The US economy has surprised with its resilience over the past year, defying consensus expectations of a 2023 second-half recession.
In line with our long-held thesis, resilience has been a function of some unique factors in this cycle, namely excess savings built up in the pandemic combined with a historically tight labour market.
So far this year US activity data has continued to be on the strong side of consensus. While growth has been resilient enough to suggest the economy should avoid a hard landing, it also highlights the possibility of the alternative “no landing scenario”.
We continue to discount both “no landing” and “hard landing” scenarios for the US, and highlight key signposts we are watching to confirm a relatively gradual deceleration in the US economy, in line with our base case for a soft landing.
Run of Resilient Data
So far this year incoming economic data has supported the view that the economy may not be slowing as much as many had started to believe, including perhaps the Fed. January’s standout employment report delivered a significant beat to the upside, indicating job growth remains robust. Consumer confidence improved in January according to both the University of Michigan and Conference Board measures, and the ISM PMIs ticked higher, surprising to the upside by a few points.
More importantly, the manufacturing new orders component ticked above 50 to 52, which tends to lead the headline index. This influx of positive data surprises has seen the Fed GDPNow model upgrade first quarter growth to 3.4%, well above the expected rate of expansion and well above the Fed’s estimate of trend growth.
This strong data has the market rethinking the timing around Fed rate cuts. Coming into 2024, the bond market had been priced for 6 rate cuts in 2024, with the first coming in March. Comments from Fed Chair Powell, in which he downplayed the possibility of a March cut, along with the run of solid economic data has led to a shift in market expectations, with the timing of the first cut pushed out to the following meeting in May.
The US equity market has largely looked through the upward move in bond yields and tempered rate expectations, instead rising to all-time highs, led by large cap growth stocks.
Jobs, Jobs, Jobs
January’s monthly US nonfarm payrolls report was extremely strong at 353k job gains. Manufacturing jobs surprised to the upside, giving credence to the uptick in the ISM PMI survey. Not only was the monthly print well above consensus of 185k and the strongest reading in 12 months, the number of payroll gains created was revised up for the entire year of 2023 by 359k.
However, the release was also subject to some unusually large seasonal distortions, which may be overstating the strength of the labour market. The general downtrend in other employment trends from the Household Survey remain much softer, as do hours worked, hiring plans, quit rates and layoff announcements. These indicators suggest weakening momentum in labour market conditions.
We don’t think job growth will sustain at current levels and ultimately expect a more meaningful moderation in the labour market in the coming months to signal that the US economy is cooling.
In addition to the unexpectedly strong increase in hiring, monthly wage data showed a seemingly alarming uptick (a 6.8% month on month annualized rate), however this data is fairly noisy. The year on year growth rate remains at 4.5% in January, averaging 4.3% in the last 3 months. It’s worth noting that average hourly earnings are only one measure of wage inflation. Other important indicators, such as the Employment Cost Index and JOLTS quits rate, do reflect more moderation in wages.
A sustainable path toward the 2% inflation target will require wage gains to moderate, which is something we are watching closely. It is likely the Fed will want to see confirmation this monthly increase was a blip, or a distortion, and not the beginning of a new trend toward higher wages.
Goodbye to the March Rate Cut?
The most acute reaction to the strength of recent macro data was in the bond market, where the short end of the yield curve, which is the most sensitive to expectations for monetary policy, sold off significantly. The 2-year yield spiked 25bps to 4.50% as the market repriced rate expectations.
Only a month ago, those expectations were firmly in March (>90% probability), but today those same odds are below 20% and the market consensus has shifted to May. In our view, a March cut was far too aggressive and a total of 4 to 5 cuts priced for 2024 (down from 6) looks much more plausible.
The key takeaway from the January FOMC meeting was that the Fed will continue to be patient, data dependent and highly attentive to inflation risks. Strong job and wages growth makes the Fed want to accumulate more evidence the downtrend in inflation can continue. We believe data delivering a sufficient degree of confidence is likely to be in hand before the Fed's May meeting, so we expect the Fed should be in a position to start cutting rates around mid-year.
Are Price Pressures Reaccelerating?
Although our base case remains that a continuation of the disinflation process will allow policymakers to pivot to rate cuts this year, we continue to monitor risks to this outlook. Pricing components of ISM surveys have recently ticked up, indicating a renewed increase in price pressures.
Although shipping costs have risen amid the tensions in the Middle East, the New York Fed’s Global Supply Chain Pressure Index suggests there are no major global logistics difficulties. The index ticked up slightly in January but remains below the historical average.
The 3 upcoming CPI prints prior to the May Fed meeting are key, and focus will be firmly on this week’s CPI release, particularly given the recent pick-up in average hourly earnings and ISM pricing measures. Ultimately, the totality of the data doesn’t warrant a change to our base case expectation that a continued moderation of inflation will eventually give policymakers confidence to start easing rates.
Discounting “No Landing” and “Hard Landing” Scenarios
We continue with our long-standing view that the US will avoid a hard landing and continue to surprise a still conservative consensus to the upside. There is the risk that further signs of economic strength combined with a stalling in the inflation downtrend could instigate a selloff in both bond and equity markets, however this is likely to be a short-term reversal rather than a genuine trend reversal.
We struggle with the view that the US is set to sustainably reaccelerate. The forces that supported above trend growth and strong labour market outcomes should fade as we move through 2024. If this is correct we also doubt that the deceleration in inflation that has been evident for some time now would be thrown off course.
Nevertheless, moderating inflation and employment will remain key data signposts for sentiment and thus market direction over coming months.
We believe data delivering a sufficient degree of confidence in the soft-landing scenario is likely to be in hand before the Fed’s May meeting, so we expect the Fed should be in a position to start cutting rates around mid-year, which should see bond yields ultimately
drift lower.
We remain somewhat cautious near term given the strength of the US market over the last 3 and 12 months, combined with the still large number of rate cuts baked into 2024. The macro backdrop will ultimately be supportive for a decent year in US stocks in 2024 but a consolidation in the near term is likely, in our view.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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