Authors: Global Investment Strategy Group
After 525bps worth of rate hikes over the last year-and-a-half, the Fed paused – holding its target policy rate steady at 5.25–5.50%. Looking ahead, the Fed’s Summary of Economic Projections (SEP) show one more hike this year (unchanged from the last meeting) and an intention to keep rates “higher for longer”. This reduces expectations for cuts in 2024 and 2025, as inflation remains elevated even with the core Personal Consumption Expenditures (PCE) inflation projection for 2023 reduced – the first time they have revised down an inflation forecast since 2020. The Fed is also now effectively expecting a “soft landing” scenario, with downward revisions to the unemployment rate and upward revisions to GDP growth. In sum, the Fed stands ready to act if needed, remaining “data dependent”. In our view, regardless of whether the Fed hikes another time this year, the era of rate hikes is coming to an end – though the pace of cuts will likely be slower than previously expected.
Strategy Question: Could recent events upset the soft landing consensus?
Our near-term U.S. macro view remains that of a soft landing, where the economy is able to avoid a recession even if growth slows under the pressure of restrictive rates in the first half of 2024. The disinflation in the labor market – driven by increased labor supply – underpins our view that core inflation can slow enough without the Fed having to engineer a more severe slowdown to achieve their target. Improved corporate sentiment and the catch-up potential for the rest of the stock market beyond the largest tech names highlight some still-attractive opportunities within equities. Rates at elevated levels and a Fed that is likely almost finished with its hiking cycle make fixed income (both short and longer-dated) attractive.
Reflecting that benign macro backdrop, our high-conviction investment ideas remain fixed income (a barbell between short and long dated), equal weighted S&P 500 and mid-cap equities, as well as private credit within alternatives.
However, recent headlines suggest that risks to our view are building. The ongoing immaculate disinflation in the labor market may be disrupted by a spate of union worker strikes. Recent inflation data saw an uptick, driven by surging oil prices. The depletion of excess household savings coupled with a restart of student loan repayments, as well as an impending U.S. government shutdown, are all adding to the risks of a more pronounced slowdown in economic activity. In this note we examine those risks and consider how they can impact our base case and investment recommendations.
Union worker strikes and the impact on wage inflation
Recent data has pointed to a cooling labor market in the U.S., with slower job additions and rising labor supply. That said, continued news about union worker strikes have sparked renewed concerns of wage inflation. Following the months-long Screen Actors Guild strike (which represents over 160,000 workers), the latest episode is in the auto sector, where the United Auto Workers union last week began a strike at the big three Detroit automakers. While the initial action is starting small, there are worries about an escalation given that the union and automakers remain far apart on pay terms.
In our view, it seems unlikely that the strikes will have a meaningful impact on the wage inflation outlook, for two reasons. First, across the broad economy unions are less important than they were. The number of people in unions has decreased significantly over time, particularly in the private sector. Only around 10% of overall employment (6% in private industries and 33% in public) are members of a union. In addition, while the headlines are catchy, the actual impact of strikes on macro data could be less visible. Take the rail industry agreement in December 2022, which impacted around 100,000 workers. There was a 14% salary bump effective immediately, and it was not noticeable in the wage data at all. By comparison, the ongoing auto strike could affect 150,000 workers. Assuming they get the 40% wage bump they are asking for, it could be a ~4 basis point impact on Average Hourly Earnings (AHE), which is hardly going to change the overall picture of slowing wage growth.
Second, non-union wages have grown faster since the pandemic, averaging 15.4% vs 11.1% since 2019. Thus, it is possible that some of these strikes are in part an attempt to catch up to the wages of non-union jobs and industries. The magnitude of wage increases may ultimately be restricted by the slowing trend of the broader labor market, and any impact is likely to be temporary.
What if we’re wrong? If the strikes significantly broaden and worsen to potentially disrupt labor supply or materially push up wage growth, we may see a re-acceleration of core inflation and renewed efforts by the Fed to tighten monetary policy, thereby raising yields in the near-term while increasing the risks of a recession further down the line.
A resurgence in oil prices
The other inflationary concern comes from energy. The price of crude oil has surged over 30% since June, popping above $90 per barrel. This has pushed the prices of distillates such as gasoline and diesel up along with it. The average price of regular U.S. gasoline is $3.85 per gallon, up from around $3.50 just a few months ago. Both supply and demand factors have been driving the surge, including Organization of the Petroleum Exporting Countries (OPEC+) supply cuts and robust demand over the summer.
Short term spikes aside, we think it would be difficult to see oil prices meaningfully higher from here unless we see an unexpected geopolitical event. On the supply side, independent producers in both the U.S. and Canada could boost supply by at least 500,000 barrels/day in the next few months in response to higher prices. As U.S.-Iran relations thaw, the latter has also been sending more oil to the market. Seasonality could also help, with demand likely to cool down as the summer travel season comes to an end.
In terms of the impact on the outlook, there are two big concerns. First, higher oil prices could finally crack the consumer as they reduce spending on other categories; and second, higher oil prices could undo the progress that central banks have made on inflation. We see a few reasons why the impact could be less than feared. Since the labor market is still strong, consumers could stay relatively resilient against higher energy bills. Even as more people use debt to finance their purchases, overall household debt-to-income ratios still look healthy. On inflation, we see upside risks to headline inflation for the next few inflation prints. Nonetheless, core inflation (which the Fed focuses on) could continue to cool as households spend more on fuel and have less disposable income to buy other goods and services. It could be negative for growth but is unlikely to reverse the ongoing disinflation trend as the key drivers (rents and core services) continue to cool.
What if we’re wrong? If oil prices continue to spike higher and lead to a reacceleration of inflation (both headline and core), the Fed may renew their efforts to tighten monetary policy to clamp down on rising prices, in turn raising yields in the near-term but also increasing the risks of a recession further down the line. This may be worsened as confidence drops further and consumers allocate more spending to gas from other categories. The probability of the much-feared “stagflation” scenario – where growth slows while inflation remains high – is also heightened in this case.
The end of excess savings and the restart of student loan repayments
Market commentators have been predicting the end of excess U.S. household savings for months. A study from the San Francisco Fed published last month seems to affirm this view, predicting that less than $190 billion of excess savings remain and that households will likely deplete this amount by around this quarter at their current rate of drawdowns. Estimating the exact amount of excess savings is filled with uncertainty depending on the methodologies and assumptions used, but signs of a slowing consumer are showing even as retail sales remain resilient. Credit card debt and delinquency rates are rising, suggesting the consumer is resorting to debt to maintain consumption levels.
The restart of student loan repayments will likely also act as a drag on the U.S. consumer – as more than $9.2 billion has been spent on repayments since the start of August. All-in-all, the end of student loan interest forbearance could reduce Q4 annualized GDP growth by around 0.6% according to estimates from J.P. Morgan Investment Bank.
However, we do not see a more severe recession emanating from this consumption slowdown given that household balance sheets remain relatively healthy. A crisis-level deleveraging of the type seen in the wake of the 2008 Global Financial Crisis is unlikely.
What if we’re wrong? If the consumer slows down more than expected, there are increased downside risks to the macro outlook and consumer-geared sectors, thereby raising the risk of a recession even as inflation concerns subside with weaker demand.
Risks of a government shutdown and its economic impact
We are drawing closer to a potential U.S. government shutdown on October 1st, as a deeply divided Congress remains at odds over spending plans. Indeed, the probability of a government shutdown in October appear to be rising. But unlike the debt ceiling mess a few months ago, which could have had significant consequences for growth and markets, a shutdown is unlikely to matter much because the impact on spending would likely be small and short-lived. While this introduces market uncertainties, we have seen shutdowns many times before (21 times, to be exact), with the longest lasting 34 days in 2018. Essentially, a government shutdown is the closure of “nonessential” U.S. government departments when “discretionary” funding runs out. It is important to note a government shutdown is different than failing to raise the debt ceiling. The debt ceiling chaos was a potential serious problem, as it could have forced a debt default eventually forcing the government to run a balanced budget and sharply tighten fiscal policy. A government shutdown, on the other hand, is much narrower in its impact. Shutdowns happen when Congress fails to pass a budget and fund the federal government through appropriations legislation. This primarily means that nonessential government functions would cease, including the temporary furlough of certain government workers, who could feel most of the impact through not receiving timely compensation during the shutdown.
As for market implications – any impact will likely only be felt in the short-term. Historically, market returns during government shutdowns tend to be mixed and flat, on average. Even if volatility could pick up in the near-term, we expect a deal to be eventually negotiated, and for the market to move on. Over the longer-term, the rising debt burden could reduce potential GDP as tax revenues are directed towards debt servicing rather than productive fiscal spending. But in the near-term, the key drivers of markets will likely remain the Fed, interest rates, earnings and economic data.
What if we’re wrong? If the shutdown persists for longer than expected or if fiscal spending is cut more dramatically, that adds modest downside to the macro outlook through reduced consumption and fiscal spending, raising the risk of slower growth.
Amid high levels of uncertainty about the macro and market outlook, resilient portfolios designed for a range of outcomes are key to achieving long-term goals. We advocate for clients to step out of excessive cash allocations and stay invested in core equities and fixed income in a balanced and diversified manner across geographies, in order to avoid missing out on an attractive entry point for long-term multi-asset investing. Alternatives remain an important source of alpha, and tactical strategies can capture market dislocations. Meanwhile, structures and derivatives are also an important area for investors to consider. We are in an unpredictable world and investors should prepare for the unexpected.
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