The US economy keeps on producing positive surprises, and there is increasing optimism it will be able to perform the soft landing that so few economists were predicting at the start of 2023.
That would mean inflation falling back to the 2 per cent target at the same time as the economy avoids a recession. Annual inflation in October was 3.2 per cent; below economists’ expectations and down from the 3.7 per cent in September.
The assumed wisdom was that the economy would have to shrink for price growth to fall this quickly. However, as of the third quarter of this year, real gross domestic product grew at 5.2 per cent (the US, unlike the UK, uses annualised figures for its GDP data) and the unemployment rate is still yet to rise above four per cent.
All this despite the effective Federal Funds Rate rising from 4.3 per cent to between 5.25 and 5.5 per cent over the course of the year. The impact of this on the stock market has also surprised some observers. Rather than remaining under pressure as they were last year, tech giants Alphabet (US:GOOGL), Amazon (US:AMZN), Meta (US:META) and Microsoft (US:MSFT) have all seen their share prices rise at least 50 per cent year-to-date. In the case of Meta, shares are up 155 per cent.
This is in part due to the growing belief that the largest tech stocks will be the ones that benefit most from the demand for artificial intelligence (AI) software. Rather than being priced as growth companies whose future cash flows are revalued as interest rates change, these mega cap companies are seen as too big to fail, and their returns have powered the S&P 500 this year.
The issue for mid and small-cap companies, by contrast, has been the simmering recession fear. Despite the positive data, there was always a thought under the surface that the economy would eventually starting shrinking due to one of the fastest hiking cycles in history. “Higher interest rates, the looming fear of recession and general uncertainty have all contributed to holding back the mid-market growth stocks,” Chris Armbruster, a portfolio manager at US investment manager Kayne Anderson Rudnick, told the IC.
However, the positive macro data over the last month has strengthened investors' hopes that the economy will avoid a recession altogether. Goldman Sachs now forecasts US GDP to grow 2.1 per cent in real terms next year, ahead of the 1 per cent consensus expectation. At the same time, Goldman is expecting core inflation to fall back to between 2 and 2.5 per cent.
The investment bank has put the risk of a US recession in the next year at just 15 per cent. For comparison, this time last year it said there was a 35 per cent risk. The thinking is that central banks now have room to cut rates to stave off growth risks, although whether they time this pivot correctly must still be up for debate. But it is not just down to monetary policy: Goldman expects the manufacturing industry to bounce back as customers have now worked their way through overstocked inventories.
Broker RBC Capital has added coatings and laminates business Chemour (US:CC) to its small-cap growth idea list. The broker is forecasting that Chemour will benefit from the energy transition tailwinds through its thermal and specialised solutions segment, which accounts for over 50 per cent of the company’s cash profits (Ebitda). The US Inflation Reduction Act has set aside billions to subsidise green investment next year.
There is hope that as recession and inflation fears ease that smaller and mid-sized businesses could join the recovery. Over the last month the Russell 1000 index, which tracks the 1000 highest ranked businesses in the US, is up 5 per cent. “Now the economic uncertainty is easing there is a lot of opportunity in the mid-market,” says Armbruster. “Many companies have improved profitability in the last year and are facing some easy post-Covid comparatives”.
Inflation to keep falling
The battle against price growth is not over yet, and many economists had warned it would be the last few percentage points of inflation that would be hardest to beat. But this is not a view held by Goldman’s economists. “We don’t think the last mile of disinflation will be particularly hard,” they have confidently proclaimed. “Shelter inflation has considerably further to fall, and most importantly the supply-demand balance in the labour market continues to improve”.
The belief that we have reached peak inflation can be seen in 10-year Treasury yields. In the month to December, yields fell from 4.77 per cent to 4.22 per cent. This has led to a surge in the price of 'risk-on' assets. In the same month, the Ark Innovation ETF (0H7G) rose 17 per cent. The ultimate risk-on asset, bitcoin, has also continued its recovery, rising 25 per cent in the last month.
Other growth shares had already adjusted their business models in order to take the higher rate environment into account. This meant tech companies that had previously been chasing revenue growth had to start cutting back on operational expenses. In the nine months to September, Uber (US:UBER) generated $2.6bn (£2.1bn) of free cash flow this compared to a free cash outflow of $61mn in the same period in 2021.
Similarly, Spotify (US:SPOT) managed to generate $296mn of free cash flow in the nine months to September, up from $98mn the year before. Spotify had consolidated its marketing teams earlier in the year, but it doesn’t seem to be finished with its efficiency push. At the start of December, it announced plans tocut 17 per cent of its workforce, equivalent to 1,500 jobs. Correspondingly, the share price jumped 7 per cent. The market has truly moved on from its growth at all costs ambitions, but the uncertainty is whether job losses will start to filter through the economy.
Will consumers wilt?
Regardless of how much companies have improved efficiency, problems will become apparent if the economy does slip into a recession. A smaller economic pie means less profits to share around, and there is some evidence the US consumer is starting to come under pressure.
On Cyber Monday, US consumers spent $12.4bn on digital shopping, making it the biggest digital shopping day of all time, according to Adobe. However, a few days earlier the world’s largest retailer Walmart (US:WMT) warned there had been “a softening in the back half of October”. Reading between the lines, some consumers might have been saving their spending for the cheaper Thanksgiving deals.
Adding to the potential gloom, US job openings in October fell to a low not seen for more than two and a half years. While this is suggests more good news on the inflation front, fewer jobs means a weaker US consumer. And the consumer still makes up over 70 per cent of gross domestic product.
The concern with unemployment is it doesn’t increase linearly. There is a negative feedback loop. The fewer people there are with jobs, the less money there is for spending, which means fewer workers are needed. The situation can escalate quickly and with interest rates haven risen as much as they have, it seems inevitable the economic growth will slow at least a little. The question is how much.
However, the effects of job losses have arguably been mostly felt in the high growth sectors such as tech. If sustained, the recent fall in the oil price, to near a two-year low, will also help consumer spending. The wider US economy has held up much better than economists were expecting, and with inflation falling the Fed has room to cut rates if monetary stimulus is needed.
This is Goldman’s argument at least, and why it is forecasting the S&P 500 index to rise 5 per cent to 4,700 in the coming year. If 2023 has taught investors anything, it is that it is never a good idea to bet against the US economy. But large caps cannot keep doing all the heavy lifting, so the market will be hoping for the soft landing that economists now expect to materialise.
