacancies, and this will contribute further to the US Federal Reserve (Fed)’s discomfort.

Wage pressures in focus

Inflation may be peaking, but it looks more like a plateau, unless commodity prices fall sharply from here. A big drop in energy and food prices would be welcome, especially for the consumer, but would not solve the fundamental problem of an exceptionally tight labour market. If real incomes receive a boost and consumer spending holds up, there won’t be sufficient job losses to ease wage pressures.

Equally, continued high headline inflation risks further second-round effects on wages. Either way, we don’t expect compelling evidence of inflation returning to target anytime soon, which means the US central bank will need to follow through on pushing rates into restrictive territory. Nobody knows, not least the Fed, exactly where this is, so the risks around market pricing of a near 4% peak seem relatively balanced.

With growth slowing, the squeeze on margins that we expect even in a soft landing scenario could be arriving soon. Next year will likely be worse for profits because it seems unlikely the Fed will be able to engineer a soft landing.

As companies guide down from unrealistic earnings expectations it will be interesting to see the extent to which recent stock declines already discount this outcome.