The U.S. economy is currently experiencing levels of inflation that have not been seen in 40 years.
Supply chain disruptions, rising global commodity and energy prices, volatility in major economies and underlying demographic factors have all contributed to rising prices. To manage this, the Federal Reserve has reacted quickly, raising interest rates earlier and more aggressively than any other major economy.
In this paper, Teneo utilizes a combination of modelling, detailed analysis and commentary from highly respected advisers across a range of subjects, including politics, economics and consumer demand, to develop a comprehensive view of how the challenges the U.S. economy faces are likely to evolve in the next 12-18 months. Included are forecasted key macroeconomic factors such as inflation, GDP and employment, and considerations of a wide range of implications for businesses, including consumer spending and behavior patterns, as well as employment, rising inventories and access to credit.
Executive Summary
While there is evidence of growth against a backdrop of global uncertainty for the U.S. economy, there remains a very real risk that the U.S. could be about to enter a prolonged recessionary period.
The U.S. government is currently trying to navigate its economy through a challenging inflationary period and orchestrate an outcome that has never been achieved. In other words, manage the dual challenges that rising inflation and rising interest rates have on economic growth while avoiding a recession and achieving its fabled soft landing.
Positive indicators point to its achievability – inflation is down, the labor market remains strong. Despite evidence of declining real wages, this has not yet translated into declines in household consumption. The line between a soft landing and a recession is thin. Consumer confidence is at record lows, and the U.S. is seeing the biggest real wage declines in the wealthiest income brackets, which make up the majority of consumption.
In this paper, we outline four potential economic scenarios for the U.S. going forwards; from a soft landing to the risk of long-term inflation and a deep recession.
While there is cause to be optimistic about the U.S. economy, there remains a significant macroeconomic uncertainty, with the very real possibility that the economy could be about to enter a deep and lengthy recession.
Source(s): Teneo Research & Analysis
Note:1Levels of Inflation forecast for December 2023, 2Interest rate outlook as of December 2023, 3Annual GDP growth outlook for 2023, 4Following the commencement of the recession
Where the U.S. lands within this range of outcomes depends materially on how quickly inflation returns to target levels. Prolonged high inflation will have a substantial impact on consumption, which could tip the U.S. into a recession.
Six Key Takeaways
- While we expect to see a material softening on inflation in 2023 compared to 2022 figures, there is a real risk that inflation remains at the 4-5% level for the foreseeable future. This is impacted by wage pressures, continued geopolitical turmoil and lack of interest rate effectiveness.
- Interest rates are expected to remain high across 2023. While they will help in managing inflation, they will also continue to impact borrowing and activity in the housing market. This is, in itself, a risk to the long-term stability of the U.S. economy. However, a repeat of the previous housing crisis is extremely unlikely.
- Real wages fell across 2022. Without a material softening of inflation towards the 2% level, we will see real wages continue to fall across 2023. The U.S. bucks the global trend with more well-off home owners seeing larger declines.
- Real wage declines coupled with low consumer confidence will translate into a drop in consumption. This is expected to be most acute in higher income groups, which have seen the largest declines in real wages.
- Unemployment is expected to stay below 5% in 2023; however, supply-side shortages within the labor market risk driving further inflation as upwards pressure on wages continue.
- While inflation has fallen significantly over the past few months, further falls at this magnitude and/or even greater levels will likely be required to avoid a recession. But this is by no means guaranteed.
The Current Situation
The U.S. is currently facing a period of intense inflationary challenge, with the highest rates of consumer price rises in over 40 years and interest rates rising steeply.
A confluence of factors, including the aftermath of the supply chain disruptions and costs relating to the COVID-19 pandemic, underlying demographic challenges and the ongoing impacts of the Russia-Ukraine conflict on energy and commodity prices, have driven U.S. inflation to a 40-year high.
Energy
There have been significant increases in energy prices driven by the Russia- Ukraine conflict and subsequent sanctions. Fuel oil prices increased by 65.7% in the 12 months to November 2022.
Commodities
The Russia-Ukraine conflict, along with supply chain issues caused by COVID-19, has created shortages and rising commodity prices.
In 2022, the average wheat price was 35% higher than in 2021.
Pent-up Demand
Following COVID-19, there was an unwinding of pent-up demand in the form of delayed purchases. This increased demand and prices for many goods and services as U.S. households spent from their $2.1 trillion excess savings accumulated during the pandemic.
Structural demographics
A tight labor market, caused by a shortage of workers and cultural shifts in the workplace, has meant that businesses have had to increase wages to retain and/or hire workers. To accommodate this increase in wage cost, businesses are forced to raise prices, thereby contributing to inflation.
Source(s): JP Morgan Asset Management, Macrotrends, Teneo Research & Analysis
To control inflation and bring it back down towards the U.S. government’s target, the Fed has begun raising its fund rate. While raising the fund rate helps to lower inflation, it also slows the economy down and dampens growth.
How Interest Rates Manage Inflation and Preserve the Value of Currency:
- Inflation: Higher interest rates increase the cost of borrowing, in turn reducing overall spend. Reduced demand for goods and services forces prices to increase more slowly, curbing the rate of inflation.
- Currency: In addition to reducing inflation relative to other countries, higher interest rates in the U.S. offer lenders greater return relative to other countries, thereby attracting foreign investment and causing the exchange rate to rise.
Source(s): JP Morgan Asset Management, Macrotrends, Teneo Research & Analysis
Note:1The Federal Reserve increased the fund rate further on the 1st February 2023, to an effective rate of 4.58%. This sits outside the time series shown on the graph
High inflation and rising interest rates are translating into negative headwinds across leading consumer and business indicators, putting the U.S. at a growing risk of recession.
With price increases outpacing wage growth and resulting in declining real wages, consumers are seeing their household budgets squeezed. As household incomes fall in real terms and consumers have less money to spend, there is already growing evidence of negative headwinds across leading indicators of business output and household consumption in the U.S. Taken together, these indicators are linked to a slowdown in GDP.
Wage Growth and Real Disposable Income
- 5.1%: Although strong wage growth has been observed, standing at 5.1% in Nov 2022, it is still well below inflation.
- -2.0%: This translates to a decline in real disposable income (-2.0% Nov 2021 to Nov 2022), eroding the purchasing power of consumers.
Consumer Confidence
Consumer confidence has deteriorated against a backdrop of declining real disposable income. Consumer confidence is currently lower than at any point during the COVID-19 pandemic and the Global Financial Crisis.
Unemployment
- 3.7%: This is in the context of a tight labor market, with unemployment standing at 3.7% (Nov 2022), down from 4.5% (Nov 2021). Upwards wage pressure created by labor shortages risks driving inflation further.
Profit Margins
The net profit margins for the S&P 500 have declined for five consecutive quarters, from 13% in Q2 2021 to 12% in Q3 2022.
Business Confidence
Business confidence has declined YoY, with current levels reminiscent of those seen during the U.S.-China trade war in 2019; however, it is still higher than the levels seen during the GFC.
Inventories
Business inventories have been rising throughout 2022 and were 16.5% higher in October 2022 compared to 12 months prior. This is indicative of slowing demand and a worsening cash position for businesses.
Source(s): BLS, Reuters, Factset, Teneo Research & Analysis
Overall Outlook
While the U.S. is seeing an economic slowdown with a recession as a very real possibility, there are diverging views on what the economic outlook looks like for the next 12-18 months.
There is broad consensus that the U.S. is likely to see an economic slowdown in Q1 2023 as the impacts of the Federal rate rises from late 2022 start to feed into the economy; however, there is a significant divergence with regards to the quarters that follow.
In a best-case scenario, the U.S. will likely see a ‘soft landing’ with low/slow growth across 2023 before picking up in 2024. However, a downside scenario is a real possibility and could see the U.S. enter a prolonged recession lasting well into 2024, as is currently forecast for the UK and Germany. Over the following pages, we assess the different scenarios that are likely to dictate where the U.S. economy lands within these ranges.
Actual GDP growth will likely be dictated by a small number of key factors.
To understand how these factors will affect the overall outlook, we outline four potential scenarios and consider how key macroeconomic metrics would look in each scenario.
Outlook Across Key Economic Metrics
The speed and the extent to which inflation returns to pre-2021 levels depend on a number of key factors. In all scenarios, we expect to see a material softening of inflation in 2023, returning to target inflation levels of 2% by 2024 in the case of a ‘soft landing.’
Integral to the economic outlook over the next 12-18 months is how quickly inflation returns to pre-crisis levels. Inflation will naturally fall across 2023 as prices are compared to the already high levels seen in 2022. Furthermore, with the Fed raising interest rates earlier and more aggressively than other geographies, it hopes to return to the target levels of 2% by 2024.
However, there are several headwinds facing the U.S. that may result in medium to long-term inflation remaining high, and it is not a given that the U.S. will continue to see the low levels it has seen historically.
Key Drivers of Go-Forward Inflation
Fed Response: Raising interest rates increases the cost of borrowing, which in turn impacts demand, putting downward pressure on prices.
The Fed has been proactive in raising interest rates as a response to inflation, with this strategy expected to continue.
Geopolitical Issues: Continued geopolitical turmoil in Europe, as well as COVID-19 outbreaks in China, could continue to disrupt the supply chain and create excess demand through shortages, driving prices upwards.
Labor Supply Shortages: There are structural issues in the labor market, which have included inactivity and long-term sickness, which have resulted in skill shortages.
While this lowers the risk of widespread unemployment being triggered by a downturn, it has placed upward pressure on wages, which may drive further inflation.
Interest rates are expected to continue to rise through the first half of 2023 before declining from 2024 onwards.
While consensus appears to be that the Fed is likely to begin lowering interest rates in the second half of the year, there are a number of scenarios in which a significantly different profile may be seen.
If inflation turns out to be harder to unwind than anticipated, the Fed may choose more aggressive rises at the expense of growth. On the other hand, a faster easing of inflation or a more significant slowdown arising from interest rate rises may result in earlier lowering.
When Could the Fed Keep Raising Interest Rates?
Inflation proves to be harder to unwind than expected: If inflation remains higher for longer than expected, the Fed may have to increase interest rates further so that long-term inflation expectations can be managed back to the target level.
When Could the Fed Lower Interest Rates?
Inflation returns to target quicker than expected: If inflation starts to show signs of falling in early 2023, the Fed may choose to lower interest rates earlier than expected.
Instability in the labor or housing market: If the housing market or labor market begins to show significant signs of trouble, such as large upticks in unemployment or significant declines in house prices, the Fed may choose to lower rates earlier to encourage growth.
A soft landing or a mild recession could mean real wages start to increase by mid-2023.
How quickly real wages return to growth is critical for the economic outlook and a key driver of consumer spending. Individuals saw declines in real wages across 2022 and, as a result, have begun feeling less well-off than they did 12 months ago. This is further exacerbated as savings accumulated during the pandemic are reduced. In a soft landing scenario, real wages are expected to grow again by early 2023.
However, long-term inflation could see real wages declining throughout 2023 and then remaining static for a prolonged period. It is in this scenario that we would expect to see the greatest impact on consumer spending.
Over the past 12 months, individuals across lower income brackets have seen faster wage growth, reversing historic trends.
The impact of these declines is not evenly distributed, with high-income households being disproportionately impacted by declines and, therefore, more likely to see the largest drops in consumption. This is distinct from what is being observed in other geographies, such as the UK, where wage growth in higher income groups has outpaced lower income groups.
Source(s): BLS, Atlanta Fed, FRED, Teneo Research & Analysis
Note:1Covers 12 month moving average of median wage growth and inflation by income as of November 2022 2Inflation November 2022 3Average income is after taxes and includes all sources of income for 2021
Declines in real wages, coupled with low consumer confidence, are likely to translate into a drop in consumption in the highest income groups.
Real wage declines in the top income brackets are resulting in drops in consumer confidence as households feel less well-off. Consumer confidence is now at lower levels than during the 2008 GFC and the COVID-19 pandemic.
Going forward, this is expected to have a knock-on impact on consumption, with low confidence resulting in households choosing to preserve savings reduce consumption. Reduced consumption, particularly in high-income groups who make up a significant proportion of overall consumer spending, is likely to have a significant impact on outlook and has the potential to tip the economy into a recession.
While the U.S. labor market seems healthy on the surface, there are structural challenges that have the potential to create headwinds in the upcoming 12-18 months.
The U.S. labor market, on the whole, appears strong. Low levels of unemployment and high amounts of open positions mean that although unemployment is likely to increase as a result of interest rate rises, the
general consensus is that this softening in the labor market will be modest. Even in worst case or more pessimistic forecasts, unemployment is only set to rise to 5%, well below the levels seen during the GFC. However, while unemployment may not rise significantly, structural challenges in the labor market, including low participation and high levels of long-term sickness, are creating supply challenges that may put further pressure on inflation.
Structural Challenges Facing U.S. Labor Market
Low participation rates: Over the last 20 years, the labor force participation rates in the U.S. have been declining from an all-time high of 67.3% in January 2000 to 62.1% in November 2022, resulting in labor shortages.
High levels of long-term sickness: U.S. life expectancy has declined by 0.6 years in the period from 2010 to 2022; 78.8 in 2010 to 78.2 in 2022.
In Europe, the increase over the same period has been 1.4 years to 82.1 in 2022.
Rising chronic health problems mean that workers are less productive and absenteeism increases, thus reducing economic output.
In fact, the CDC estimates that six in ten adults in the United States live with a chronic disease.
Cultural shifts: Following the pandemic, 38% of workers looking for a new job were doing so because of work-life balance challenges.
Since certain job roles are limited by the type of flexibility they can offer, certain sectors will likely face labor shortages as workers transition to alternative careers.
Sources: United Nations, Prudential, Statista, Teneo Research & Analysis
Note:1Not seasonally adjusted
Supply-side shortages created by structural challenges in the labor market could lead to further wage pressure and drive up inflation as a result.
While low levels of unemployment and high amounts of open positions today generally point to a strong labor market, this is a dynamic primarily driven by supply-side shortages rather than strong growth in business output. These supply-side shortages are creating upwards pressure on wages. While this wage growth has helped individuals partially cover the cost of rising inflation, it can also be a driver of further inflation.
Changes to interest rates, inflation and suppressed consumer demand will have a direct impact on business output.
Sector-Specific Outlooks
Consumer-Facing Industries
Any reductions in consumer spending are expected to acutely impact discretionary consumer-facing industries, as individuals re-prioritize spending as household income declines.
As Consumption Declines, Significant Changes in Spending Behaviors are Expected
Evidence from the 2008 GFC is informative regarding where consumers may cut back. For instance, between 2006 and 2010, U.S. consumers materially adjusted their proportional household spend in order to prioritize certain goods and services over others. However, today’s environment is different in several ways.
Greater competition for spend: There are a number of goods which were
previously considered discretionary but are now considered essential and therefore are fighting for a wallet share, including broadband, mobile telephone and streaming services.
Latent demand for unavailable COVID-19 activities: Consumers have been prevented from travel and tourism activities. There is evidence that consumers are looking to travel more and prioritize that spend. In 2022, 60% of travellers planned on visiting a new desitination1. This makes it likely that consumers trade down in other areas of expenditure categories.
Source(s): Labor Turnover Survey (US Bureau of Labor Statistics); Morgan Stanley; CNN Business, OAG, Teneo Research & Analysis
Note:1Results from a survey in April and May 2022 via OAG’s flight tracking app
Beyond a reduction in spending, consumers are also more likely to ‘trade-down’ their current spending for cheaper alternatives.
Retailers that can demonstrate value for money are likely to win over trade-down customers.
Consumers May Switch to Cheaper Alternatives due to Current Economic Conditions
Signs of ‘trade-down’ behavior are emerging, with a consumer survey from September 2022 indicating that 70% of respondents indicated they were
trading down3.
In the event of persistently high inflation and low growth, it is likely that consumers will continue to ‘trade-down’ throughout 2023 to offset reduced real incomes.
For businesses to retain customers and protect against trade-down behavior, they need to be competing on the value for money they provide – offers and loyalty will become increasingly important.
In addition, unlike previous slowdowns, another emerging ‘trade-down’ market segment is poised to see significant gains:
Resale market growth: Increasingly environmentally aware consumers will look to save money by purchasing second-hand. The secondhand fashion market is set to grow by 26% across 20232.
Source(s): 3US Consumer Pulse Survey (Morgan Stanley); 2thredUP, Teneo Research & Analysis
Note:1Luxury segment tends to trend more regional than national, 2Corporate identifies discount stores separately to supercenters
Real Estate
Interest rate rises have had a major impact on the housing market with mortgage rates doubling in the last 12 months, resulting in steep declines in activity and falls in house prices.
Source(s): FRED Economic Data, Mortgage Bankers Association of America, Freddie Mac, Teneo Research & Analysis
Note:1Calculated using the average mortgage value of a house: $387,600 (Dec 2022) multiplied by the Avg. 30 year mortgage rate 2Forecast from Case-Shiller survey of 25 house pricing strategists
Industrials
Though initial warning signs are there, the industrial and manufacturing sector is likely to be more insulated than other industries due to pent-up demand, offsetting price pressure.
Purchasing Managers Index (PMI) Indicates the Industry is in Decline
PMI is a leading indicator, calculated using survey responses from purchasing managers in the U.S. economy, that gauges the outlook for the manufacturing sector based on five key components.
- Overall sector outlook is neutral/negative for 2023, as high order backlogs, easing supply chain pressures and margin tailwinds from recent price increases offset weaker macroeconomic growth.
- Pent-up demand has driven solid orders through Q3 2022 for most issuers, which should support mid-single digit sector revenue in 2023.
- Demand risks include China’s Zero Covid policy, the Russia-Ukraine conflict and capital spending.
PMI Underlying Components
In the manufacturing sector, downward pressures are coming from a lapse in new orders, production and supplier deliveries. Additionally, inflation pressure is driving up costs, though this is expected to lessen for 2023.
That being said, employment is expanding, and though inventory levels are unusually high, the risk of write-off is limited, largely due to products waiting on components for completion and companies holding higher a safety stock of key raw materials. Additionally, a backlog of orders is supporting growth.
Sources: ISM PMI, Teneo Research & Analysis
Aerospace and Aviation
Aerospace and aviation are highly cyclical businesses and are heavily connected to the state of the economy.
Key Features of the Airline Performance During Recessions
Cyclicality with GDP Growth: Airline profit cycles closely follow that of the economy, as aviation demand is primarily a consumption-led phenomenon – in 2009, at the height of the GFC, air traffic dropped 6.1%.
Lagged recoveries: Passenger numbers generally lag behind the recovery in industrial output due to reliance on employment and household incomes; this lag is exacerbated further for ‘premium’ class travel as opposed to ‘economy’ class.
Freight often recovers before passenger travel: As freight is linked inextricably to industrial output, and is typically a preferred mode of transport for shipping due to its low transit times, it often recovers first –during the GFC, freight began recovery four months before world trade and two months before industrial production.
Source(s): US Department of Transportation; (Franke and John, 2011) What comes next after recession? – Airline industry scenarios and potential end games, Teneo Research & Analysis
Aviation and aerospace players should see the looming recession as a considerable headwind.
Private Equity
Private equity houses have become accustomed to operating in low-interest rate and low-inflationary environments. The highly leveraged nature of this industry poses potential risks to the sector going forward.
Technology
Amid increasing interest rates, investors fail to see the value in technology stocks as the path to growth is unclear.
Comparisons
Previous U.S. slowdowns and recessions can inform the likely outlook of the next 12-18 months.
Comparisons to 2023:
- The Federal Reserve needs to balance boosting economic activity while maintaining inflation, which limits the extent to which expansionary monetary policy can be leveraged and may result in a prolonged period of challenge.
- A soft landing scenario most closely mimicking the dotcom crash, defined by a prolonged period of slow growth.
- A deep recession/long-term inflation scenario may be closer to the stagflation of the 1970s.
Businesses should seek to prepare for a prolonged high interest rate environment, unlike previous recessions.
Compared to Europe, the outlook for the U.S.’s GDP growth in 2023 has improved in recent months due to stronger economic performance.
For the majority of 2022, U.S. growth in 2023 was forecasted to be lower than that in Europe. This trend has reversed since Q4 2022. The U.S. is now expected to perform better than Europe throughout 2023 for several key reasons:
- U.S. response to inflation in 2022 was rapid – the Fed raised interest rates before other major economies.
- European dependence on energy from Russia meant that the 2023 outlook for real GDP in Europe has been further revised downwards as the conflict continues.
