Inflation Vanquished?
Monthly inflation over the last two months has, according to the BLS, tracked at 1.9%, below the Fed’s 2% target.
BLS data also show goods prices have deflated over the past two months. Services, aside from shelter, have fallen below their long-run average inflation rate. Even rent has seen deflation over the past two months. But we don’t expect outright headline deflation in the near term.
The main concern is housing. Housing shortages and lack of inventory have led to a rebound in home price growth since January, with the Case-Shiller home price index coming in at an annualized average of 13%, compared with its long-run average of 5%. The Housing Affordability Index, which considers price and mortgage rates, shows housing is at its least affordable since July 1985.
Looking forward, it’s unclear how the situation will be alleviated. Housing construction hasn’t had a robust response to the shortage, with Census data showing minimal growth in units under construction.
Credit Still Tightening
We expect the ongoing tightening of bank lending standards to continue for some time.
The most recent Senior Loan Officer Survey suggests that lending standards are close to recession levels. Loan demand remains weak. We believe recent bank downgrades will only exacerbate any unwillingness to lend.
On the consumer side, Federal Reserve data shows credit growth has declined from its peak of 7.6% in 2022 to 4.3% in June as consumers increased their debt burden more slowly. It has some ways to go before becoming contractionary but appears to be weakening.
Consumers Remain Optimistic
Consumers continue to reap the benefits of a tight labor market and moderating inflation, and consumer confidence has had two months of surprising improvements — moving the indicators from red to green in our table. We expect consumers to continue spending on services, and also increase goods purchases as prices fall due to goods deflation. Given the behavior of consumers postCOVID-19, continued strong consumption expenditures and the upcoming holiday season, we do not expect consumers to willingly slow down spending going into the fourth quarter.
However, higher credit usage, low savings rates and restarting student loan payments may cast a shadow on the sustainability of consumer strength and spending, especially if the labor market weakens.
Risks to the Outlook
The risks to the outlook remain significant. The U.S. fiscal situation is concerning and has deteriorated in recent months as the growth in interest payments accelerates, claiming an increasing share of tax revenue.
We do not expect substantial near-term effects from the U.S. credit downgrade, but a longer-term concern is the potential for other credit ratings to reset relative to the new debt rating.
Heading into the fall, we are likely to hear more about a potential government shutdown, which would increase market volatility, particularly in light of the credit downgrade.
U.S. Outlook Summary
We expect that a recession will likely be avoided until 2024. We have raised our U.S. growth forecast to 2.1% in 2023 on the back of an unexpectedly high Q2 GDP print. We have also raised our 2024 forecast to 0.0% (from -0.2% previously). Despite the improvement, we still expect at least two quarters of negative growth in 2024.
We believe the Fed has completed its hiking cycle with the July rate hike. We expect a rate cut cycle to begin in 2024, whether or not a recession takes place.
We foresee a 10-year U.S. Treasury yield of 4.00% at year-end 2023. We believe, the downgrade to U.S. debt is unlikely to lead to an enduring rise in rates, although they are approaching cycle highs.
As noted in our Q3 2023 Relative Value Allocation, we still do not think credit markets have priced in sufficient downside risk yet. Looking forward, we expect the credit cycle to turn in the coming quarters, with spreads widening further on continued recession risk. As a result, we continue to recommend “up-in-quality.”
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