Inflation Persists
Inflation appears to have peaked in the United States as the rate of increase in service-sector inflation has moderated. We continue to see inflation above the Fed’s 2% target rate but cannot rule out a brief period of deflation should the labor market weaken faster than we expect.
For now, month-on-month core inflation remains above target. This has sustained the Fed’s concerns about price stability and lies behind its hawkishness around an additional rate hike in July.1
The Fed’s past aggressive rate increases remain a concern. The Fed has raised rates by the most since the early 1980s, helping to create the conditions that have pressured the U.S. banking system and concern among business leaders.
Credit Tightening
MIM’s proprietary default rate leading indicator for Q1 suggests we are in a period of “danger” for increased defaults.
We expect the ongoing tightening of bank lending standards to continue. In our view, the additional stressors, such as the “rescue” of another regional bank in April, the subsequent regional bank volatility seen in equity markets, the increasing reliance on more expensive funding, such as Federal Home Loan Bank advances, and the continued burden of higher rates would add another headwind to economic activity.
Consumers Resilient
Consumers have been reaping the benefits from a tight labor market, as real disposable personal income has continued to improve over the past year. Over this time, the consumer has been maintaining a relatively healthy rate of consumption growth. Given the behavior of consumers post-COVID-19, we believe it is unlikely that consumers would willingly pull back on consumption during the end-of-year holiday season and, as a result, do not expect that we would see the start of the recession during the fourth quarter.
Nevertheless, we see the rise in credit usage, a higher savings rate and relatively poor consumer confidence as reasons for caution about the sustainability of this growth driver and believe that efforts to maintain consumption through the holidays may result in a sharper slowing when the labor market weakens.
Risks to the Outlook
The combination of aggressive rate hikes coupled with banking stress suggests a higher probability that the Fed is either stuck—unwilling to risk a banking crisis to curtail inflation pressures if that is what is required—or will be forced to push rates in excess of what is needed in the medium term to lower inflation to its target. We see the labor market has been more resilient than had been anticipated. This raises the risk of a low unemployment, higher, for longer inflation scenario at the expense of a normal recession or a soft-landing scenario (where the Fed seems set to achieve its inflation target with only a modest increase in unemployment).
U.S. Outlook Summary
We expect that a recession is likely to be avoided until 2024. Growth in the United States is expected to be 1.7% in 2023 but fall to -0.2% in 2024, when MIM anticipates three quarters of negative growth. Inflation is likely to be near 3% at year-end 2023 but move below that level during the recession.
The federal funds rate is expected to peak at 5.25-5.50% as the Fed hikes rates one additional time in 2023. We no longer expect the Federal Reserve to cut rates in 2023 but do expect a substantive rate cut cycle to begin in the first half of 2024.We foresee a 10-year U.S. Treasury yield of 4.00% at year-end 2023. We continue to believe the peak in yields for this cycle has occurred. We expect the yield curve to remain inverted for some time. As with its other recent course changes, the Fed is likely to be slow, delaying cuts—and therefore yield curve normalization—until a recession is already under way.
As noted in our Q3 2023 Relative Value Allocation, we do not think credit markets have priced in sufficient downside risk yet. Looking forward, the credit cycle is expected to turn in the coming quarters, with spreads widening further on continued recession risk. As a result, we continue to tilt toward “up-in-quality.”
Endnote
1 Source: Summary of Economic Projections, June 14, 2023 (federalreserve. gov); Financial Stability and Economic Developments, speech by Chair Jerome H. Powell, June 29, 2023
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