Why the outlook for the US economy has changed

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Supported by
Vanguard
Why the outlook for the US economy has changed

Cleveland said this was looking less likely  given that labour market data in the US remained strong and lay-offs had not increased.

He said: "That implies to me that rates will keep going up into next year, and then need to pause later in the year, but not be cut."

Rupert Thompson, investment strategist at Kingswood, agreed. He said: “The turmoil kicked off with the meeting of the US Fed last Wednesday. Its decision to hike rates by a further 0.75 per cent  was no surprise but its new forecasts put paid to any hope that rates were now close to a peak and would be lowered again any time soon.

"It is now projecting rates to rise to around 4.5 per cent by year-end and remain around here through next year, with any easing delayed until 2024.The Fed’s doubling down on its hawkish stance followed the inflation numbers of a couple of weeks ago which showed a worsening in underlying inflation pressures.

"Unsurprisingly, the Fed has cut its growth forecasts significantly given the additional policy tightening it is now planning, although it is still not predicting a recession."

Early in 2022, the US economy recorded two consecutive quarters of negative GDP growth, which meets the technical definition of a recession in most economies around the world. That negative reading was confirmed on September 29.

But the US does not use this definition and the designation of a recession is instead within the purview of the National Bureau of Economic Research. 

Cleveland believes the changed inflation data means the US economy will be able to “trundle along” in 2023, and mean there won’t be an incentive for the Fed to cut interest rates.

He said: "I think it would take core inflation to fall quite a lot, to say 0.2 per cent, for the Fed to consider cutting rates, and we are a long way from that."

One feature of the present monetary policy environment is the dollar, partly as a result of the rate rises, and partly as a result of its safe haven status continues to strengthen relative to other currencies.

This effectively exports inflation to Europe, because commodities are priced in dollars, so wherever they are bought in Europe, the price is higher. 

Cleveland says the issue facing central banks in the UK and Europe is that if the Fed continues to raise rates, policy makers must either try to match that to maintain the relative strength of their currency or accept higher imported inflation and try to crush inflation in the domestic economy.

George Lagarias, chief economist at Mazars, said: "Other central banks are compelled to follow to reduce the impact of a stronger dollar, further suppressing their own consumption. Meanwhile financial markets have become very volatile, as the search for the next market-friendly narrative remains elusive.

"The stakes are very high. Political leaderships have a low tolerance for a deep recession. Unless the Fed’s aggressive strategy bears visible fruit within the next few months, the US central bank could be blamed for crashing the fragile post-pandemic global economy.”

Cleveland says the above says the above approach risks central banks lifting rates by more than the respective economies can tolerate, which would likely lead to inflation.

The latter approach would potentially mean allowing inflation to remain higher for longer, a scenario which could also lead to recession. 

But Cleveland doesn’t believe the strong dollar will have a negative impact on the US economy. He said: “It can help keep the costs of US imports low. Though where it could hurt investors is, the value of overseas earnings of US companies could be lower.” 

He adds that if the global economy does weaken, and enter a recession, the tendency is for dollar assets to become a safe haven. That means even if central banks outside the US did intervene to keep their currencies relatively strong against the dollar, if those actions led to a recession outside the US, it would result in the dollar strengthening anyway.   

Anthony Rayner, multi-asset investor at Premier Miton, said markets continue to predict peak inflation, “and keep getting it wrong”, and as long as inflation continues to rise, the dollar is likely to strengthen,  something which dampens the returns available from most asset classes as liquidity is reduced.  

Reduced liquidity occurs because dollar strength makes the income from US government bonds relatively more attractive, causing US investors to bring the capital they had deployed over seas back home. 

In terms of what the central banks dilemma means for investors, Thompson said: “The temptation at times of market turmoil is always to bail out. However, the indisputable lesson of history is that this is the wrong course of action for any investor with a medium to long-term horizon.

"Over the last 50 years, there have been numerous crises and sell-offs and yet equities have always managed to recover and produce long-term inflation-beating returns. Trying to time a market bottom is all but impossible and risks missing the best performing days in any rebound, which has proven very costly in the past.

"This is far from saying that we are taking no action on our client portfolios. But it is all about rebalancing, rather than wholesale de-risking. Bonds for instance are looking considerably more attractive now they are once again paying a respectable yield. As for equities, a considerable amount of bad news is priced in and sentiment fast approaching rock-bottom levels” 

Rayner is another who is now relatively more positive on the US, as he believes its economic outlook is now profoundly better than that of the UK. 

david.thorpe@ft.com