A challenging short-term environment could give way to multi-year tailwinds for growth

  • 22 March 2023 (5 min read)

Key points: 

  • The transition to lower, less inflationary US growth may not be as smooth as was once hoped.
  • While equity valuations have improved, if interest rates remain elevated this could potentially present opportunities for bond investors.
  • Supported by strong multi-year tailwinds in the longer term, we believe the outlook for growth sectors such as technology remains very positive.

Economists have predicted that the U.S. will endure virtually no growth in 2023 along with inflation will continue to lower. Should both outcomes play out, they would be seen in response to the Federal Reserve’s (Fed) ongoing tightening of monetary policy, which commenced in January 2022.

The transition to lower, less inflationary growth, however, is proving less smooth than investors ideally would have liked. There is some stickiness in the inflation data, for example, which is keeping the core consumer price inflation rate well above 5%. Meanwhile, the labor market remains strong, with job vacancies massively outstripping those looking for work.

The official unemployment rate, at 3.4% in January 2023,1 is the lowest since the late 1960s2 – inspiring a growing confidence that, after all, the US will avoid a recession. This, of course, has mixed implications for investors: growth may be better, but interest rates might remain higher for a longer period of time than initially anticipated.

The reality, though, is that the economy has slowed. Real GDP growth in 2021 was 5.9%.3 By the end of 2022, Real GDP growth had dropped to an annualized rate of just 1%.4 While a slowdown from the strong pandemic recovery growth rate of 2021 was to be expected, there has also been a response to higher interest rates.

Remember how we arrived at this point: The Fed increased its policy rate seven times in 2022. Another rate hike in February 2023 saw the Fed Funds Rate climb to 4.75%. It seems only likely that it will rise further.5

The market has already priced in another rate hike, currently projecting it will rise to 5.25% before the Fed pauses to assess the economic impacts of its tightening policy for the rest of the year.

Labor market will be central to Fed decisions

While official GDP numbers highlight a slowdown, some other economic data is less convincing. The labor market, specifically, is causing some confusion among investors – non-farm payroll growth, for example, has continued to be strong, rising by a huge 517,000 in January alone.6

The U.S. economy generated almost five million new payroll jobs in 2022 alone.7 A lot of this shift in the labor market reflected the ongoing recovery from the pandemic, with companies across many industries struggling to reach pre-2020 levels of employment.

Sectors such as healthcare, as well as leisure and hospitality, were badly hit during lockdown but have seen very strong employment growth in recent months as staffing levels normalized.

However, in aggregate, labor shortages persist because many workers left the workforce during the pandemic. Imbalanced supply and demand within the labor market has had an impact on wage growth. Average hourly earnings growth reached 6% year-on-year in early 2022,8 yet by January of this year had slowed to 4.4%.9

The currently tight labor market is a central dynamic that figures to shape what actions the Fed takes over the course of the coming year. The thinking is that if unemployment remains low, wage growth will continue to be elevated as well. This suggests it will take more monetary tightening to get inflation down.

Fed Chair Jerome Powell has maintained quite a hawkish message in his public comments – leaning heavily against the idea that interest rates could be cut before the end of 2023. The market has listened and is now pricing that the Fed Funds Rate will end the year higher than where it sits currently.

Tighter conditions in financial markets

We do expect slower growth in 2023, as well as lower inflation. Not only has the Fed increased interest rates significantly, but it is also in the process of reducing its balance sheet. This quantitative tightening should lead to tighter liquidity conditions in financial markets.

The U.S. government, at the same time, needs to continue to borrow heavily as it refinances existing maturing debt. By issuing new Treasury securities, it can fund a deficit that will likely total between 4% and 5% of GDP, according to Bloomberg consensus economic forecasts.10

During the quantitative easing era the Fed would have simply rolled over any maturing debt into new investments in the Treasury market. Now, however, the Fed is intent on reducing its holdings of government debt by $760bn per year.11

Washington must now call even more on the private sector as a result – banks, investors, and individuals – to fund the deficit. Households and companies alike could face higher borrowing rates and tighter financial conditions in this landscape.

So, it should be noted that there are still risks to growth. The Fed may not be quite done raising rates – and figures to keep interest rates elevated for some time – if it elects to maintain a hawkish stance. Balance sheet shrinkage will also contribute to a further tightening of financial conditions. On this front, we have already seen some tightening of lending standards from U.S. commercial banks.

There is good news, however: Inflation should continue to fall barring another sharp increase in global oil prices. The Bloomberg consensus forecasts consumer price inflation to fall to 3% by the end of the year and decline even further in 2024.12 Easing inflationary pressures should, in turn, allow for some easing of monetary policy next year.

Positive for fixed income and equities

Higher rates have unsurprisingly made the bond market more appealing for investors. Yields have risen significantly, providing investors with the opportunity to benefit from higher income levels compared to the last few years.

While there are legitimate concerns about growth, investors can tap into the credit markets right now and find yields hovering at close to 5% and sub-investment grade debt even higher. With the Treasury yield curve inverted, investors typically opt for investment grade credit for longer duration bond exposure and high yield for short duration bond exposure.

Interest rates and growth are of course important for the equity market. After a torrid performance in 2022, equity markets have performed better to start the year, driven by the idea that rates are close to peaking. But a sustained performance from the equity market relies on strong corporate earnings. Wise investors will proceed with cautious optimism given the level of uncertainty here.

The most recent earnings season reveals growth has turned flat, with aggregate earnings for the S&P 500 flat compared to a year ago. The earnings growth picture for the Nasdaq fares worse, with technology companies reporting a 12% decline in earnings per share compared to a year ago. The communications services sector – which includes names like Netflix, Meta, and Alphabet – has been harder still, with earnings down by a third.13

That being said, valuations have also improved. Compared to the peak price-earnings ratio in late 2021 of 30 times, the Nasdaq 100 index traded as low as 19.2 times in October last year.14 The market has rallied in line with generally improved sentiment across bond and equity markets. Keep in mind, this has all come at a time when several constituent companies have reported difficult trading conditions, with some even announcing layoffs in response to pressure on margins. The longer-term outlook for growth equities remains positive nonetheless. Equity analysts expect 18% growth in earnings in 2024, a rate that would be in line with the historical long-term average for earnings growth.

Potential multi-year tailwinds ahead

Overall, in light of the monetary tightening that has already happened and the need, from the Fed’s point of view, to see inflation lower, it’s fair to say that the short-term outlook remains difficult. Businesses, however, have proven to be resilient and have adjusted to the more challenging short-term environment.

The longer-term outlook for technology and other growth sectors, meanwhile, remains positive. Increased infrastructure and renewable energy spending, along with more domestic investment in such things as semiconductor manufacturing, are all likely to provide strong multi-year tailwinds for growth companies.

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