Investors in U.S. stocks are becoming increasingly confident that a soft landing for the U.S. economy is achievable. That the Fed can bring inflation under control, without inducing a recession. Indeed, Goldman Sachs now think the chances of a recession are just 20%.*
Market consensus is that Wednesday will see the last 25bp rate hike in the current cycle from the Fed, before a pause, and thereafter sustained interest rate cuts.
Fed chair Jerome Powell may be about to pull off what many would have considered an impossible feat six months ago. Sceptics were then warning of a severe recession this year, resulting from the fastest pace of interest rate hikes in the central banks’ history (up 5% in just over a year).
If a soft landing is achieved, the bulls argue, then last year’s sell-off on Wall Street was overdone. And the recovery in stock prices we have seen this year has further to run.
Some might argue with that analysis. However, it’s hard to deny that the evidence in favour of a soft landing is looking more compelling than it has during previous market bouts of euphoria this year.
Why? Because pay growth looks likely to weaken soon. This is the all-important factor that perpetuates strong core inflation, which now dominates headline CPI inflation (non-core inflation, being food and energy, is actually down year-on-year).
It may seem odd to speak of imminent weakening of pay growth, when June’s average hourly pay growth was ahead of expectations at 4.4% and well above the headline 3% June inflation number. It is uncomfortably high. But it is a lagging data point and unlikely to be sustained.
A recent run of data suggests that slack in the labour market is appearing, which will reduce pay pressure. June non-farm payroll showed 209,000 new jobs created that month, lower than expected and the two previous months were revised downwards. A rise in part-time work was reported, which suggests weakening demand.
The Atlanta Fed’s Wage Tracker, based on census data, shows that the average reward for switching jobs 12 months ago was a 26% pay rise. Yesterday, it was back to its normal level of 1%.**
As demand for labour weakens, and new labour continues to come on stream thanks to a relatively youthful population, inflation busting wage rises are unlikely to be sustained.
What could go wrong?
Two points to look for. First, the Fed’s nervousness over reducing rates prematurely and second the rundown of excess savings. Both themes could yet lead to recession.
While U.S. economic data has been weakening generally, surprises still emerge. And as we have written before, Powell is acutely conscious of the dangers of cutting rates prematurely, as Paul Volker did in 1980, only to see inflation ignite again and needing much higher interest rates -and a severe recession- to extinguish.
Hawks on the Fed don’t have to look far for signs of a still-robust economy, e.g., last week’s New York Fed manufacturing index came in well above expectations, at +1%, compared to a forecast of -4.3%. This suggests a majority of respondents continue to report an overall expansion of business activity.
The Fed may therefore run interest rates much higher, over the next year or so, than the market expects, even if this week’s rate rise is the last.
Second, consumption has been kept strong by the drawing down of excess pandemic-era savings. These are now running out. Bloomberg recently cited a study from Citi Research, using data as of July 6*** that showed excess savings are almost depleted (in contrast to the U.K., Australia, Europe and Japan). Households are almost back to the long-run level of precautionary savings.
As pay growth weakens and precautionary savings are eaten to, spending on discretionary items is likely to weaken. This would accelerate the path to the Fed’s 2% target inflation, but at the price of a recession.
Investors should remain diversified across asset classes and geographies, in order to get the best long-term risk-adjusted returns.
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