U.S. Economy's Landing Will Be Determined By These Three Factors

There seems to be a clear analogy between the approach of those storms and the current economic outlook in the United States.

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It was a highly uncertain storm track, as the result of several interconnected, rapidly changing meteorological conditions that resulted in interconnected storm tracks. At the same time, preparing for the arrival of a storm was equally fraught with danger - the storm's path could shift at the last minute, and your preparations might be for naught, or even insufficient for the damage that would be caused.

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Today, investors are keenly focused on how the U.S. economy is likely to fare during its economic landing and how they can best position themselves for a variety of possible outcomes. The U.S. economic outlook will depend mainly on three variables that are likely to influence one another in the near future: the U.S. consumer, the labor markets, and the Federal Reserve, just as weather conditions affect the path of hurricanes. In Florida years ago, and today, both as a macro investor, I would always start with the potential worst-case scenarios and make sure I had a plan in place to deal with them as well as possible. Nevertheless, I would also think about other scenarios and how to make sure that I could benefit if the rain and wind didn't fall on me as well.

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Considering that portfolios today tend to be heavily tilted towards equities, it is likely that the worst-case scenario would be a resolute Fed that tightens more than expected, undermines the consumer, and forces companies to cut costs partly by laying off workers. It is anticipated that this storm will lower earnings and push up risk rewards, which in turn will negatively impact cyclical assets and overall returns.

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There are a couple of options available to mitigate the impact of the current crisis, including shifting some of your exposure to short-duration fixed income or focusing more on sectors that are more defensive, such as utilities within your equity portfolio. Ideally, you want that protection to be liquid so that you can redeploy your money quickly into market weakness; you also want it to be incremental - not the entire portfolio - since it can be very difficult to predict market tops and bottoms with any degree of accuracy. In order to decide how much money should be invested in “rainy day” assets, it is important to take into account how much damage you are comfortable sustaining over a short period of time.

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Federal Reserve, labor, and consumers

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To track the storm, you need markers in addition to having a plan. Let's begin by focusing on the consumers. In the last year, they were able to spend down excess savings accrued as a result of pandemic fiscal transfers. It must be said, however, that spending has remained strong for the majority of the month, largely because credit (both mortgages and credit cards) has been increasingly used. There was an increase in household debt balances of nearly $400 billion during the fourth quarter of 2008, the largest nominal increase in household debt balances within 20 years, according to data from the Federal Reserve Bank of New York. Credit-card rates also rose to multi-decade highs, reaching 20% on average, for the first time in many decades.

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It remains to be seen whether consumers will be able to continue borrowing and spending in the future as a result of the strong labor market. This was evident from the 1.1% increase in real consumption in January as a result of the strong labor market. Given the fact that consumption represents around two-thirds of the economy, it is extremely important that this is addressed in the broader growth outlook. It's precisely those incomes and spending that will push the Fed to potentially tighten more than is already anticipated, and it's the inflation that will come as a result, that will push the Fed to potentially tighten more than is already anticipated.

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There is disinflation being achieved by the Fed, although so far it has primarily been through goods and energy prices. It is still a challenge to find ways to combat inflation in the service sector, which has been supported in large part by tight labor markets, with wage growth ranging from 4% to 6%, depending on the metric that is being watched. If the central bank is serious about its 2% target, then this number is still a lot too high compared to what it should be. The Fed may have to do more in order to meet the consumer demand for services the longer it persists. As we see the Fed pause later this spring to assess the impact of the tightening already underway, that is very different from the easing cycle that will be reflected in market pricing by the end of the year.

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It is now time for us to turn our attention to the third force that will shape this macro-storm track - labor markets. As much as there has been a lot of attention paid to layoffs announced by large technology companies in the past few months, they have more of an impact on equities than they do on the underlying economy because of their weight in stock indexes. There are only about 2% of Americans work in the technology sector in the United States. Those are just a fraction of the jobs available in the service sector - more than a quarter of the American labor force is employed in health care and hospitality.

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The economic outlook in the U.S. is causing many firms to be nervous, yet at the same time, many of them are still seeking to hire new employees to meet their needs. It is evident that there is a dichotomy between growth and labor forecasts. This dichotomy is also evident in the latest small-business sentiment survey from the National Federation of Independent Business, which indicated that nearly half of all small and medium-sized U.S. companies are still unable to fill open positions.

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Companies could pare back openings and potentially reduce existing headcount as a result of Fed action to raise borrowing and debt-servicing costs. This would in turn lead to a greater number of consumers putting away their plastic as well. This would likely result in a negative feedback loop, with less income weighing on spending, and less spending causing companies to be more cautious as a result.

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Preparing for tough times

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There could be a number of reasons why this figurative storm missed land and moved out to sea. It is likely that a further reduction in commodity prices (especially gasoline and food for U.S. consumers) will help boost sentiment and real incomes, which would allow spending to continue while reducing pressure on the Fed to raise interest rates. There is little doubt that a 2% inflation rate alone wouldn't suffice to bring wage pressures down to a level that would be in line with a 2% inflation rate. Moreover, the outlook for major commodity prices is itself uncertain at present, especially when one considers the degree to which China is reopening and the degree to which the Middle East is unsettled when it comes to supply and demand.

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There is an opportunity cost involved with putting temporary storm windows in a portfolio if the hurricane turns out to be a passing shower rather than a hurricane. The longer-term investors, however, who wish to limit the downside in order to maximize their returns over time, would do well to consider potential storm tracks now in order to maximize their returns in the future.