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.