It’s a big week for data in the US and there is a big debate among economists about where we are headed, so I thought I’d use this week’s Market Perspectives to set out where I think things stand.
The US economy is slowing and looks set to suffer a mild recession. The support to consumer spending from all that cash accumulated during the pandemic – the so-called “Covid piggy banks” – has been exhausted. Data released last week confirmed this: consumer spending is growing slowly and the savings ratio is edging higher. The resumption of student loan repayments in September, worth an average of $400 a month per recipient, will provide a further hit. Meanwhile, the temporary boost to housing from lower mortgage rates in early spring, and home builders clearing their inventories, is behind us. CAPEX is falling. Employment figures are due on Friday and, whatever that number is, the bigger picture is one of slowdown. Labour supply has picked up so even a reasonable rise in employment would see unemployment begin to pick up.
Meanwhile, inflation is falling. Food and energy prices are lower and core inflation has also slowed markedly. The Federal Open Market Committee (FOMC) meet to set interest rates on 26 July and the data between now and then, notably on CPI and employment, will determine whether they go ahead with a further increase. Either way we think we are near the peak. The big issue is whether the Federal Reserve cuts aggressively in 2024. Before the collapse of Silicon Valley Bank in March, the market expected the Fed funds rate to end 2024 at 4.25%; that then dropped precipitously to 2.8% but has since clawed its way back above 4%. I think US rates will be lower than the market expects next year, and certainly lower than the Fed is leading us to believe. We shall see.
Meanwhile, in the UK core inflation has gone is the opposite direction: it is currently significantly higher than expected and I have had to raise my own forecast for year-end inflation – instead of 3% I now think it will be 4%. That is still a big decline and would allow the prime minister to meet his target of halving inflation (it was running at 10% when he set the target). Energy prices have already fallen and by October household energy bills should be showing a decline of around 20% year-on-year – quite a contrast to the 200%+ increases seen earlier this year. Food price inflation should also come down markedly from the peak of almost 20% in March to well into single figures. There is additional better news on the way, with goods price inflation also falling. Much of this reflects international prices, but sterling strength is also helping. I estimate that sterling weakness is adding close to two percentage points to current inflation; by Christmas that effect will have disappeared.
But none of this represents a sustained fall in inflation and the strength of UK wage growth will keep the pressure on the Bank of England to raise rates further. Improving confidence is encouraging UK consumers to draw down on their Covid piggy banks. In contrast to their US cousins, UK consumers did not spend last year, frightened by the prospect of sky-high energy bills over the winter. As that fear has abated, they are spending more. Given time, however, the surge in UK mortgage rates will sap consumer spending, weaken the labour market and slow wage inflation. But that looks like a 2024 event. For now, consumer demand will keep the UK economy chugging along.
What does all this mean for markets? If we are right about a US recession, risk assets would struggle. The dollar often rises in such an environment but if interest rate differentials move against the US, as we expect, the opposite might be the case. Either way bonds should rally. We do not foresee a deep US recession so the sell off in equities should be limited and provide a buying opportunity, supported by the prospect of lower interest rates. But weakness may be evident first.
We shall see. Until next week, goodbye.