Thematic View: What if there’s a slowdown in the US economy (part 2)?

Market and economic highlights:

• A key focus of attention for the year has been the geopolitical tensions in the Middle East and Eastern Europe.  We have, of late, seen an escalation in the conflict in the Middle East that poses some risks to the global inflation outlook.
• While inflation in March continued to trend down across most economies, it is in the US that it has proven to be most sticky. It thus becomes incrementally more difficult for the US Fed to justify a cut in interest rates in the near term. The market consensus is for one 25bps cut in December.
• US growth was also in sharp focus towards the end of April. Most market participants were expecting a modest slowdown in growth in the first quarter this year from the buoyant 3.4% print in the fourth quarter last year. Growth surprised materially to the downside, coming in at 1.6%, primarily driven by weaker consumption, government expenditure and exports (see below for more on the risks to growth).
• In a lower growth environment, we would expect inflation expectations to be anchored lower and the market to reprice interest rate cut expectations. However, a material beat (3.7% versus 3.4% expected) in core personal consumption prices in the US in the first quarter means the Fed may opt for interest rates to remain higher for longer.
• In South Africa, the country moves steadily towards the National and Provincial government elections. Polls released in March by the Brenthurst Foundation and the Social Research Foundation suggest that the ruling party remains on a slippery slope toward significant electoral losses. However, we note that predicting election outcomes is inherently difficult, and polls are not always completely independent.

Thematic View – What if there’s a slowdown in the US economy (part 2)?

In the last edition, we looked at the various obstacles to continued robust economic growth in the US this year. While we acknowledge that we, along with most of the market, got the GDP projections wrong over the last fiscal year, it’s important to highlight some of the risks that could hamper economic activity from now on.

In this thematic view, we look at the most important facet of GDP in the US, consumption. This is particularly important given how strong consumption was in the US over the last year (see chart 1 below, showing that consumption was up 2.2%) despite high interest rates. In the current environment, the typical monetary policy transmission mechanism has proved evasive: economic activity has been healthy, and we haven’t seen the archetypal downturn that usually follows a sharp rise in interest rates.

Given the strong economic activity in the US, it is becoming incrementally more likely that the US Federal Reserve’s (US Fed) Federal Open Market Committee (FOMC) will keep interest rates higher for longer to induce an economic slowdown. Higher rates for longer will prolong tight financial conditions in the US, which should lead to “some” economic stress.

As we head into the second quarter of 2024, there is now broad consensus that not only will the US economy avoid a recession (no “hard landing”) but also that there will be no material slowdown at all (“no landing”). In this article, we interrogate this position and look at some of the risks relating to potentially weaker economic growth in the US relative to the key drivers of economic activity last year.

Chart 1: Growth among the various components of GDP (for the US)

Date sampled: 15 March 2024
Source: Investec Wealth & Investment, BEA

As Chart 1 shows, the key drivers of GDP growth in 2023 were exports (+2.7%), government expenditure (+4%) and consumption (+2.2%), while the drags on US economic activity were investment and imports. Following on from our last edition, let’s zone in on these questions:

1. What could happen to consumption? Elevated interest rates and their lagged effects on consumption may continue to filter through the system. Inflation expectations suggest a more subdued consumption environment. Remember, consumption makes up around 70% of the US economy, and any material changes to consumption would have a material impact on economic activity.
2. What could happen to gross fixed capital formation (i.e. investments)? Gross fixed capital formation by the private sector and government has been below trend over the last two years and in the last quarter of 2023 breached the long-term trend. In essence, we answer the question: "What are the implications of greater investment on the US economy?”
    

Consumption

In 2023 we highlighted various risks to consumption and the relative impact that lower consumption would have on taxes (particularly the profitability of corporates when consumers are spending less). However, in this article, we analyse the relative impact of lower consumption on GDP growth, cognisant of consumption’s contribution of around 70% of GDP.

Chart 2: Core consumption and inflation

Date sampled: 26 March 2024
Source: Investec Wealth & Investment, Bloomberg

The first point related to risks around consumption is that inflation and consumption in the US are highly correlated, meaning that when inflation is high that is typically associated with high consumption and vice versa. This is important relative to where inflation in the US is currently, and where it is trending towards. Inflation in the US is currently at around 3%. But the real question is, what is the underlying driver of consumption and inflation? The answer is interest rates. High interest rates imply that inflation should continue to weaken from current levels, given that the underlying objective of restrictive monetary policy is to bring inflation under control.

Chart 3: Core consumption and the federal funds rate

Date sampled: 26 March 2024
Source: Investec Wealth & Investment, Bloomberg

Interest rates are a leading indicator of consumption in the US, and as expected, we have seen a sharp decline in core personal consumption expenditure. Higher interest rates are therefore negative for consumption. This implies that from a consumption perspective, there is some reason to be cautious about GDP growth expectations in the US, particularly in an environment where the US Fed is unable to justify reducing interest rates and where restrictive monetary policy stays in place for longer.  The first quarter’s GDP growth print of 1.6% annualised (vs expectations of 2.5%) may be a sign of this playing out.

Chart 4: The relationship between wage growth and nominal GDP growth

Date sampled: 26 March 2024
Source: Investec Wealth & Investment, FRED

Our departure point is the link between nominal GDP growth and wage growth. There is a positive correlation between nominal wage growth and nominal GDP growth. This suggests that a slowdown (for example the US economy slowing from 2.5% to 2.1% or lower) should result in weaker wage growth, which similarly impacts consumption as disposable income growth is lower. We have also seen that as the economy has slowed after the initial boom in the post-Covid-19 economic recovery period, so has wage growth (around 5.0% in Jan 2024). Wage growth has been on a sustained downward trajectory since the third quarter of 2022.

Chart 5: US overall wage growth

Date sampled: 26 March 2024
Source: Investec Wealth & Investment, BLS

There is similarly a link between wage growth and personal consumption expenditure. Weaker personal consumption expenditure has some important implications for the broader economy (non-exhaustive list):

1. Weaker consumption is negative for GDP.
2. Weaker spending in the economy is negative for revenue growth for corporates, and therefore impacts the profitability of firms and this can lead to job losses.
3. The weaker profitability of firms, as a function of weaker consumption, can lead to lower corporate tax revenue collection.

Therefore, if interest rates remain elevated and continue to influence the current trajectory of inflation and wage growth, thus having a material adverse impact on consumption, this will have a major impact on US GDP growth outcomes.
 

Investment

Chart 6: Year-on-year change in gross fixed capital formation in the US

Date Sampled: 26 March 2024
Source: Investec Wealth & Investment, FRED

In this section we explore the relationship between gross fixed capital formation (GFCF or investment) in the US and its impact on nominal GDP growth. Our departure point is exploring the most recent trends in gross fixed capital formation relative to history. In the final quarter of 2023, we saw GFCF resurge back to above-trend levels for the first time since two years ago. The recovery in GFCF should be good for growth, particularly if it is driven by the private sector at a time when we have argued the US government is set to become more fiscally constrained. One risk worth highlighting when it comes to private sector investment however remains the elevated level of interest rates in the US, and the attached cost of capital, making private sector investment expensive to fund. The same is true for the government; if it prints/issues more debt it would face increased costs of capital.

Chart 7: Nominal GDP growth and gross fixed capital formation

Date sampled: 26 March 2024
Source: Investec Wealth & Investment, FRED

Chart 7 above highlights how nominal GDP growth and gross fixed capital formation move together, which ought to be expected given that GFCF is a component of GDP. The question that we pose then is “How much do changes in investment impact GDP?”. This is done through regression analysis which explores the inherent link between GDP and gross fixed capital formation.

Table 1: Regression of nominal GDP growth and gross fixed capital formation

Date sampled: 26 March 2024
Source: Investec Wealth & Investment

The regression results indicate that there is a positive correlation between nominal GDP growth and the year-on-year change in gross fixed capital formation. We are cognisant of the limitations of the regression given the limited number of variables, however, the point to bear in mind is that as gross fixed capital formation recovers, this should be positive for nominal GDP growth. We have indicated that recent data suggests gross fixed capital formation has breached the long-term trend level of 3.3% and this should be a tailwind for growth expectations in the US.
 

So what?

In an environment where GDP growth slows, and we face some risks that the slowdown may be marginally more material than previously expected, we would expect earnings to come under pressure. Out of the sample of data we have explored over the last few weeks, gross fixed capital formation appears to be the variable out of the GDP equation that should remain robust. There are a variety of factors set to influence consumption, net exports and government expenditure in the coming year, which we should continue to monitor as data is released. Given our analysis around GDP growth expectations potentially being elevated, this implies that consensus estimates for earnings growth in the US may be somewhat optimistic given that earnings are expected to grow by around 12% this year.

Chart 8: Earnings growth and GDP growth

Date sampled: 14 March 2024
Source: Investec Wealth & Investment, Bloomberg

The chart above shows how low earnings growth is typically associated with a lower GDP environment.

But it is not all doom and gloom. Economic growth could remain robust in the US, even in an environment when there are some reasons to expect that economic activity may unwind, for example if inflation falls by more than expected. Lower inflation is good for real (inflation-adjusted) GDP growth.

The US economy will certainly keep us on the edge of our seats over the company year, especially given the role it plays in the global economy. The US remains a key trading partner for South Africa, and an incrementally more robust economic environment in the US will be good for South Africa’s economic performance (particularly our exports, should our logistics and energy situations improve).

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