Whilst the outlook for manufacturing activity in the United States (and developed markets more generally) is decidedly gloomy, the surprise of the year so far is that services activity has held up well and not followed the downward path of manufacturing activity. The main reasons for this appear to be twofold.
Firstly, manufacturing companies over-reached during the initial economic boom following the release from COVID and supply chain fragilities led to significant over-ordering. Inventory levels remain too high and need to be 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 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 COVID period and the US stock market has done well. Thus consumers’ aggregate wealth (net of debt) is healthy and has held up well. With the unemployment rate (3.5%) sitting at cycle lows and wage growth of 6% 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 downwards.
So the key question is whether consumer demand will persist and, thus, ensure a fairly shallow and short de-stocking cycle and will then help the manufacturing sector revive and prevent a full blown recession, or not.
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 at least, 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 an appreciable increase. For smaller, more indebted, more economically sensitive companies, the increase in debt service costs has risen by significantly more and this is particularly the case for firms that rely on banks to obtain the necessary debt finance.
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 US Federal Reserve (Fed) sets interest rates dependent upon their interpretation of core inflation and employment data. This data lags what is happening in real time in the economy. During most economic down cycles, it is market participants who come to the view first that interest rates are being held too high relative to the deteriorating outlook for the economy and so mark risk assets down before the Fed has had time to act. It is these abrupt market moves that then spur policymakers to cut interest rates. We see no reason to believe that it will be different this time. What we don’t know is when will investors suddenly turn against the Fed interest rate policy.
What we do know, however, is that there is quite a lot of complacency in the markets currently. Volatility in equity markets is relatively low and the yield demanded to hold higher risk corporate (‘high yield’) debt is low relative to safer corporate (‘investment grade’) debt.
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 assets within these asset classes, once nominal GDP growth starts to fall and interest rate expectations rebase downwards.
However, 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.