Whilst the outlook for manufacturing activity in the United States (and developed markets more generally) is decidedly gloomy, the surprise of the year, thus far, is that services activity has held up fairly well. The predominant reasons for this are as follows:
Firstly, manufacturing companies over-reached during the initial economic boom following the release from coronavirus and supply chain fragilities and this led to significant over-ordering. Inventory levels are too high and are being worked down. Recently there have been a slew of profit warnings from specialty chemical companies as orders have dried up as a result. This dynamic is likely to course through other economically sensitive sectors as the year progresses.
Secondly, the consumer in the United States is, broadly, in a pretty good place and still has some excess savings, built up during lock downs, to spend. Furthermore, whilst US house prices have come off the boil, house prices rose by over 20% during the coronavirus period and the US stock market has done well. Thus, consumers’ aggregate wealth (net of debt) is healthy. With the unemployment rate (3.6%) sitting close to cycle lows and wage growth of over 5% beating the most recent headline inflation numbers, real wage growth is resuming.
Whilst housing activity reacted negatively to the shock of mortgage rates more than doubling, more recently activity has started to improve as house prices have begun to adjust.
The argument that manufacturing activity can bounce back is supported by the mis-named ‘Inflation Reduction Act’ which promotes US onshoring of manufacturing capacity and, in the near term, is boosting fixed asset investment which will help counteract some of the negative impacts of higher interest rates.
However, financing costs for companies have increased materially and are now beginning to filter into the real economy. Good companies with low debt levels and relatively little exposure to the economic cycle are finding that debt costs have risen from the 2% to 3% range to the 6% to 7% range. This is a significant increase. For smaller, more indebted, more economically sensitive companies, the increase in debt service costs has risen by significantly more. This is particularly the case for firms that rely on banks to obtain their debt finance. Corporate debt delinquencies, whilst still low, are beginning to rise noticeably.
The jump in debt servicing costs across the economy means there is less cash available to do other things. This hits confidence as well as end demand and we are likely to start to see companies start to make efficiencies, which will include redundancies.
The Federal Reserve sets interest rates dependent upon their interpretation of core inflation and employment data. These data series lag what is happening in real time in the economy.
There is quite a lot of complacency in the markets currently and volatility in equity markets is relatively low. Diversifying assets such as infrastructure and commercial real estate have performed poorly, however, we believe there is scope for strong returns, going forward, from less economically sensitive companies within these asset classes, once nominal GDP growth starts to fall and interest rate expectations rebase downwards.
Whilst we have a high conviction in this view, a prolonged period of persistent inflation cannot be ruled out, particularly given the likely impact of the Inflation Reduction Act in the US (see above) and real wage growth turning positive, but we do believe, at some stage, investors will start to price in the risk of a central bank policy error and a heightened risk of an economic hard landing.