Investment Comment
29th September 2023
Growing pains?
With inflation in the US sticky but definitely cooling, the minds of central bankers and investors begin to pivot to understand the impact of the tightening cycle thus far, epitomized by the Federal Reserve’s “pause” in its hiking regime. Investors, in the main, sit in one of two mutually exclusive groups. The first think that the recession has been delayed but not avoided. These investors believe the ripple effects of the pandemic, supportive fiscal policy and other exogenous shocks have all contributed to increased liquidity and therefore delayed the impact of the hiking cycle; consequently, the Fed may have to keep rates higher for longer to achieve their goals, which will likely see the US fall into recession albeit later than first anticipated. The other school of thought centres around immaculate disinflation – investors here believe the Fed can engineer a scenario in which the hiking cycle has the desired effect on inflation, whilst tailwinds including a strong consumer, huge fiscal support and a resilient labour market help avoid a meaningful slowdown in growth and so avoid a recession.
Irrespective of the individual school of thought, the trajectory of US economic growth is the topic du jour, specifically will the rapid tightening of monetary policy drive the US economy into recession? An interesting disparity has arisen over recent months between the two most widely accepted measures of economic activity, GDP (Gross Domestic Product = consumption + investment + government spending + net exports) and GDI (Gross Domestic Income = wages + profits + interest income + rental income + net taxes), that complicates drawing definitive conclusions on the current state of the US economy. These two measures of growth should, in theory, be the same, as all spending within an economy (GDP) is subsequently received by another party (GDI).
Over the long term this relationship broadly holds true with the two measures tracking closely. However, the correlation between both measures has broken in the US since the end of 2022, turning its most negative since the onset of the Global Financial Crisis in 2008. As the chart below shows, GDP is painting a far more positive picture of the economy than GDI.
Gross Domestic Product shows a resilient US economy. Gross Domestic Income, on the other hand, suggests activity in the US is beginning to feel the impact of the Federal Reserve's aggressive tightening cycle.
Source: Artorius, Bloomberg
Which measure to trust?
With both GDP and GDI showing markedly different estimates both the ‘delayed not avoided’ and the ‘immaculate disinflation’ camps could be forgiven for exhibiting a little confirmation bias here. Whilst acknowledging that data flaws and measurement errors mean that estimates for both measures of economic growth are frequently revised, we should consider the comparative reliability of the measures. Studies by the US Bureau of Economic Analysis (BEA) suggest that although GDP is the more widely used measure, GDI may in fact provide a better reflection of economic conditions.
Here we refer to the workings of the BEA who examined the recessionary predictive powers of both measures using implied recession probability estimates, which concluded that:
1. for a series of historic recessions (1980, 1981, 1990, and 2001) GDI has performed better in signalling the onset;
2. the deterioration of GDI growth during a recession is greater than that of GDP, and;
3. where there have been subsequent revisions of both measures, it is more often that GDP moves towards the GDI estimate.
The probability estimates show that GDI estimates more accurately forecasted the onset of recessions in 1980, 1981, 1990 and 2001, although it did also raise concerns of a recession in 2003 – which in hindsight was a false alarm. Additionally, the evidence that GDI is on average more accurate does not inherently suggest that GDP is not useful as exhibited during 2003, when GDP was more accurate in its prediction that there would be no recession. The BEA suggest a combination of both GDP and GDI may provide a better forecast of economic conditions. Below, for simplicity, we use an equally weighted measure as a proxy for economic growth. The results show a stalling growth outlook.
An equally-weighted measure of GDP and GDI suggests a softening in economic activity.
Source: Artorius, Bloomberg
The conflicting economic growth figures only further highlight what has been a year of mixed economic data, neither the bears nor the bulls are yet willing to disregard their theories, as both can make justifiable cases given the variability in the data. Investors will continue to keep an eagle-eye on incoming economic data in the hope that it reaffirms their view. Currently, markets take a more sanguine view on growth, and sit firmly in the immaculate disinflation camp. In contrast, the “delayed not avoided” contingent would place less emphasis on GDP, point to the weakness in GDI (or the stalling in the combined measure) and other deteriorating indicators, and suggest a rethink – this would certainly ease the punishment felt by defensive assets year-to-date, of which the bearish investors disproportionately own. One thing is clear, any disappointment in the current narrative priced into US equity markets would have a negative impact. While the economic picture is uncertain, we remain concerned that the impact of monetary policy tightening has not been fully felt and that economies (not just the US) will struggle to avoid recession. To this end we are comfortable holding defensive positions, such as short-dated bonds, while we wait for opportunities.
While equity markets have been generally strong this year, reflecting a more sanguine view on growth, they have come under some pressure following the Federal Reserve’s decision last week to leave policy rates unchanged, which was followed by post-meeting comments that restated the committee’s hawkish rhetoric. Investors took this as another indication that interest rates could be staying higher for longer, weakening US equities and resulting in a rise in longer-dated US Treasury yields. This also led to a strong rally in the US dollar on the back of the move up in yields reversing most, if not all, of the dollar weakness we’ve seen this year.
All expressions of opinion reflect the judgment of Artorius at 29th September 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
FP20230929001