Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Is the economic pain coming after great delay?
Peter Garnry
Chief Investment Strategist
Summary: Economists predicted a recession in 2023, but the US economy has shown unexpected resilience. Two factors have helped offset the pain of rising interest rates: fiscal expansion and investment in AI and semiconductor manufacturing. The US economy has never been this strong so many months after a peak in US Leading Index, so will the economy finally enter a recession or will it indeed be a soft landing? The next 6-9 months will tell.
A remarkable cycle so far
The consensus call among economists in late 2022 was that the global economy would enter a recession in 2023, and we also quiet negative going into the year. The US yield curve inversion was also reflecting this view and the brief banking crisis in March with the meltdown in Silicon Valley bank supported the view. Two factors played a key role in offsetting the pain from rising interest rates. The $1trn fiscal expansion by the Biden Administration and the investment boom related to generative AI and reshoring of semiconductor manufacturing capacity through the US CHIPS Act underpinned growth.
Economic activity in the US is roughly around trend growth since the 1980 (the zero value on the first chart below) which is the strongest economic activity recorded in the US since 1978 after 23 months of the US Leading Index peaking (it peaked in December 2021). Only the Great Financial Crisis path was roughly as strong at this point in the cycle. There are two main paths from here.
- US economic activity begins to significantly deteriorate with the US economy entering a recession before the second half of 2024. A side effect might be a debt crisis or liquidity shock as a causal effect from the steepest policy rate trajectory since WWII.
- The US economy and consumer absorbs the interest rate shock with the labour market remaining strong enough to support real wage growth and a soft landing making it the first slowdown of this scale that does not end up in a recession. A side effect of this scenario is inflation dynamics will strengthen and push US long-end bond yields higher.
The fiscal deficit trajectory is going to be important and already now there are signs that the US fiscal cycle is turning as the US government is forced to rein in spending. In this case the US economy will experience a significant negative fiscal impulse forcing the economy to slow unless it is offset by private investment boom.
One thing is for sure. If history is any guidance, and we dare point weight on six independent periods in which the US Leading Index peaked (ahead of recession), then the next 6-9 months are going to be some of the most fascinating for financial markets in a long time.
Will generative AI and automation make the 2020s like the 1960s?
Longer term the most interesting debate and economic observation will be that of 1) potential negative impact from a debt crisis or unsustainable government debt dynamics spurred by the higher interest rates, and 2) productivity boost from generative AI and automation technologies. In the now famous McKinsey report on generative AI and its potential productivity boost, it is estimated that generative AI in combination with other automation technologies could boost productivity growth by 0.2 to 3.3 percentage points by 2040. If that becomes a reality then it is a new paradigm for interest rates.
The previous productivity boom periods in the US were the 1950-1969 and 1995-2004 periods were estimated annualized productivity growth was around 2.5 to 2.7 percentage points. In the post GFC period from 2010-2018 the annualized productivity growth was only 0.9 percentage points leading to great debate about low productivity growth. The period 2019-2023 has delivered annualized productivity growth of 1.9 percentage points with the recent reading at 4.7 percentage points which is the highest reading, excluding the data points during the pandemic rebound in Q2 2020, in more than 13 years.
Imagine an economy that delivers a 1950-60s style productivity growth of 2.7 percentage points with 0.8 percentage points annualized increase in the labour force, then the real GDP growth could be around 3.5 percentage points. If we then add 3 percentage points of annualized inflation due to reshoring, green transformation, and disruptive weather (price of food production) then we are suddenly talking about nominal GDP growth above 6.5% annualized. If this longer term scenario becomes a reality then US long-end bond yields will not return to the low levels observed in the post GFC period.Latest Market Insights
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