The current economic landscape is characterized by moderating growth momentum – consistent with our base-case expectations of a labor market rebalancing from the extremely tight conditions in 2022. However, this growth slowdown leaves investors grappling with a challenging question: Is the slowdown a precursor to a recession, or a benign slowing that will ultimately extend the economic cycle?
We believe it is benign but a slowing growth trend can make market participants uneasy as they recalibrate their growth expectations.
Recent data: Consistent with a soft landing
We maintain our base-case view that U.S. growth should gradually slow to a trend-like pace of around 2%, providing scope for extending the economic cycle. We assign a 20% probability to a U.S. recession over the next 12 months – slightly above the baseline estimate of 15% in any given year.
Recessions are typically breaks in an economy’s behavior caused by the interaction of an adverse shock with imbalances built up in the economy over the cycle. The rapid Federal Reserve (Fed) hiking cycle of 2022–23 might be counted as such a shock due to the speed and size of monetary tightening. However, the factors that typically precipitate a recession – signs of exuberance, extended leverage or significant imbalances, for example – are absent, supporting our view that recession risks for the U.S. economy are relatively contained.
Nor does the constellation of current economic indicators suggest an imminent downturn. The trends evident in recent data releases have confirmed that the U.S. economy’s disinflation trajectory remains intact, and the backdrop is one of resilient growth in economic activity. A tame CPI print in July validated this optimistic view of inflation, countering a string of upside price surprises at the beginning of the year. Looking ahead, we continue to expect some disinflation in core services, particularly shelter, and forecast core inflation moving closer to the Fed’s target in 2025, amid easing wage pressure.
The U.S. consumer also appears solid. Robust retail sales data for July – sales rose 1.0% month-over-month and the control measure increased 0.3% – has alleviated concerns about demand deterioration. This trend, combined with positive carryover effects from previous months, suggests real U.S. consumer spending is off to a good start in Q3 and is likely running at a solid annualized pace of around 2%. Initial jobless claims have stopped moving higher over the past three weeks, further dispelling the narrative of an imminent collapse in U.S. demand.
A synchronized global easing cycle
Aggregating the latest data with our views on the cycle, we now expect the Fed to start cutting rates in September. Fed Chair Jerome Powell’s remarks last week at the annual Jackson Hole symposium, that “the time has come for policy to adjust,” reinforced this idea, although he did not say whether the initial cut would be 25 basis points (bps) or 50bps. That decision will depend on incoming data, especially the August jobs report.
Powell's speech leaned dovish, highlighting the Fed's focus on the labor market and on diminishing inflation risks. He noted that nominal wage inflation has moderated and that labor market conditions are less tight than before the pandemic, reducing the likelihood of labor-driven inflation. Powell stressed that the Fed does not seek further cooling in the labor market but aims to support a strong labor market while achieving 2% inflation.
Powell's comments suggested the central bank will take a flexible approach, and left open the possibility of larger cuts, if they prove necessary to address labor market weaknesses. The change in tone reinforces that the Fed has shifted its focus from inflation first to jobs first – and that policymakers are committed to a forward-leaning risk management approach. We continue to look for the Fed to start the easing cycle with a 25bps cut in September and anticipate two to three cuts of 25 basis points this year.
More broadly, central bankers’ comments in Jackson Hole confirmed that progress on disinflation has paved the way for a global easing cycle. The European Central Bank, the Bank of England and the Bank of Canada have already kicked off policy easing and are expected to continue cutting rates, in alignment with the Fed. In some cases, these central banks may adopt a more aggressive stance on rate cuts if inflation continues to cooperate, which would further support global economic expansion.
Asset class implications
Moderating inflation allows central banks to reduce rates closer to neutral levels, something particularly supportive of duration in Europe, the U.K. and other regions where growth momentum is tepid and inflation is cooling. This environment should create opportunities for investors to capitalize on supportive monetary policies and the resulting market conditions.
In the U.S, we maintain a neutral stance on duration. The market is currently pricing in more than 200bps of cuts in the upcoming rate cutting cycle, exceeding our base-case expectations of four to six 25bps cuts in all. We believe the range for the U.S. 10-year bond yield is between 3.75% and 4.5%.
Although the market is closer to the lower end of this range, we do not yet think it is time to move to underweight duration in our portfolios. There are three main reasons: Currently high bond market volatility (the MOVE index is still hovering above 100, vs. a long-run average of 90) makes it challenging to have strong conviction in any directional move.
Second, in periods of growth scares, the correlation between stocks and bonds can turn negative, enhancing the diversification benefits of holding bonds. Finally, we prefer to wait for the Fed to initiate rate cuts before reassessing our stance on duration.
In equities, we maintain our preference for the U.S. equity market. A robust U.S. macro backdrop, our base case, should continue to support demand, and corporations’ top-line growth. Our earnings outlook also supports a pro-risk stance. We continue to view as achievable year-over-year earnings growth of around 8% in 2025.
The latest strong 2Q 24 U.S. earnings season, in which earnings grew around 11%, surpassing the expected 8% rate, offered further evidence that corporate health remains decent overall. While the Magnificent 6 and their sectors – communication services and IT – contributed significantly to 2Q 24 earnings growth, this time we also saw other sectors, including health care and utilities, slowly emerge from their earnings recession to deliver earnings growth. This supported our expectation that earnings growth would broaden out beyond the familiar tech leaders.
As we continue to lean into the U.S. equity market, we acknowledge that our base case of an economic rebalancing, in which U.S. growth gradually slows to about 2%, seems to already be priced in at the current price-to-earnings multiple of 21.2x (Exhibit 1).
To be clear, we believe that valuation expansion will likely be limited. But we think that positive earnings, and a robust macro environment, can help equity markets maintain their momentum.
However, at current valuations, technicals and positioning in equities become all the more important to monitor. Should various gauges of equity positioning and technicals begin to look stretched, it will be prudent to right-size any portfolios that are overly exposed to risk.
