The latest combination of high US inflation and slower economic growth has increased market worries over stagflation. But for now, weaker growth seems to be just what the economy needs.
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After three months of high and higher-than-expected inflation in the US, investor hopes for a ‘soft landing’ – that is, inflation returning swiftly to the Federal Reserve’s 2% target with only a modest slowdown in growth – have been disappointed.
Growth, however, has continued to slow. If the weakness in the economy persists while inflation remains high, the environment could eventually become stagflationary. In the worst case, the slowdown would go so far as to turn into a recession.
The most recent data pointing to a less robust economy concerned private, non-farm payrolls. Just 167 000 jobs (seasonally adjusted) were created in April after 243 000 in March; a 180 000 rate had been expected. The unemployment rate rose slightly.
Encouragingly (at least from the Fed’s point of view), the higher unemployment rate was accompanied by slower wage growth: this fell from 4.1% year-on-year to 3.9% as measured by average hourly earnings.
Wage growth has been viewed as a key driver of services inflation. One should not be too comforted, however, as the rate of growth in average hourly earnings has been declining for months, while core services inflation has risen.
One reason can be seen in another measure of wage inflation: the Employment Cost Index. The ECI remained high in the first quarter. As it is the Fed’s preferred measure of wage inflation, policymakers will not put too much weight on the decline in average hourly earnings.
Besides the labour market data, the most recent release of purchasing manager indices (both by S&P Global and the Institute for Supply Management) similarly point to modestly weaker economic growth.
The two services indices fell in April, though one indicator was below 50 (indicating a contraction of the services sector), while the other one was above.
The situation was similar for the manufacturing sector: both figures decreased; while one fell below 50, the other stayed above. One can conclude that the rate of economic growth slowed, but it is unclear whether there is in fact a contraction.
Soft landing delayed, not aborted
To round out the picture, US first-quarter GDP appeared to confirm a deceleration. The economy expanded by just 1.6% (seasonally adjusted annual rate, SAAR), when the consensus estimate had been for a 2.2% increase after the 3.4% gain in the fourth quarter of 2023.
The modest headline figure, however, is misleading. Looking at the components, one sees that growth in the demand factors (consumption and investment) remained robust. Only a decrease in inventories and net exports pulled down the overall figure (see Exhibit 1).
The change in inventories and net exports is itself a reflection of the strong demand: domestic producers were not able to meet the demand for goods and services and so they had to draw down inventories or turn to imports. Excluding these two factors, GDP growth was above 2.5%.
The slowdown seen recently is encouraging, insofar as it is necessary for inflation to revert to the Fed’s 2.0% target. Inevitably, there is a worry that it will go too fast or too far, or that inflation will not decrease quickly enough, but investors should be more encouraged than worried by the recent developments. The soft landing will likely only be delayed, not aborted.
Whither US interest rates
Thanks to the high inflation data over the last few months, expectations for the number of cuts in policy rates from the Fed we might see this year has fallen from nearly seven to at times nearly zero. After the latest non-farm payrolls data, it has moved back to a range of one to two.
The 10-year US Treasury yield peaked at 4.7% on 25 April, but has since fallen back to 4.5%. The market odds of a rate cut by the Fed in June are low, but might change again if inflation moderates in the next two months.
Whether we’ll see a rate cut in September (the market is currently placing around a 50% probability on a cut) will be as much a function of political as well as economic considerations. The Fed might be reluctant to change policy rates close to the November election so as to not appear to be trying to influence the outcome. Consequently, it may not be until later in November or even December that the Fed actually cuts rates, though that too could depend on the outcome of the election.
Equity indices have held up
Alongside the decline in rate cut expectations, real (inflation-adjusted) 10-year bond yields have risen by around 50bp this year. This has had the predictable effect of weighing on equity prices, particularly those of growth stocks: the tech-heavy NASDAQ 100 is currently 2% off its peak from late March.
Given the size of the increase in yields, however, one might have expected a bigger fall in equities. What has sustained the stock market have been good earnings reports, both for US and European equities.
NASDAQ 100 companies had been expected to show a roughly 20% increase in first-quarter earnings, Russell Value companies a roughly 5% decline, and S&P500 companies a 7% increase. Earnings for companies in the MSCI Europe index had been forecast to drop by around 10%.
The results so far have been rather better. Earnings surprises have been over 7%, when a typical quarter sees results only 3-4% higher than forecast (see Exhibit 2).
Assuming the policy rate expectations (and real yields) do not move much higher, earnings should remain the primary driver of equity indices. And as long as the slowdown in economic growth does not go too far, earnings should continue to rise.
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