Thomas Holzheu: The easy phase of disinflation is over and further labour market rebalancing is needed to return inflation to target. Inflation dynamics have been encouraging, with core CPI inflation slowed to 4.3% in August, the slowest pace since late 2021.
The progress on both core goods and services disinflation supports our view that headline inflation will average about 4.0% this year and cool to a 2.5% average in 2024. However, historically low unemployment, elevated job vacancies, and above-average wage growth will keep labour income strong and continue to support demand. Whilst we don't think a recession is necessary to return inflation to the 2% target, we do think a modest increase in unemployment will be needed to put sustained downward pressure on prices.
"Higher growth may also convince the Fed that further interest rate increases would be needed to restore price stability, but we expect a growth slowdown."
Inflation expectations are an additional key channel to watch. By and large, they remain well-anchored despite some marginal recent uptick. However, inflation expectations, particularly for consumers, are uniquely tied to gasoline prices, which have risen sharply amid a global shortage in oil supply. If this persists into Q1, we could see upward pressure on both expectations and inflation metrics.
Finally, economic growth will also factor into the outlook for both rates and inflation. US GDP growth likely reaccelerated in Q3 as consumer spending remained on a firm footing. Ongoing strength in consumption would represent an upside risk to core inflation, particularly as households continue to normalise spending on services, which typically relies less on credit compared to goods.
Higher growth may also convince the Federal Reserve (Fed) that further interest rate increases would be needed to restore price stability, but we expect a significant growth slowdown at the turn of the year.
Thomas: We believe the Fed is finished with its hiking cycle given the gradual loosening we are seeing in the labour market and the fact that core inflation pressures appear to be moderating.
However, the Fed is likely to remain hawkish and further tightening is possible, if, for example, we see the recent increase in energy prices persist and filter back into core inflation measures, delaying the disinflationary impulse that has been in place for much of this year.
Some segments of the economy saw the impact of interest rate increases filter through more rapidly than others. This includes the housing sector, where the 30-year fixed mortgage rate ascended sharply and today is close to 8%, weighing on housing affordability and contributing to the moderation in house prices. The same is true for auto loans, which have seen monthly payments rise to record highs just as vehicle inflation surged in 2022.
"We expect the impact of the tightening policy will intensify into 2024 as the maturity on corporate debt forces firms to refinance at much higher rates."
However, the full impact of tightening is yet to be observed, particularly given the recent steepening of the yield curve.
Furthermore, many corporations refinanced their debt burdens at historically low interest rates in 2020-2021, which has slowed the speed of transmission from monetary policy to the real economy. We expect the impact of the tightening policy will intensify into 2024 as the maturity on corporate debt gradually forces firms to refinance at much higher rates and profit margins slow as consumer demand moderates.
Thomas: While near-term growth has turned more positive, we continue to expect a recessionary environment ahead.
Some segments of the economy have effectively been in a recession for the last year and are now recovering or stabilising. As a result, a traditional two-quarter negative quarter recession seems difficult, but we expect consumption to slow as the strength of household balance sheets gradually weaken amid rising debt burdens.
This is already apparent with a modest increase in auto loan delinquencies and the resumption of student loan payments. Savings rates remain near historic lows, down to 3.9% in August, suggesting consumers continue to spend out of savings, which is not sustainable.
Long lags in the transmission of higher interest rates into the economy imply that financial market stability remains on the agenda. This includes concerns about bank liquidity and profitability as well as market liquidity. Large issuances of new treasury debt and the Fed's quantitative tightening change the supply and demand balance at a time when market participants need to digest the surge in interest rates.
"Government spending was a growth driver in 2023 as federal non-defence spending benefited from infrastructure investment legislation passed."
Commercial real estate is a sector to watch. While distress is concentrated (i.e., office) and will not pose systemic risks, we do expect to see a moderate increase in defaults in stressed properties, a lengthy workout period, and loan modifications between lenders and challenged borrowers.
Loan-to-value ratios and debt-service coverage ratios are low, providing material cushion. However, small banks are disproportionately exposed to Commercial Real Estate (CRE) loans, and their balance sheets are much more vulnerable to a prolonged CRE downturn than long-term investors and insurers.
Government spending was a growth driver in 2023 as federal non-defence spending benefited from infrastructure investment legislation passed in prior years. However, reductions in discretionary outlays detailed in the Fiscal Responsibility Act, which averted the debt ceiling crisis, will limit government spending and act as a drag on growth later this year and early next.
Current political gridlock about government funding could exacerbate this effect.
Thomas: Any further geopolitical volatility will likely have short-lived implications for financial markets, barring a significant shock to the domestic economy.
The typical market response to a flare-up in geopolitical tensions is strong demand for US treasury bills as the most liquid and safest asset. This role is fortified by rising Treasury yields that we expect will remain elevated over the medium to longer term. Equity markets typically sell off in the short run, but these developments are usually priced in rapidly before investors shift their priorities back toward fundamentals.
"Some sectors including technology and manufacturing, will see greater impacts from ongoing tensions as the US seeks to shore up national security."
Global geopolitical risk is elevated as the US 2024 presidential elections approach, the war in Ukraine continues, Taiwan's elections take place in January 2024, and tensions with China remain high.
We don’t expect US/China tensions to abate any time soon, but we also do not expect to see a "cold war" between the two economies given their interdependence on each other. We view the evolving relationship to be an indication that the world is past peak globalisation, exemplified by the diversification of supply chains post-pandemic. This will serve more of a re-direction of trade flows instead of a dramatic change in the way the economies have interacted over the last twenty years.
That said, some sectors including technology and manufacturing, will see greater impacts from ongoing tensions as the US seeks to shore up national security (e.g., CHIPS act) in the wake of pandemic dislocations that curtailed production of key goods including vehicles and electronics.
