The widening path to a soft landing

We believe that in the second half of 2023, the regime will be more consistent. The path to a soft landing for the US economy has widened and is poised to get wider in the coming months. Inflationary pressures are decelerating, and the labor market is resilient. As such, we expect real income growth will continue to support an ongoing expansion in US consumer spending. Further bolstering the US growth outlook is the rebound underway in real residential investment after a multi-year retrenchment.

Investors are warming to our view that the US expansion is likely to prove much more durable than consensus wisdom anticipated at the start of the year. As such, there are still segments of the market that have ample catch-up potential as recession risk is priced out.

We favor equities as sturdy growth and decelerating inflation reduce the risks to both earnings and valuations. In particular, we prefer the US equal-weight index and US mid-cap stocks, which are more levered to domestic activity than the large-cap, market-weight S&P 500 Index.

We remain vigilant in keeping track of threats to the expansion, including signs of deterioration in the labor market or an unexpected degree of stickiness in inflation.

We have conviction that in the third quarter, core inflationary pressures will downshift meaningfully – both in terms of the annual rate of change as well as on shorter time horizons.

For core CPI in particular, we have turned a corner on shelter inflation, which is slated to make a smaller and smaller contribution to price pressures through at least year-end. There are also tentative signs of slowing in some of the ‘stickier’ measures of inflation most tied to the labor market, namely core services ex housing and healthcare. While it is too soon to call this a trend, it is encouraging to see progress. Aggregate labor income growth and the private sector quits rate have both reverted to near pre-pandemic levels. As such, we have confidence that price pressures linked to a strong job market and services spending are poised to decelerate.

Keeping you up-to-date with markets

The Federal Reserve raised its 2023 core PCE inflation forecast from 3.6% in March to 3.9% in May. We believe the risks to this higher bar are tilted to the downside. Additional US monetary tightening, in our view, will be primarily a good news story about the strength of domestic activity, not a panicked, belated response to drive inflation below the Fed’s forecast.

Since the start of 2022, the economy has had a series of “rolling recessions” with weakness isolated to certain parts of the economy, such as technology and housing. More recently, global manufacturing outside the US has struggled. Overall US consumption has been able to cover up those weak points because of the long-lived stimulus provided by income support programs, strong balance sheets, and an increasingly robust labor market.

The US economy continues to produce impressive job growth. However, the slowing in income growth and shrinking excess savings imply that consumption growth should moderate. Importantly, we expect inflation to fall faster than nominal incomes, which should keep real incomes and spending solid into year end. And even as services slow, other pockets of strength in the US economy should be sufficient to keep recession risk low.

Since Q1 2022, real residential investment has fallen by 22% -- a contraction similar to what was experienced during the early-90s recession in the US. The sharp recovery in homebuilder sentiment, high number of new homes under construction, and strong pipeline of new single-family home sales where construction has not yet started, suggest that this headwind is turning into a tailwind.

It is remarkable that there are elements associated with an early-cycle economic backdrop – particularly, US consumer confidence and the housing market inflecting higher –in what is a more mature economic expansion and on the heels of 500 basis points in Federal Reserve rate hikes. This reinforces our view that this is a very unique economic cycle, and we are in the midst of a slow slowdown in growth that makes for a more prolonged late-cycle environment.

Even in areas of the US economy where there is perceived weakness, such as manufacturing, there is surprising resilience as well, with new orders for durable goods rising to a fresh cycle high in May.

Of course, we will closely monitor incoming economic data, earnings, and policy changes to assess potential challenges to our optimistic view on the US economy and risk assets.

The lagged impact of previous monetary tightening and March’s episode of financial system stress could turn what we expect will be a mild default cycle into something more concerning or imminent, and jeopardize the strong labor market.

There is also the possibility that progress on inflation, particularly in services ex-shelter components, proves short-lived and limited amid resilience in the labor market and economic activity. Seasonal factors and an upturn in medical costs may also arrest the downward trend in CPI inflation during the fourth quarter.

In the near term, we believe the more likely risk involves the debate over the state of the US economy shifting from “recession or soft landing?” to “soft landing or no landing?” as labor markets and activity remain solid. The ‘no landing’ scenario is one in which inflation remains sticky high, forcing the Fed to hike to 6% or beyond. The rise in yields and resultant strength in the US dollar could also challenge risk assets.

In summary, we anticipate a moderation in inflation will support a continuation of this expansion, by supporting real incomes and taking some pressure off of central banks. Even as services spending slows, the housing market should put a floor under US growth. We are overweight equities, and favor US equal-weight and mid-cap exposures. There has been positive breadth in US earnings revisions recently that stands in sharp contrast to the narrowness of the year-to-date equity rally in US stocks. The performance of equal weight relative to market-cap indexes has lagged the upward move in US Treasury yields and US economic surprise indexes, so these positions have room to catch up to these improved fundamentals, in our view. There is also valuation support, as the S&P 500 equal-weight index and S&P Midcap 400’s forward price to earnings multiples are in the lowest quintile of their 10-year range.

Exhibit 3: Compelling valuations for S&P 500 equal weight, US mid-cap stocks

Credit should also perform well, in our view, as the expansion extends and interest rate volatility will likely subside with a slowing Fed. We are neutral on long-term government bonds, as downward risks to yields from inflation are offset by the pricing out of recession risk. Of course, duration still plays an important role in well-balanced portfolios to protect against economic downside scenarios. In currencies, long US dollar versus short Chinese yuan is a useful hedge in our view due to the relative shift in growth momentum away from China and towards the US, as well as its typically strong performance in risk-off environments.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of 30 June 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the ACA does not include all asset classes, the net overall signal may be somewhat negative or positive.