Navigating the Narrative Seas: The Journey to a Soft Landing in the US Economy

In the realm of finance, narratives are akin to the changing tides of the sea, dictating the direction of markets and investor sentiment. The narrative surrounding the US economy has been particularly dynamic, oscillating between the spectre of a looming recession and the emergence of a softer economic landing, in which a recession is avoided. What began as a consensus view veering towards a recession has given way to a fresh narrative bolstered by recent economic indicators, thus painting a more optimistic picture of the economy's resilience. 

The Narrative Shift

As headlines in financial publications like the Financial Times painted a portrait of economic uncertainty, market participants found themselves in the throes of recession apprehension. However, economic views are malleable, and the present narrative is charting a course back toward the idea of a gentle, gradual economic slowdown—a soft landing. 

This narrative shift is rooted in a retrospective analysis of data covering the first half of the year, despite the persistence of certain forward-looking indicators pointing toward a recession. While the prospect of a recession still looms on the horizon, the new storyline proposes an alternate trajectory—one marked by controlled inflation, steady economic growth, and an intact labour market.

•  Unravelling the Soft Landing 

The essence of a soft-landing hinges on the notion that inflation can be reined in organically, gradually returning to target levels. All this, while avoiding the upheaval of a recession or labour market turmoil—a true Goldilocks scenario in which economic growth is sufficient to avoid a recession but not so much growth that stokes inflation. So not too hot, not too cold! The ensuing data points offer insights into the prevailing economic landscape.

•  Inflation's Journey

Key to this narrative is inflation—a metric that draws both public and policymaker attention. The Personal Consumption Expenditure (PCE) inflation measure, a yardstick favoured by the Federal Reserve, portrays a telling tale. Distinguished into core (excluding food and energy) and headline (all-inclusive) inflation, both measures have shown marked progress. While they remain above the coveted 2% target, the trajectory of a downward trend for both core and headline inflation has bolstered the case for a soft landing.

•  GDP Growth Defying Expectations

Gross Domestic Product (GDP) growth, a cornerstone of economic health, has defied predictions. The first half of the year saw GDP growth rates surpass earlier forecasts, registering at around 1.5% for the first quarter and a notable acceleration to nearly 2.5% for the second quarter. This growth rate has significantly outpaced consensus estimates, offering an encouraging sign of economic resilience. Quarter 3 forecasts by the Atlanta Federal Reserve show a further acceleration.

• Resilient Real Estate and Construction 

The real estate sector's robustness has been a star player in the narrative shift. Strong  new home sales and positive construction activity, have reinforced the idea of a soft landing. New home sales, a cyclically influential sector due to its capital-intensive nature, have surged, while construction activity in residential real estate has maintained its momentum. Government policies such as the CHIPs Act and Inflation Reduction Act promoting manufacturing, investment have also spurred construction activity in this sector. 

• Consumers Propel Economic Strength 

Aggregate consumer spending, summarised by Personal Consumption Expenditure (PCE) , provides a crucial metric to gauge economic vitality. Comparing spending patterns to historical cycles, the resilience of spending on goods and services has been conspicuous. This suggests consumer confidence and willingness to contribute positively to economic growth by continuing to spend—a testament to the prevailing strength of the economy. 

Deciphering Resilience 

How can we account for the more positive economic indicators that have created the shift in narrative? The explanation lies in understanding the evolving economic composition. 
The declining influence of cyclical sectors, particularly manufacturing and construction, has rendered the economy less susceptible to interest rate fluctuations. Corporations' robust cash balances have also cushioned the impact of higher interest rates on net interest expenses as they earn high short-term interest rates on their cash, while paying lower interest rates locked in during the pandemic on their longer-term borrowings. 
The inertia in existing home sales due to homeowners' reluctance to leave favourable mortgage rates, has sustained the strength of new home sales and consequent construction activity. 

Points of Fragility

Weakening labour markets could impact existing home sales. The hiring intentions of the National Federation of Independent Businesses (NFIB) have dipped, albeit amid an overall strong labour market, potentially influencing housing dynamics. One of the only times people stop paying their mortgage is when they lose their job, so should the labour market weaken, and unemployment rises, this could cause existing home sales to rise as people struggle to be able to afford to pay their mortgages and therefore, conversely, blunt the economic activity usually associated with new home sales.

Higher interest rates may eventually ripple through businesses, as they are forced to refinance into higher interest rates. The leveraged loan market is a portion of the corporate debt markets where lower quality companies go to borrow money and in this market, interest rates tend to be floating rather than fixed, this market has seen an uptick in defaults as these firms are the first to deal with high interest rates. Corporates have also cut their bond issuance significantly as interest rates have risen, suggesting many firms could not stay solvent if they were to refinance at current high interest rates.

Conclusion 

In the dynamic world of finance, narratives wield the power to steer markets and investor sentiment. The evolution of the US economic narrative, from recession fears to a brighter outlook, exemplifies this phenomenon. The shift towards a gentle economic slowdown, marked by controlled inflation, robust GDP growth, and a resilient labour market, defies earlier projections of recession apprehension. Inflation's retreat and GDP surpassing forecasts underscore the narrative of a soft landing. The real estate sector's vitality, consumer spending resilience, and evolving economic composition further explain the recession's avoidance. Despite potential fragilities such as labour market shifts and interest rate challenges, the economy's resilience shines through, reaffirming its dynamic nature.

Although this Market Update is focussed on the US economy, as the old adage says ‘if the US sneezes, the rest of the world catches a cold’, so what we are seeing in the US is likely to be significant globally and affect your investments. 

Note: This Market update is for general information only, does not constitute individual advice and should not be used to inform financial decisions. Additionally, past performance is not a guide to future returns. Investment returns are not guaranteed, and you may get back less than you originally invested.