As sustained positive economic data comes in from the United States, financial markets have been pulling back bets on the world’s largest economy falling into recession.
According to the latest Gross Domestic Product (GDP) estimates, the US economy is set to grow at an annualised rate of 2.4 percent in the second quarter of 2023, topping the 2 percent growth in the first quarter.
US labour markets also continue to show resilience. The private sector in the US has seen a sustained addition of jobs. The US unemployment rate continues to be at historically low levels. The other widely tracked elements of the US economy, like consumer confidence, retail sales, service sector PMI, wage growth and housing prices (although weakening housing activity) have also displayed robustness.
All this, despite the US benchmark interest rates being taken up by a massive 525 basis points to a 22-year high in a little over a year. On the other hand, headline inflation in the US has been cooling off sequentially. A win-win situation some might say.
Is it indeed a smooth sailing?
But how has the US economy managed to defy expectations that the most aggressive monetary tightening cycle in decades will bring it to its knees?
Has inflation been truly conquered? Is a ‘soft landing’ for the US economy a realistic proposition? Answers to these questions are key to making smart investment decisions today because what happens in the US, typically, has ramifications for global policies and markets. So, we decided to look beyond the typical indicators and dig deeper to understand some underlying trends.
1) A widening US fiscal deficit has been undermining tight monetary policy and supporting US growth. Lower capital gain tax receipts during the bearish stock and bond markets of 2022, coupled with higher interest payments on government debt and higher spending programmes of the Biden administration, have resulted in a budget gap of nearly $1.4 trillion, between October 2022 and June 2023 – a 170 percent increase from the same period a year earlier, as per the US Treasury Department. It is estimated that this pro-cyclical fiscal policy has had a stimulative impact on the US economy, helping it dodge a downturn. While higher interest rates will keep the government’s interest expenses elevated, Biden has agreed to certain spending controls, in a compromise to the debt ceiling impasse. This should lead to some discretionary spending cuts.
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2) Since the Federal Reserve embarked on its tightening journey last year, the central bank’s balance sheet has shrunk by $700 billion — from $8.9 trillion in March 2022 to $8.2 trillion, as of July end. That reduction seems to have a limited impact on tightening US economic conditions till now, if we consider research estimates that equate a $2.5 trillion balance sheet reduction to a 50-basis point rate hike. Also, the impact of Fed’s balance sheet reduction on the economy was delayed when the Fed expanded its balance sheet again in March in response to the US regional banking crisis. At a rate of $95 billion monthly reduction, there’s a long way to go before the Fed can bring down its assets closer to the pre-COVID levels — enough to weigh on growth and a big question mark on whether that will ever happen.
3) Inhibited spending and stimulus checks from the pandemic era resulted in excess savings for US consumers. These savings have softened the impact of high inflation and supported household spending until now. According to a recently published research note by Federal Reserve economists, after peaking at nearly 7 percent of the GDP, the stock of excess savings in the US gradually declined over the last two years and was depleted in Q1 of 2023. The New York Federal Reserve Bank’s latest household debt and credit report showed credit card balances crossing the $1 trillion mark last quarter. This data is further proof that household savings are running low as consumers borrow to spend. With interest rates at elevated levels, time will tell how sustainable this borrowing will be. Thus, going forward, the consumer’s support to the US economy is expected to dwindle.
4) While US M2 – a measure of money supply in the economy — has been on the decline since December 2022, the first-ever decline on record, the amount of liquidity in the economy remains high, supporting the economy. The US M2 to GDP ratio is now 6.9 percent above Q1 of 2020 levels, and down from 9.7 percent in Q1 of 2023. It is also at a peak of 25 percent above Q1 of 2020 reached in Q2 of 2020. As this ratio falls back to pre-COVID levels over the course of this year, we can expect it to weigh on US economic activity.
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5) The Fed’s latest Senior Loan Officer Opinion Survey reported tighter credit standards and weaker loan demand from both businesses and consumers during the April-June quarter. US banks have tightened lending standards after the March crisis, given the deterioration in economic conditions. Borrowers have been deterred by higher interest rates. The lower credit offtake is expected to weigh on economic growth, going forward.
6) A large part of the disinflation momentum in the US can be attributed to moderating commodity prices, which had run up in the immediate aftermath of the Russia-Ukraine war. Thus, core inflation which does not include food and energy prices, hasn’t cooled off as much as the headline numbers. In addition, the slowdown in inflation over the last few months was also driven by high base effects, which are now starting to move out. Also, labour participation rate in the US continues to be below pre-pandemic levels, supporting wage growth.
Thus, incremental reduction in inflation from here on looks harder to achieve.
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The outlook indeed remains clouded. Does the economic firmness and sticky inflation mean the American central bank has more headroom to tighten? Does this increase the odds of the Fed over-tightening? Will a US recession be deep or shallow? Will stagflation be the new reality for the US economy? Will a marked slowdown in the US economy force the Fed to ease again? Evidently, the answers to these questions are not straightforward.
Looking at the way the above trends are shaping up, it seems likely that most of the tailwinds for the US economy are behind us. The probability of a US slowdown seems to be increasing at the same time as the soft-landing rhetoric is growing.
It is in times like these when investors, while capitalising on the domestic economic story, should be cautious of a looming external shock and should rely on a prudent asset allocation strategy. Investors can use the current weakness in gold prices to build their allocation to this portfolio diversifier till more clarity emerges on the prospects of the US, and, in turn, the global economy.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Chirag Mehta is the CIO & Ghazal Jain is the fund manager at Quantum AMC.
Chirag Mehta Chirag Mehta is the Chief Investment Officer at Quantum AMC. Chirag has more than 19 years of experience in the financial markets. He specializes in the field of alternative investment strategies.
Ghazal Jain is Fund Manager, Quantum AMC
