Will the US economy have a soft or hard landing? It’s still too soon to say

There is much contradictory evidence on whether the US will go into recession, and if so, when
For a recession to materialise, there would have to be worse corporate news and a higher unemployment rate

Chris Iggo

Published: 6:15am, 29 Jun 2023

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Whether the US economy achieves a soft landing, falls into recession or sees some other outcome, it remains central to the global investment outlook. The United States Federal Reserve has not claimed victory over inflation yet, but it has paused its rate-hiking cycle on the assumption that its 500 basis points of tightening so far should have an effect on growth and price rises.

Currently, economic data does not overwhelmingly point to recession. There is not a lot of bottom-up evidence. Markets can’t seem to make up their minds what to expect, even if some indicators suggest recession is nailed on. While fixed income remains the main attraction for many, equities keep going up – but of course, prices are vulnerable to any change in the narrative and the economic data flow. Investors should enjoy the summer if they can.

The Fed kept its key policy rate unchanged at 5 per cent on June 14, in line with most expectations. The decision has been described as a “hawkish skip”; Fed officials’ updated forecast suggests there could be more hikes to come. The view is that inflation risks remain, while the economy is more resilient than thought during the wave of bank failures.

Inflation coming down represents an increase in implied real interest rates. Put another way, market expectations for rate cuts have eased; rates are now expected to stay at, or slightly above, the current levels for an extended period. This makes sense, given that inflation is still well above the Fed’s target. Until the momentum of core inflation eases, the central bank is going to keep sending the message that monetary policy will need to remain tight for some time.

The debate on whether it will be a soft or hard landing for the US economy continues. Equity and credit markets are betting on the former. Looking at the macroeconomic, interest rate and credit outlook, one thing is clear: company fundamentals are solid.

Strong nominal earnings growth has allowed leverage to come down and borrowers have been able to raise money comfortably in the bond market in recent months, building up cash buffers in case growth does weaken markedly. Unemployment remains low, consumer spending steady and, given the recent decision on the US debt ceiling, there is no shock coming from the fiscal side.

The recession, if it comes, has been well flagged. It is not surprising that investors are cautious. If you can earn 5 per cent from money market funds and 5.5 per cent to 6 per cent from short-term investment-grade bonds, why take any additional risk? The defensive allocation to cash shows no sign of being concerned about reinvestment risk when the Fed is telling us that rates will stay high for some time.

A resilient US economy and weak recovery in China? Think again

There is so much contradictory evidence on whether the US will go into recession, and if so, when, or how deep. The Treasury yield curve is inverted; the situation is similar in Europe. But if we look at the US labour market, it has not shown any significant weakness. American companies are usually very quick to shed labour if they see demand weakening and profitability eroding.

Since Covid-19, labour supply has been impacted by factors including a behavioural shift which has led to people leaving the workforce in many economies. So, firms are hanging on to workers, reluctant to shed jobs in case it proves difficult to re-hire once growth returns.

A server sets a table at a restaurant in San Francisco, California, on June 26. Considering the tightness of the US labour market, it looks unlikely that a recession is coming. Yet other indicators, like the Treasury yield curve, are pointing the other way. Photo: Bloomberg

There is more work to be done on this, but it certainly seems that since the pandemic, labour situations in major economies have shifted and contributed to tighter labour markets and higher wage growth. Bringing inflation back to or below central bank targets might be difficult over the medium term.

A soft landing for the US is still possible given corporate and household resilience. The last three years have seen companies and households dealing with major events – lockdowns, the energy shock and a huge tightening of monetary conditions. Inventory and spending management has become more prudent as a result. Digitalisation of more aspects of economic life is underpinning investment spending and product development.

It is true the Fed rarely engineers a soft landing, but you could argue that it did in 1994-5 and 2018-9. The debate will not be settled any time soon.

There can be a long lag between recession indicators – the start of the tightening cycle and the inversion of the yield curve – and the actual downturn in gross domestic product. A recession in early 2024 would not be out of line with historical relationships. For it to become more material, however, worse corporate news and a higher unemployment rate would be needed. Until then, markets might be rangebound, with only technology stocks providing any real capital growth opportunities.

Chris Iggo is chair of AXA Investment Managers Investment Institute and chief investment officer of AXA IM Core