Laura Winter, investment manager at Rathbones Investment Management International, explains why America’s economy is slowing
BEFORE the recent banking-related sell off, US stocks were not pricing in a recession. Investors probably over-interpreted some encouraging data from the start of the year, which may have been flattered by exceptionally warm winter weather and problems with adjustments that government statisticians make for seasonal consumption patterns.
The bigger picture is that the US economy has already slowed significantly since its boom in 2021. While GDP growth has been volatile, owing to swings in inventories and international trade patterns, measures of growth in underlying domestic demand had already slowed to a crawl by the end of last year.
The economy would have slowed more last year had consumers not spent some of the extra savings built up during the pandemic lockdowns but there is evidence to show that support from this source is fading. Loan delinquency rates began to rise again late last year, a sign that at least some households have already burned through their cash buffers.
Interest rates rose at the fastest rate since the early 1980s in the second half of last year. The key point is that monetary tightening tends to hit the economy with a lag. Most evidence suggests that it is typically more than a year before the peak impact of rate hikes is felt. There are lots of reasons why it takes time for higher rates to bite. Loans, for example, are not all refinanced at once. They gradually roll onto higher rates.
Given this economic backdrop, analyst forecasts for the earnings of US companies in aggregate still look much too bullish. While their forecasts have been falling gradually since mid-2022, in our view they have not adjusted nearly enough yet. They remain consistent with earnings slightly higher than last year, followed by strong growth in 2024. When earnings expectations do fall, the market usually struggles.
Current consensus forecasts clearly contrast with the typical experience in recessions. Nearly every recession is associated with a double-digit percentage decline in earnings. One challenge this time is that profit margins are already very high by past standards. They jumped to all-time highs during the exceptional circumstances of the pandemic and have yet to normalise fully again. In other words, it made sense to expect some downward pressure on margins even without a recession but we have not seen that reflected in analysts’ forecasts yet.
There are reasons to be optimistic, especially as any recession should be mild, the US has an abundance of world-leading businesses and valuations are not extreme by historic standards. However, given a clear contrast between analyst forecasts for earnings and America’s economic outlook, we are currently being very selective in our investments.