Midyear outlook: The return to normal comes into focus
Fiduciary Trust International
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Evidence of economic normalization has continued to come into focus after a strong start to the year that surprised broad-based expectations for a slowdown. Getting back to normal was our theme as we headed into 2024, at which time we contended that easing consumer demand would guide the economy back down to a more sustainable long-term growth trend.
We believe the return to these longer-term trendlines is nearly complete, and that softening economic data is largely in keeping with this theme rather than evidence of weakness.
As the second quarter began, we described an emerging theme on the tradeoff of more durable U.S. economic growth at the expense of delayed action by the Federal Reserve (Fed) to ease restrictive financial conditions. Investors have been mostly satisfied with that trade so far this year, although there have been stumbles on the path toward normalization that have left them dismayed at times.
Recent economic data trends suggest the resiliency that raised concerns about a “no landing” scenario earlier this year—in which growth and inflation would not alleviate enough to allow the Fed to begin cutting rates—is giving way. We’re seeing early signs that an anticipated slowdown is beginning after a prolonged period of abnormal economic strength, and we’re heading back to normal even though it has taken longer than expected.
Consumer demand continues to drive economic fortunes
Personal consumption expenditures accounted for 68% of U.S. gross domestic product according to the latest data, so the health of the consumer is critical to understanding the path of the economy. Employment, wages, savings and credit have served as the four main pillars supporting elevated consumption over the last several years. Each of these pillars has undergone major swings in the post-pandemic period that are worthy of exploration as they return to more sustainable levels.
Employment: The workforce is the backbone of the economy—income provides consumers with confidence to make spending decisions, driving the economic cycle. The U.S. economy has added a staggering 28 million jobs since the low point of the pandemic, but total employment has only increased by 3 million from its pre-pandemic peak (exhibit 1). It’s clear that these additions were driven by restaffing needed to backfill open positions created by pandemic-era dislocations, and that full employment has been restored. The extreme misalignment in job openings from just two years ago—when there were three jobs for every potential applicant—has been resolved as the economy returned to full employment (exhibit 2). Leisure and hospitality job openings, which were arguably thrown farther out of line during the pandemic era than the rest of the economy, have completely normalized.
Wages: Demand for workers far outstripped supply during the restaffing era, driving average hourly earnings to a peak of more than double the year-over-year growth rates that prevailed in the period between the Global Financial Crisis and the pandemic. As supply and demand have come into greater balance, employment income has followed. Year-over-year average hourly earnings growth, at about 4%, has come most of the way back down from its 2022 highs. It’s now just slightly above the top end of its pre-pandemic range and right in line with a rising wage trend that preceded the pandemic era.
Savings: As earnings growth has softened during this period, consumers have also relied more on savings to maintain spending levels. Saving less to spend more, and spending down savings, are both well underway (exhibit 3). The personal savings rate has fallen below its pre-pandemic trend, meaning Americans are saving a smaller share of their wages. The aggregate level of personal savings has fallen back in line with the pre-pandemic level, indicating that excess savings have been exhausted.
Credit: Additionally, consumers have increasingly turned to credit as a funding source for spending, but even credit growth has slowed after recovering sharply in the post-pandemic period (exhibit 4). Credit card and consumer loan delinquency rates have slowly but steadily increased over the last two years, and they’re now above their respective 10-year averages of 2.31% and 2.11%. The average interest rate on credit card balances is currently more than 22%, up from the mid-teens immediately before and in the early pandemic period.
What’s in store for the second half?
As we move past peak labor demand, we believe we’ll see monthly payroll reports settle back to their historical range by the end of the year. The trend in recent retail sales data validates that consumer spending is already nearly back to normal. These drivers of economic growth are downshifting, not reversing, and we appear on track to settle at a pace consistent with sustainable longer-term growth and inflation rates.
We understand these indicators of slowing economic conditions may look like weakness. But that’s not the case, in our view. Slowing back to long-term trends that were disrupted in the pandemic era is quite different from the type of weakness that would indicate an approaching recession.
Taken together—with savings spent, wage growth completing the trend back toward normal levels, and borrowing strains beginning to surface—it’s inevitable that softer consumption will produce slower economic growth and allow inflation to finish easing to more sustainable levels. Recent earnings reports show U.S. corporations—from big box retailers to fast food restaurants—once again weighing the tradeoffs between prices and volumes as consumers growing increasingly sensitive to pricing.
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Softer inflation will enable the Fed to begin recalibrating policy. We believe the Fed will be able to start lowering rates later this year. In this sense, the Fed would be paralleling the economy as it begins to cut rates and move back toward a neutral monetary policy orientation. It would also be consistent with the trend unfolding among the Fed’s central bank peers around the world, as both the European Central Bank and Bank of Canada have already begun to ease.
Market pricing reflects a great deal of positivity
Investors have been attuned to the positive developments in recent inflation reports as markets recalibrated for a modest upgrade in the likelihood of Fed rate cuts this year. The 10-year Treasury yield has come far down from its 2024 peak of 4.7% in April, declining rapidly from late May to early June in response to cooperative inflation data. After starting the year priced for as many as six rate cuts, resilient economic activity and sticky inflation moved market forecasts early in the second quarter to only one cut anticipated in December. Recent subdued inflation and consumer-focused data have pulled that cut forward to September according to the latest pricing.
The combination of declining rates and healthy earnings has been beneficial for U.S. equities, which are near all-time highs. S&P 500 companies posted the highest earnings growth in two years during the latest quarter. However, while the earnings backdrop has alleviated some of the pressure on valuations at these levels, U.S. equities are still expensive compared to their longer-term average price-to-earnings ratios (PEs). The earnings outlook is positive, but profitability will need to accelerate from current levels to hit full-year forecasts.
In short, we believe equity valuations reflect positive developments in earnings, economic trends and Fed policy. In our view, investors should be prepared for a rangebound market environment between now and the U.S. election unless another catalyst materializes.
Lastly, with the S&P 500 near record levels, the premium investors receive for investing in equities over bonds has decreased to its lowest point in 23 years. The U.S. equity risk premium, which compares the earnings yield of the S&P 500 to short-term Treasury yields, is now at its lowest level in about two decades, highlighting the relative appeal of fixed income investments at these levels.
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