Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

There is still no clear answer to this year’s key question: is the U.S. economy headed toward a no, soft or hard landing? We see plausible reasons why any of these scenarios are possible.

What are the different outcomes for the U.S. economy?

The reacceleration (no-landing) case is supported by above-trend jobs growth, double-digit expectations for corporate earnings growth and inflation that remains stuck above 2.5%.

The potential for a soft landing or a period of below-trend growth is backed by the slowdown in forward-looking labor market indicators. These include hiring rates, the cooling in wages growth that will depress real household incomes, and signs of distress from low-income consumers indicated by rising default rates on credit cards and auto loans.

The case for a hard landing (recession) relies on historical precedent. The U.S. Federal Reserve (Fed) has embarked on the most aggressive tightening since former Fed Chairman Paul Volcker’s tenure in the early 1980s, and the yield curve (10-year minus 2-year) has been inverted since mid-2022. This is a classic recession warning sign: the U.S. economy has never previously avoided recession after a sustained period of restrictive monetary policy.

No landing seems the least likely outcome. There is enough evidence that the economy is slowing and inflation pressures are easing. Households have exhausted their pandemic excess savings and the 2023 fiscal boost from the federal government’s Inflation Reduction Act of 2022 has turned into an economic drag. The recent uptick in six-month annualized measures of core inflation is, in our view, more noise than signal and we expect the ongoing moderation in wage growth will eventually return inflation to the Fed’s 2-2.5% comfort zone.

Is the U.S. economy headed for a soft landing or a recession?

The main debate is between a soft landing or a recession. The economic data aren’t much help as the slowdown signs can be read as either a healthy rebalancing that allows inflation to cool without triggering negative growth, or the pathway toward a mild recession beginning later this year or early 2025.

The case for a soft landing is that this cycle is so different that the normal rules do not apply. The inflation spike was mostly due to demand recovering more quickly than supply following the Covid-19 pandemic. In contrast to previous Fed tightening episodes, households and the corporate sector did not overborrow, and have been protected from Fed rate hikes by locking in low rates on 30-year mortgages and longer-term corporate bonds. Tight Fed policy has been less painful than usual, which has allowed the economy to slow gradually and bring down inflation without triggering a recession.

But it could also be a case of this time is longer rather than this time is different. The soft landing could overshoot into at least a mild recession. In fact, the resilience of the economy potentially makes the hard-landing more likely by delaying the timing of Fed rate cuts.

Are markets underappreciating the risk of a mild recession?

Financial markets are backing the soft-landing scenario. This is evident in the optimism around earnings-growth expectations and in high-yield credit spreads that are pricing cyclically low levels of defaults. We think both scenarios are possible, but that the market is underappreciating the risk of a mild recession. This creates an asymmetry in the return outlook. There is some return upside if soft-landing expectations are correct, but a potentially significant drawdown if a recession occurs.

Conditions are improving in most other developed economies as they catch up from relatively lackluster post-Covid gross domestic product (GDP) growth trajectories. Europe is recovering from near-recession conditions in 2023, jointly boosted by the upturn in global manufacturing and a resurgence in bank lending growth. Japan’s GDP growth was surprisingly subdued over the first quarter of 2024, but the near-term outlook is more promising with support from improving manufacturing activity and the weak yen. The United Kingdom is experiencing a modest improvement in growth indicators, although persistent inflation is delaying the timing of Bank of England rate cuts.

The China outlook is also brightening as a range of policy measures are being implemented to stabilize the property market and boost the economy. China faces significant longer-term structural issues related to high savings, low consumption, over-capacity, and a reliance on export demand. The policy moves, however, have boosted the near-term outlook and have helped Chinese shares bounce from deeply oversold levels earlier in the year.

This year has become a three-scenario problem for investors¹ Our view is that the no-landing scenario is unlikely, the soft landing is possible, and the hard landing is more probable than priced by markets. Soft-landing expectations are likely to persist over the next few months as inflation concerns decline. The asymmetry in the mid-year return outlook, however, means we will be watching closely for signs of a deeper downturn.

Beneath the market hype around artificial intelligence (AI) there has been an important debate about the impact AI will have on productivity and economic growth. On the skeptical side is Economics Professor Daron Acemoglu at the Massachusetts Institute of Technology, who thinks the cumulative boost to U.S. GDP over the next 10 years will be not much more than 1%. This compares with optimistic predictions from analysts at McKinsey & Company and Goldman Sachs who argue that the cumulative increase in GDP could be as high as 7% (or nearly US$2 trillion in inflation-adjusted terms). The International Monetary Fund published staff notes in January that stated AI has the “potential to reshape the global economy”.

Long-term GDP trends are determined by the growth in the working-age population and productivity (i.e., output per unit of input). Ageing demographics mean current GDP growth trends can only be maintained with rising productivity. The growth optimists see green shoots from the potential exponential advances in artificial intelligence.

How much could AI potentially boost GDP growth by?

AI is already resulting in cost-structure improvements for some firms. For example, computer programming and coding groups have reported dramatic increases in productivity. These are still early days for large language models² , and we should not forget that the virtual assistant ChatGPT was released just 18 months ago in November 2022.

The gap between the skeptics and optimists is largely about the proportion of tasks that can be done by AI on a cost-effective basis. Professor Acemoglu believes this is quite low. We’re more optimistic given the early indications of efficiency gains in certain industries, and the speed at which improvement is occurring. Additionally, the benefits of AI will likely lead to reallocation of labor and new tasks, rather than simply being a cost-saving measure.

The two useful historical analogies are the introduction of electricity and the early days of the internet. Both technologies eventually resulted in about a one percentage point per year boost to productivity, consistent with the optimistic range of AI forecasts.

This has several implications. First, an increase in potential growth should lead to a higher equilibrium interest rate (r-star). Second, absent changes in taxation and distribution policy, a boost in productivity through AI should favor capital over labor, meaning that corporate profit margins should be supported. Third, it increases the fair value range for equity markets by supporting margins and increasing the potential for longer-run earnings-per-share growth.

U.S. companies recorded respectable earnings in Q1 2024. S&P 500® earnings grew by around 11% year-over-year, stronger than in the prior quarter. Once again, Magnificent Seven companies played a key role, growing earnings by more than 50% year-over-year. By contrast, earnings-per-share (EPS) growth for the S&P 493 (S&P 500 excluding Magnificent Seven) was near 3% year-over-year. Nevertheless, this was an important quarter for the S&P 493, as it marked the beginning of an earnings recovery. As the year progresses, industry analysts expect that S&P 493 EPS growth will increase, while the Magnificent Seven companies decelerate.

What’s the earnings outlook for small-cap companies?

U.S. small-cap companies (see chart below) have been hit harder than their large-cap peers by sensitivity to higher interest rates but showed tentative signs of stabilization in the first quarter. Russell 2000® Index earnings growth was close to flat year-over-year, versus negative growth rates in 2023. Industry analysts expect a sharp rebound in small-cap earnings, with earnings growth rates reaching more than 50% year-over-year by the end of the fourth quarter of 2024.

We think these consensus expectations are too optimistic. They could be correct if the soft landing eventuates (our base case scenario), but we still see a 35% probability of a recession over the next 12 months. A recession would see earnings contract by 10-15% year-over-year.

The consensus optimism might be correct if the no-recession soft landing eventuates. However, there is little scope for further upgrades, and this potentially places a ceiling on how much further U.S. equities can rally.

Global equities delivered solid returns in the first half of 2024 with those gains once again spearheaded by U.S. mega-cap growth stocks. Dispersion within the Magnificent Seven and across the broader equity market remains high, however. NVIDIA continued to shine with strong demand for its computing technology, particularly graphics processing units, propelling a blockbuster earnings report and stock performance in the period. Meanwhile, smaller companies—which tend to be more exposed to interest rates via short-term and variable interest rate borrowing—have faced stiffer headwinds from the Federal Reserve’s restrictive monetary policy. The U.S. small-cap Russell 2000 Index went sideways in the year to mid-June, trailing U.S. large-cap performance by a wide margin.

Volatility in fixed income markets remains high as data-dependent central banks were met with volatile—and at times discordant—inflation and growth data. Sovereign yields rose sharply through mid-April as hotter inflation figures in the United States delayed the expected timing of Fed rate cuts. Softer growth and moderating inflation more recently caused a U-turn lower in yields with markets now expecting a September rate cut from the Fed, following similar moves in June by the European Central Bank and Bank of Canada.

Asset-class performance, year-to-date through June 14

What’s the business cycle outlook?

We assess the market outlook through our cycle, valuation, and sentiment (CVS) investment decision-making framework. The cycle remains highly uncertain. Economies operating at full employment with inverted yield curves suggest we are late cycle. But resilient growth, improving corporate earnings, disinflation, and expected central bank rate cuts leave the path to a soft landing open. Valuations for risky assets such as equity and corporate credit skew expensive, particularly in the United States, where investors are pricing in a soft-landing scenario with high confidence. Meanwhile, government bonds look attractively priced across most of the developed markets, with high real yields and diversification potential should a more adverse economic scenario materialize. Finally, our sentiment indicator shows market psychology is optimistic but not at an extreme of euphoria that would warrant a sharply risk-off posture in our portfolio strategies.

Sentiment

While our CVS framework skews somewhat cautious—suggesting some potential downside asymmetry for stocks and corporate credit—we do not see the current setup as being an unsustainable extreme that would warrant a significant deviation away from our long-term strategic asset allocation. Our portfolio strategies are generally emphasizing diversification into high macro uncertainty and emphasizing security selection as the primary driver of active return.

Our asset class preferences as of mid-2024 include:

• We do not see extreme tactical opportunities across equity regions, sectors, or styles. Cheaper segments of the equity market include the value factor, small cap, financials, and the emerging markets. But most of these exposures carry higher betas⁵ in a period of elevated uncertainty. As a result, our equity strategies are generally neutral and emphasize stock selection as the main driver of risk and return in portfolios.
  
  
• Government bonds are attractively valued. We think many developed market sovereigns offer good carry with real yields at their highest levels in decades and the potential for double-digit returns in a recession scenario. Credit spreads are historically tight for both investment grade and high yield corporates, leaving an unattractive risk-reward profile for multi-asset investors.
  
  
• With central bank rate cuts kicking off in parts of the developed market, the expected decline in borrowing costs should create a tailwind for listed real estate due to its interest-rate sensitivity. Meanwhile, net operating income (NOI) growth has remained healthy, as supply is still tight in some markets. Listed real estate and listed infrastructure valuations are more attractive than equities, making them a notable diversifying asset for a balanced investment portfolio. While we are cautiously optimistic on the U.S. economic outlook, risks remain. Listed infrastructure’s low downside capture can help buffer portfolios should equities sell off. OPEC+’s extension of its oil production cuts, along with heightened geopolitical tensions, create a floor for crude oil prices. But oil prices may also be constrained by lackluster demand as the global economy transitions toward a period of below-trend growth. Gold has been buoyed by geopolitical tensions and central bank purchases, but stretched valuations relative to real interest rates, combined with reports that the People’s Bank of China paused gold purchases in May, may result in downside risk to gold prices going forward. The global transition to sustainable energy should support healthy demand for base metals.
  
  
• We are neutral on most major currencies, with the US. dollar looking expensive and the Japanese yen particularly cheap on a purchasing power parity basis over the medium-term.
  
  
• Private markets have demonstrated resilience, particularly in midst of rising costs of capital and the uncertainty stemming from a year filled with several national elections. However, a considerable amount of unrealized value remains in the market and distributions to paid-in capital continues to be low as a weak exit environment has challenged many sponsors. While the proliferation of continuation vehiclesis expected and will continue to be a source of proceeds for investors in private equity, we anticipate some transactions will come under increasing scrutiny in a more contested valuation environment. Higher interest rates are forcing management teams to be more creative and focus on operational value-add to drive outcomes. Yields on private credit remain attractive; however, elevated macro uncertainty suggests that choosing private credit funds with robust asset management capabilities remains critical. Within real assets, commercial real estate values are expected to bottom out in 2024 with gridlock between buyers and sellers addressed, in-part, via debt maturities.