The economy is holding up better than expected, but recession risk remains.
In the third quarter, easing inflation and stronger economic growth helped fuel optimism for a soft landing. However, monthly data suggest economic momentum is slowing, and we may not be out of the woods just yet.
Business spending has held up more strongly than expected due to higher spending on manufacturing and slowing corporate profits could still constrain growth in capital expenditures.
The housing market appears to have stabilized, albeit at low levels, due to tight housing supply. Trade should be a mild drag on the economy due to the lagged impact of a strong dollar and slowing momentum from the global economy.
Overall, the U.S. economy should continue to grow at a moderate but slowing pace from here, and while a near-term recession is not guaranteed, a slower-moving economy will be increasingly sensitive to shocks. With risks remaining on the horizon, we see at least a 50/50 chance of a recession starting by the end of 2024, and a greater chance of a recession in 2025 if one fails to materialize earlier.
The labor market is gradually easing.
Labor market strength is gradually easing. The pace of job gains, while still robust, has been trending lower since last year. Improved labor force participation has so far supported job growth, with the participation rate for adults aged 25-54 having fully recovered to pre-pandemic levels.Overall, the labor market still looks strong, and the risk of a recession this year remains low. However, cooling demand for labor suggests that job growth should decelerate in the coming months.
The unemployment rate should remain low until we see a recession.
A tight labor market has allowed the unemployment rate to hover around its 50-year lows despite cooling demand, averaging at 3.6% this year despite rising to 3.8% in August. Importantly, cooling labor market conditions have contributed to a moderation in wages, which only grew by 0.2% month-over-month in August for all private workers. Wage growth has now come down to 4.3% year-over-year from a peak of 5.9% in March 2022 and, while still above its long-term average, we do not see it contributing
Because of this, the unemployment rate may only nudge slightly higher in the year ahead despite businesses reeling back hiring efforts in the face of slower demand and higher costs. However, wage growth should continue to decelerate and help give the Federal Reserve confidence that inflation is sustainably coming down.
Inflation is gradually falling to more manageable levels.
After nearly two years of hot inflation, a sustained inflation downtrend is now underway. Headline CPI inflation has fallen from a peak of 9.1% y/y last June to 3.7% y/y in August. Similarly, core inflation has shown a continued downtrend after peaking eleven months ago.While inflation may still be above the Fed’s 2% target, it is gradually falling to more manageable levels. Indeed, we expect CPI inflation to decline to 3.0% year-over-year by the end of this year and to 2% by the end of 2024, even without a U.S. recession.
The Federal Reserve is near the end of its tightening cycle.
The Federal Reserve (Fed) has hiked rates by a cumulative 5.25% over the last 18 months in an effort to battle inflation. At their September meeting, the Fed left the federal funds rate unchanged in a range of 5.25% – 5.50%. While this move was widely telegraphed, forward guidance was still moderately hawkish. Indeed, the median FOMC member still expects one more rate hike this year, but now expects only two cuts in 2024.
Global economic momentum, outside the U.S., is more mixed.
At the end of last year, the global economy was losing steam with only 27% of the countries shown on page 48 registering a manufacturing PMI above 50, the level associated with accelerating economic momentum. Since then, Europe avoided an energy-induced recession and China lifted its “zero-COVID” policy, raising the prospects for stronger global growth momentum. However, both the Eurozone and China have proven weaker-than-expected, leading to a more challenged global picture.With sluggish growth in Europe and China offsetting stronger growth from India and Japan, global activity may be challenged in the coming months. However, lower export prices from China could help the global fight against inflation and a resumption in the dollar’s decline should boost returns for U.S.-based investors. Moreover, emerging markets have performed better outside of China, and investors may find better entry points to key secular themes in technology in east-Asian markets than in the U.S.
Despite this year’s rally, many asset valuations still look reasonable.
In the wake of last year’s broad market sell-off, lower valuations presented investors with a new slate of opportunities across asset classes. Markets have since seen solid gains in 2023, but this rebound has not been evenly distributed. While valuations still look better compared to the end of 2021, some asset classes look more attractive than others.As investors assess positioning for the rest of the year and 2024, it’s important to assess both risks and opportunities after this year’s market rally. Within equities, investors may want to lean into international markets and focus on finding attractively valued companies poised to drive long-run returns, diverting some focus away from the top few stocks that have driven this year’s gains. Moreover, the current opportunity presented in fixed income could pass rather quickly once the Fed begins lowering rates, and investors would be well served to take advantage of current yields.
A wide dispersion in stock valuations point to opportunities for active management.
A surge among some of the largest tech stocks have driven strong gains in the S&P500 so far this year. While this year’s performance is a welcome rebound from last year’s dismal returns, with the S&P500 now trading above 18 times forward earnings, valuations look stretched and warrant some caution. That said, for active managers looking beneath the surface, there are still plenty of attractive opportunities.Environments like these are where active management shines. While investing passively will likely lead to an overweight to expensive parts of the market, active management allows investors to lean into the undervalued segments of the market, and prudent security selection is even more important if stretched valuations are a warning of future market pullbacks.
